What is a payroll deduction?
A payroll deduction is the wage that’s taken out of employees’ paychecks. It makes up the difference between an employee’s gross pay (the amount stated in their contract) and net pay (take-home pay).
The money from deductions is used for paying taxes, benefits like health insurance, or contributions to a retirement plan.
Your company’s benefits, state or local taxes, and employee withholding allowances will influence the amount and type of deductions you make.
These deductions fall into two categories: mandatory and voluntary.
Mandatory payroll deductions
As an employer, you’re responsible for withholding payroll taxes from your employee’s wages and submitting them to the IRS. These taxes are statutory deductions from employee payroll. If you don’t pay them, you will face penalties.
Two federal taxes are mandated by law: Federal Insurance Contributions Act (FICA) and federal income tax. You should state those taxes on Form 941 or Form 944 and deposit them electronically through electronic funds transfer (EFT).
Employers and employees contribute equally to FICA taxes, which go toward funding Social Security and Medicare.
Employees whose income is at or below the Social Security wage base are subject to a Social Security tax of 6.2%. Employees must also pay 1.45% of taxable wages for Medicare.
FICA deductions from an employee’s paycheck total 7.65%. As an employer, you are also responsible for contributing 7.65%.
FICA taxes go towards publicly funded care for the elderly and low-income individuals. Social Security tax covers retirees, disabled individuals, or families of deceased individuals. Medicare helps cover hospital inpatient care, skilled nursing, hospice, and home health care for Americans over the age of 65.
Federal income tax
Your employees’ gross income and Form W-4 information determine their federal income tax liability. Using the IRS’s Publication 15-T, you can calculate how much income tax to withhold from an employee’s paycheck.
State and local taxes
State and local taxes support public services, just as federal taxes do. But income tax structure varies from state to state. So, contact your state if you’re unsure how much you need to withhold from an employee’s paycheck for state and local taxes.
Wage garnishments may be necessary if an employee has an unpaid tax debt or is ordered to pay child support. The court or government agency will issue an order if you’re required to withhold garnishments from an employee’s paycheck.
Voluntary payroll deductions
Voluntary payroll deductions cover things like health insurance, disability benefits, and retirement plan contributions. To participate in your company’s available benefits, an employee must opt-in and consent to having a certain amount withheld from their paycheck. Here are a few standard voluntary payroll deductions, all of which are pre-tax (taken out before taxes and other mandatory deductions):
Health insurance premiums
Employees’ health insurance deductions will vary depending on what your business offers and the plan they select. Insurance coverage may include prescriptions, medical, dental, and vision.
If you offer a retirement plan such as a 401(k) or an Individual Retirement Account (IRA), your employee can choose to have their contributions taken directly out of their paychecks.
If you offer group-term life insurance, employees who opt-in will have their monthly premiums deducted from their paychecks.
How do you calculate payroll deductions?
No matter how big or small your company is, you’ll calculate payroll deductions the same way. You’ll follow these six steps:
- Withhold pre-tax contributions to your health insurance, 401(k) retirement plans, and other voluntary benefits (like health and wellness, financial wellness, personal benefits, and security) from gross pay.
- Calculate and deduct federal income tax using the employee’s W-4 form and IRS tax tables for that calendar year.
- Withhold 7.65% of adjusted gross pay for Medicare and Social Security taxes, up to the wage limit.
- Deduct 0.9% additional Medicare tax if the employee’s income was $200,000 or more during the past year.
- Withhold state income tax according to your state’s employer’s tax guide or tax code instructions.
- Finally, deduct any wage garnishments, Roth IRA retirement contributions, and other post-tax obligations to arrive at the employee’s net pay.
Tracking and calculating these deductions may feel like a daunting task. The IRS has an online calculator that can help calculate payroll deductions for you, or you can use cloud-based payroll software to do the work for you (which is what many small businesses do). We wrote a guide to some of the top payroll solutions that can help you decide.
One of the great things about payroll software is that providers must keep it updated to reflect new tax laws and regulations. This makes it easier to ensure that you’re always compliant.
Common payroll mistakes to avoid
Taxes are serious business at the IRS, and more than a third of small business owners are fined yearly for payroll tax mistakes. Note that no matter who handles your payroll, you as the business owner are legally responsible for all payroll taxes.
Here are a few mistakes to avoid:
Misclassifying employees and independent contractors
Whether it’s intentional or not, if you misclassify employees as independent contractors and fail to correctly withhold or pay the required amount of taxes, the IRS may flag your business and order you to pay back-taxes, on top of penalties for income taxes, Social Security, Medicare, and unemployment taxes.
To prevent misclassification (which is against employment law), it’s best to familiarize yourself with the IRS’s definitions. If you’re not sure, check with a tax professional.
Further reading: Independent Contractor vs. Employee: What’s the Difference?
Misclassifying exempt and non-exempt employees
For payroll purposes, it’s critical to know the difference between these two categories, which refer to whether an employee is eligible for overtime pay or not. Exempt employees don’t receive overtime pay for time worked beyond 40 hours, but non-exempt employees do.
To be exempt, an employee must:
- Earn a salary of at least $455 per week ($24,660 annually). In some states, the wage may be higher. For example, the minimum annual salary in California is $33,280.
- Hold a role high up in the company, with a job that directly affects the business’s operations.
It’s always a good idea to check your specific state laws just in case.
Miscalculating overtime pay
If your employee works more than 40 hours a week, you must pay them 1.5 times what they usually make (time and a half). Be sure to verify, as the rules can differ in each state and city. If you don’t pay the correct overtime rate, you’ll have to pay more to cover fines, interest, and penalties.
Miscalculating taxable income
It’s easy to forget to factor in applicable payroll taxes when paying unused vacation pay or overtime hours. Taxes still apply to vacation pay, sick pay, and overtime. To remit the proper payroll taxes, you should calculate it based on all taxable income (including extras) and any minimums or maximums caps that apply.
Missing payroll tax deadline
You’ll have to report payroll taxes every quarter, just like you pay your estimated taxes quarterly. You can report taxes and FICA to the IRS using Form 941. You can also report Federal Unemployment Tax Return (FUTA) taxes using Form 940.
Deadlines may vary from state to state, so be sure to check with your state government. If you miss a deadline, late fees typically range from two to ten percent.
Helpful resource: When are Taxes Due? 2022 Filing and Extension Deadlines
Paying the wrong tax rates
If you pay the wrong annual tax rate, you’ll be accountable for the missing tax on top of interest and a fine. Check the current tax rates at Publication 15 (Circular E) — The Employer’s Tax Guide.
Paying the wrong state taxes
There’s a chance you may be paying the wrong state taxes for your employee if they live in a different state than the one where they work. Be sure to pay according to the state they live in, not the one they work in, if they’re different.
How Bench can help
As America’s largest professional bookkeeping service for small businesses, we can take care of your bookkeeping and tax filing while you focus on running your business.
Your bookkeeping and accounting become more complex when your business grows from a sole proprietorship to one with employees. Bench can help ensure you’re able to spend time managing your growing company—not poring over your books every month.
Along with monthly bookkeeping, the Bench team also prepares a tax-ready year-end financial package for every client, making tax time easy.
The bottom line
Managing payroll is significant from a tax perspective—for both your business and your employees. Taking the steps necessary to process your payroll accurately and efficiently, and understanding the different payroll deductions, will give you peace of mind that you’re complying with government regulations and running your business successfully.