The Complete Guide To Payroll Deductions
Understand which payroll deductions are voluntary and mandatory in our easy-to-follow guide on payroll deductions.
Running payroll is more complicated than simply calculating employee earnings and cutting a check every pay period. Employers are also responsible for ensuring deductions are correct and taken out of an employee’s paycheck in a timely manner.
Payroll deductions can be mandatory or voluntary, and differ in whether they need to be made pre- or post-tax. To help make sense of it all, this guide will introduce common payroll deductions, break down their requirements, and explore methods for calculating federal withholdings.
Table of Contents
What Is A Payroll Deduction?
A payroll deduction is money withheld from an employee’s earnings each pay period to pay for taxes, benefits, or garnishments. Taken altogether, payroll deductions represent the gap between an employee’s gross pay and net pay.
Some leading examples of payroll deductions include the following:
- Income tax
- Social Security tax
- 401(k) contributions
- Child support
- Medical, dental, and vision insurance premiums
Mandatory Payroll Deductions
Employers are required by law to withhold certain payroll deductions and submit them to tax agencies. Failure to pay payroll taxes in full and on time may result in fees and penalization from the IRS.
To get started with mandatory payroll deductions, it’s helpful to determine the work status of each employee. Generally, employers do not have to handle payroll deductions for independent contractors, just their employees.
If your employees qualify, you’ll need to complete the following payroll deductions:
Federal Income Tax
A percentage of an employee’s earnings are taxed by the federal government. The 2020 tax rate (those due April 15, 2021) includes seven brackets, ranging from 10% to 37%. An individual’s tax rate is determined by income and filing status, which can be found on an employee’s W-4 form.
Employees making less than $9,875 that file as single — or separately from a spouse — have a 10% tax rate. If they’re the head of the household or filing jointly, the 10% threshold increases to $14,100 and $19,750, respectively.
To qualify for the 37% tax rate, an employee would have to make $311,026 if filing separately from a spouse, $518,401 if filing as single, or $622,051 if filing jointly.
Keep in mind that the IRS can update the income range for tax brackets every year.
The Federal Insurance Contributions Act (FICA) tax is more commonly referred to by its two subcomponents: Social Security and Medicare. This federal withholding is split evenly between an employee and employer.
Instead of the tax bracket system, FICA taxes are calculated as a flat rate of an employee’s income. The Social Security tax rate is 6.2% and Medicare is 1.45%, making a total payroll deduction of 7.65% from an employee’s earnings.
The FICA tax rate does have a couple of caveats for higher-earning employees. Social Security tax has a wage base limit, which constitutes the maximum earnings that are subject to the 6.2% withholding. For 2020 earnings, the Social Security wage base is $137,700, while the 2021 limit increases to $142,800.
Regardless of filing status, employees earning over $200,000 annually must have the 0.9% Additional Medicare Tax withheld too. This added tax only applies to wages exceeding the $200,000 threshold.
State & Local Taxes
Tax structures vary greatly by state. As of early 2021, nine states have no income tax on wages or salaries, while others employ a flat or graduated-rate income tax.
Additional local income taxes can be imposed in 17 states. Depending on the state, these can be levied by counties, municipalities, school districts, and other special districts.
Unless your employees live in Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, or Wyoming, it’s important to check with state and local government tax authorities.
After federal withholdings and requisite taxes have been taken care of, some employees may need garnishments withheld too. Mandatory garnishments are usually issued by court order or government entity. Some common types of garnishments are alimony, child support, or unpaid debt.
Employers should expect to be notified if wage garnishments are required for an employee, including the amount or percentage of earnings to be withheld and where it needs to be sent. Employee earnings in the form of hourly wages, salaries, commissions, bonuses, and benefits contributions may be subject to garnishments.
Voluntary Payroll Deductions
A voluntary payroll deduction can be arranged if an employee gives consent to have money withheld from their paycheck for certain employee benefits or workplace expenses.
