Payroll Deduction 101: What You Need to Know
Setting up a payroll system can involve many moving parts and special considerations. HR leaders can make payroll a streamlined and worry-free process by having a proper system in place.
From payroll deductions to pay periods, setting up a way to pay your employees can involve numerous moving parts. Having a good system in place can help make payroll an efficient and worry-free task. However, before developing a payroll process, it's important to understand the meaning of payroll deductions and how they work.
What is a payroll deduction?
A payroll deduction is any part of an employee's earnings withheld by an employer to pay for taxes, benefits or garnishments. It's what makes the difference between gross pay and net pay and may include Social Security tax, 401(k) contributions, wage garnishments, child support payments and more.
Payroll deductions can be voluntary or mandatory. Voluntary payroll deductions — such as health insurance, group-term life insurance, retirement plans and job-related expenses — can be taken out of a paycheck either pre- or post-tax. Because voluntary deductions are optional, HR leaders should make sure their employees are fully aware of them. This can be done by obtaining an employee's written consent before withholding insurance premiums or any other benefit costs from their pay. HR should 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 record-keeping regulations.
Mandatory deductions include federal and state income taxes, FICA taxes and wage garnishments. Employers who fail to accurately withhold these deductions may be liable for the missing amounts.
How does a payroll deduction work?
Generally, payroll deductions are processed each pay period based on the applicable tax laws and withholding information supplied by your employees or a court order. Payroll calculations can be done either manually or automatically by using a payroll service provider. Automation is a popular choice because it reduces errors and ensures that payments are filed with the proper authorities on time.
The withholding amount for each employee will depend on the individual's federal Form W-4 as well as state and local withholding certificates, benefit selections and other details. Keep in mind, the place where your business resides and where your employees perform services also play a factor in payroll deductions because not every state collects income tax.
Getting started
When setting up a payroll system, think first about how frequently you will pay your employees. You may need to check local laws because some states have specific pay frequency requirements. Consult the chart provided by the U.S. Department of Labor and contact your state and local labor departments.
Tax-related matters also must be settled before starting payroll. For instance, all employees must provide appropriate tax ID numbers. The Internal Revenue Service (IRS) can provide you with an employer tax ID number as well as the income tax withholding and unemployment IDs for the states where your employees live and work. In addition, some states have local tax jurisdictions that require ID numbers.
Before paying anyone through payroll, make sure you have classified each worker correctly as either an employee or an independent contractor. If you're not sure how to classify a worker, check the IRS's criteria and the U.S. Department of Labor guidelines as well as any state agencies that may have their own criteria. Misclassifying a worker can result in costly penalties and other administrative actions.
Understanding withholding
Once you've established the payroll basics, you must learn how to withhold, remit and file various payroll taxes. "Using a payroll service provider is beneficial because they will withhold the correct tax amounts, deposit them at the proper time and complete the quarterly and annual tax filings for each jurisdiction," says Diana Yarbrough, DVP of HR, ADP. Of course, this requires business owners to keep their paperwork for the payroll service provider.
In addition to taxes and other mandatory deductions and withholdings, employees may have other deductions withheld from their paychecks. For example, certain administrative orders may require you to garnish employee wages to pay for child support, tax levies or student loans.
"The most important thing to remember with any garnishment is to carefully read the garnishment order," Yarbrough says. "This document should provide the amount to be withheld and any restriction on wages as well as where to remit payment. If anything within the order is unclear, it is best to contact the agency directly to avoid any type of penalty." In some cases, a failure to garnish means that the business (not the employee) ends up being responsible for the full balance of the garnishment. A payroll service provider can also assist with this process.
Payroll deduction considerations
An employee may ask you to withhold voluntary deductions from their check. Common ones include retirement account contributions, loan payments and insurance premiums. Take note that various regulations may mean timing the deductions before or after taxes. For instance, medical and similar benefit deductions can be withheld either after taxes or, if the contributions are made through a section 125 plan, before taxes. Deductions into a 401(k) account will lower an employee's taxable wages, but contributions into a Roth IRA are made after taxes are paid.
"Always make sure to have all the proper documentation before withholding anything other than taxes from an employee's paycheck, whether it is a copy of a garnishment order or their signature acknowledging that insurance premiums will be deducted," Yarbrough says.
Yarbrough advises showing all deduction information on the employee's pay stub, including the amount withheld year-to-date, to make it easy to see what has come out of their paycheck. Hofmann suggests keeping thorough records in case of an inquiry from an employee or an auditor. Ultimately, it's a best practice for HR leaders to stay organized, comply with federal, state and local records requirements, and understand how (and when) taxes and deductions need to be withheld and paid. These actions can solidify an organization's payroll deduction process and make it less of a struggle for administrators.
