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Payroll deductions are wages withheld from an employee’s total earnings for the purpose of paying taxes, garnishments and benefits, like health insurance. These withholdings constitute the difference between gross pay and net pay and may include:
- Income tax
- Social security tax
- 401(k) contributions
- Wage garnishments1
- Child support payments
Some payroll deductions are voluntary and may be taken out of a paycheck on a pretax or post-tax basis as long as the employee provided written authorization. Taxes and wage garnishments, on the other hand, are mandatory and employers who fail to accurately withhold these deductions may be liable for the missing amounts.
How do payroll deductions work?
Payroll deductions are generally processed each pay period based on the applicable tax laws and withholding information supplied by your employees or a court order. The calculations can be done manually or you can automate the process using a payroll service provider. Many businesses choose automation because it reduces errors and ensures that payments are filed with the proper authorities on time.
The amount you withhold for each employee depends upon the individual’s Form W-4 Employee’s Withholding Certificate, state and local withholding certificates, benefit selections and other details. For instance, has the employee enrolled in your health insurance plan or is there a court-ordered garnishment to comply with?
Your place(s) of business and where your employees perform services also play a factor in payroll deductions because not every state collects income tax.
Pretax deductions are taken from an employee’s paycheck before any taxes are withheld. Because they are excluded from gross pay for taxation purposes, pretax deductions reduce taxable income and the amount of money owed to the government. They also lower your Federal Unemployment Tax (FUTA) and state unemployment insurance dues.
Types of pretax deductions include, but are not limited to, health insurance, group-term life insurance and retirement plans. And while employees are not required to participate, it’s often in their best interest to do so. Pretax contributions can save them considerable money compared to what they would pay for benefits and other services post-tax.
The savings, however, are not limitless. There are usually caps on how much employees can contribute on a pretax basis. The IRS, for instance, regulates the total amount that can be deferred pretax to a 401(k)-retirement plan each year.
Statutory deductions are mandated by government agencies to pay for public programs and services. They consist of federal income tax, Federal Insurance Contributions Act (FICA) tax (Medicare and Social Security) and state income tax. To file them correctly, you need to know the work status of your employees.
If you hire independent contractors, you usually don’t have to withhold income tax, Social Security tax or Medicare tax from their wages. That’s because these types of workers pay self-employment tax on their income. On the other hand, if someone is a bona fide employee, you’re required to deduct the necessary taxes. You can submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding to the IRS for further assistance.
FICA taxes support Social Security and Medicare. Employees pay Social Security tax at a rate of 6.2% with a wage-based contribution limit and they pay Medicare tax at 1.45% without any cap. This equals 7.65% in FICA taxes per paycheck (until the Social Security wage base is reached), which you are legally obligated to match.
Some employees may also be subject to Additional Medicare tax. Starting with the pay period in which an individual’s earnings exceed $200,000, you must begin deducting 0.9% from his or her wages until the end of the year. Additional Medical Tax also applies to certain levels of railroad retirement compensation and self-employment income. You’re not required to match this deduction.
Federal income tax
The federal government has seven income tax brackets, ranging from the 10% marginal rate to 37%. These rates are applied progressively, which means that an employee’s wages are first charged at the lowest rate until they reach that bracket’s threshold. They continue to be charged at each subsequent rate until they reach their total gross income or the highest tax bracket.
The taxable income in each bracket varies depending on the individual’s filing status – single or married filing separately, married filing jointly, or head of household – which is noted on Form W-4. Yearly adjustments for inflation by the IRS will also determine the tax bracket thresholds.
To withhold federal income tax each pay period, you generally have two options – the wage bracket method or the percentage method – both of which can be found in IRS Publication 15-T.
State and local taxes
State income tax laws vary widely, ranging from simple to complex. Some charge a fixed rate against all income, others have multiple tax brackets and a few charge no income tax at all. Still others follow the federal tax code instead of creating their own. For these reasons, you should consult with all the state governments you operate in to make sure your payroll complies with local regulations.
Post-tax deductions are taken from an employee’s paycheck after all required taxes have been withheld. Since post-tax deductions reduce net pay, rather than gross pay, they don’t lower the individual’s overall tax burden. Common examples include Roth IRA retirement plans, disability insurance, union dues, donations to charity and wage garnishments. Employees can decline to participate in all post-tax deductions but wage garnishments.
Courts, regulatory agencies and the IRS may order you to withhold a portion of an employee’s post-tax or net wages to cover unpaid taxes, child support, alimony or defaulted loans. The types of income that can be garnished include:
- Hourly wages
- Pensions and retirement plan payments
The garnishment order will typically specify the withholding amount or percentage of withholding and where to send payment. Read and understand these documents carefully. If you deduct garnishments incorrectly or fail to pay them entirely, your business could be liable for the back payments, not the employee.
In addition to the garnishment order itself, you must abide by Title III of the Consumer Credit Protection Act (CCPA). This law restricts how much of an employee’s wages can be garnished per week and prevents you from firing an employee if his or her pay is garnished for any one debt.
Employees may choose to have more money taken out of their paycheck to cover the cost of various benefits. These are known as voluntary payroll deductions and they can be withheld on a pretax basis (if allowed under Section 125 of the Internal Revenue Code) or post-tax basis.