Section 125 of the Internal Revenue Code outlines types of employee benefits, such as health insurance, that can be deducted before taxes. Other voluntary payroll deductions can be done on a post-tax basis. Depending on the benefits package, organization, and employee preferences, these deductions may include:
- Life Insurance: Employees may have up to $50,000 in coverage through a group term life insurance policy without taxation. If an employee decides to take on additional coverage, the premium may be withheld after taxes.
- Retirement Plans: Employees can opt to have contributions to a 401(k) or IRA withheld after taxes.
- Union Fees: If unionized employees have membership dues and benefits, these payments can be taken out as a voluntary payroll deduction on a post-tax basis.
- Workplace Expenses: Some work-oriented expenses, like a cafeteria plan or commuter benefits, can be deducted before taxes. Other job-related expenses, such as uniforms, may be withheld, but eligibility varies between states.
Federal Income Tax Withholding Methods
Of all the payroll deduction calculations, federal income tax is arguably the trickiest. First, you’ll need to refer to your employees’ W-4. From there, there are several federal income tax withholding methods to do the calculation, including the following:
- Percentage Method For Automated Payroll: Employers with automated payroll systems can use worksheet 1 on the 15-T form for past, current, and future W-4s. This method will work for any amount of employee earnings, as well as any number of allowances for W-4 forms from 2019 or earlier.
- Wage Bracket Method For Manual Payroll From 2020 On: The wage bracket method determines withholdings according to W-4 filing status and gross pay. First, identify the table that fits your payroll schedule (weekly, biweekly, etc.). Then, employers simply locate the intersection of the wage rate range and applicable filing status to figure out the tentative withholding amount. Worksheet 2 only applies to W-4s from 2020 and later.
- Wage Bracket Method For Manual Payroll From 2019 Or Earlier: This version of the wage bracket method operates essentially the same, but should only be used for employees that have not submitted a W-4 since 2019 or earlier. Take note that the wage bracket method is limited to employees earning $100,000 or less.
- Percentage Method For Manual Payroll From 2020 On: For employees earning greater than $100,000 and claiming more than 10 allowances, the wage bracket method table won’t do. To do the calculation, employers must identify the correct adjusted wage amount range and then multiply the tentative withholding by the percentage provided in worksheet 4.
- Percentage Method For Manual Payroll From 2019 Or Earlier: If an employee hasn’t submitted a W-4 for 2020 or beyond and makes six figures, IRS worksheet 5 can walk employers through the calculations to determine withholdings.
- Alternative Methods: There are additional options for calculating how much federal income tax to withhold from your employees. Some examples include:
- Annualized Wages: Using the percentage method tables and worksheet for automated payroll, employers can determine the necessary withholding based on the annualized wages.
- Average Estimated Wages: A pay period’s withholdings can be calculated according to estimated average wages for any quarter.
- Cumulative Wages: Employees who have larger fluctuations in earnings between pay periods, such as commissioned salespersons, may ask to have their withholdings calculated on a cumulative basis.
- Part-Year Employment: Seasonal or short-term workers employed for fewer than 245 days of a calendar year can request employers to use the part-year employment method. Essentially, this method calculates deductions based on the assumption that earnings are spread throughout the entire year rather than just a portion.
Top Tip: Use Payroll Software To Calculate Payroll Deductions
Payroll represents just one of many responsibilities that business owners have to juggle. Although calculating federal withholdings and payroll deductions in-house can save money, it can be time-consuming and leaves employers liable for fines and penalties if they make errors.
Instead, investing in payroll software can streamline the process and get you back to running your business. An entire industry has come about to fill the need, giving businesses plenty of options to choose from.
Smaller businesses looking for a straightforward payroll solution that integrates benefits administration might want to consider Gusto. Companies with 50 or more employees may prefer ponying up for ADP’s advanced employee management features and 24/7 customer support.