Because voluntary deductions are optional, you should make sure your employees are fully aware them. Obtain an employee’s written consent before withholding insurance premiums or any other benefit from their pay. Also, display the current deduction and the year-to-date total on every pay statement and keep accurate records in case an employee or auditor questions a deduction. Many states require this as part of their recordkeeping regulations.
Types of voluntary payroll deductions include:
Offering medical, dental and vision coverage to your employees is a great way to improve retention and attract new talent, but you don’t want the cost to be burdensome. It’s is usually more advantageous for both you and your employees to pay insurance premiums on a pre-tax basis. If you wish to do so, the IRS requires that you make the contributions through a Section 125 plan.
Group-term life insurance
Some employers make basic term life insurance available to their employees at no additional cost up to $50,000 of coverage. Anything more than this will result in imputed income. If employees want to add supplemental coverage or purchase life insurance for a dependent, you typically deduct these funds from their pay on a post-tax basis.
Employers offer many different retirement saving options, but two of the most popular are 401(k) and Roth Individual Retirement Accounts (IRA). Employee contributions to a 401(k) are deferred for federal income tax and most states income tax, but are subject to FICA taxes. IRA contributions, on the other hand, are withheld on a post-tax basis.
If your employees are unionized, they’ll likely have to pay for their membership and any taxable benefits offered through the union. Other types of job expenses that can be deducted from payroll include uniforms, meals and travel. Some states, however, may prohibit these kinds of deductions.
How to calculate payroll deductions
Calculating payroll deductions is the process of converting gross pay to net pay. To do this:
- Adjust gross pay by withholding pre-tax contributions to health insurance, 401(k) retirement plans and other voluntary benefits.
- Refer to the employee’s Form W-4 and the IRS tax tables for that year to calculate and deduct federal income tax.
- Withhold 7.65% of adjusted gross pay for Medicare tax and Social Security tax, up to the wage limit.
- Deduct 0.9% for Additional Medicare tax if year-to-date income has reached $200,000 or more.
- In states that charge income tax, withhold it according to the instructions found in each state’s employer’s tax guide or tax code.
- Subtract garnishments, contributions to Roth IRA retirement plans and other post-tax dues to achieve the total net pay.
Payroll deductions calculator
Payroll deduction FAQs
Knowing when and how to make payroll deductions isn’t always easy and mistakes can be costly. Our frequently asked questions can help you avoid compliance violations.
What are examples of incorrect payroll deductions?
Incorrect payroll deductions are often the result of employers charging their employees for benefits and services that they should be paying themselves. This includes:
- Federal unemployment tax (FUTA)
- State unemployment tax
- Workers’ compensation insurance
- Personal protective equipment required by OSHA
- Tools necessary to perform work
There may be additional restrictions at the state level on withholding income to cover uniforms, cash register shortages and job-related expenses.
What are payroll deductions for insurance?
Many Americans who have health insurance purchase it through their employers via payroll deductions. This offers considerable cost savings because the premiums can be withheld from their wages on a pre-tax basis under a Section 125 plan. In actuality, however, employees are not paying for their health coverage directly, but are reimbursing their employer, who submits payment to the health insurance provider.
How are payroll deductions reported?
When reporting employee tax withholdings and filing the required employer tax payments to the federal government, you typically use the following forms:
- Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return
- Form 941, Employer’s QUARTERLY Federal Tax Return
- Form 944, Employer's Annual Federal Tax Return
These documents can be submitted via paper or e-file. Individual states have their own guidelines for reporting payroll deductions, so it’s important to check with your local authorities.
What are examples of payroll deductions?
Payroll deductions fall into four different categories – pretax, post-tax, voluntary and mandatory – with some overlap in between. For instance, health insurance is a voluntary deduction and often offered on a pretax basis. Specific examples of each type of payroll deduction include:
- Pre-tax deductions: Medical and dental benefits, 401(k) retirement plans (for federal and most state income taxes) and group-term life insurance
- Mandatory deductions: Federal and state income tax, FICA taxes, and wage garnishments
- Post-tax deductions: Garnishments, Roth IRA retirement plans and charitable donations
- Voluntary deductions: Life insurance, job-related expenses and retirement plans
What is the LTD deduction on paychecks?
The long-term disability (LTD) deduction covers a percentage of wages for employees who are injured or too sick to work for an extended period of time. When LTD is deducted pre-tax, employees pay slightly less for premiums, but are charged federal income tax on any benefits received. Post-tax LTD deductions, on the other hand, result in employees receiving slightly less take home pay each pay period, but their benefits aren’t subject to any further tax if they use them. Short-term disability (STD) is often taxed in the same manner.
This guide is intended to be used as a starting point in analyzing an employer’s payroll obligations and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
Tax figures provided are as of the 2020 tax year
1Amount subject to withholding is governed by the federal Consumer Credit Protection Act.
Important note on the salary paycheck calculator: The calculator on this page is provided through the ADP Employer Resource Center and is designed to provide general guidance and estimates. It should not be relied upon to calculate exact taxes, payroll or other financial data. These calculators are not intended to provide tax or legal advice and do not represent any ADP service or solution. You should refer to a professional advisor or accountant regarding any specific requirements or concerns.