Payroll 101: What to Know About Payroll Deductions
Once you've established the payroll basics, you must learn how to withhold, remit and file various payroll taxes.
From payroll deductions to pay periods, setting up a payroll system can involve numerous moving parts. Having a good system in place can help make payroll an efficient and worry-free process.
When setting up a payroll system, think first about how frequently employees will be paid. You may need to check local laws, as some states have specific pay frequency requirements. Consult the chart provided by the Department of Labor and get in contact with your state and local labor departments.
There are also tax-related matters that must be settled before starting payroll. 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 are living and working. 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 appropriate DOL guidelines. Also check applicable state agencies who may have their own criteria, as misclassifying a worker can result in costly penalties and other administrative actions.
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 Emily Hofmann, senior support services specialist at ADP. Of course, this requires small business owners to keep their paperwork in order for the payroll service provider.
In addition to taxes and other mandatory deductions and withholdings, employees may want or need to have other deductions withheld from their paychecks. For instance, certain administrative orders may require you to garnish employee wages for child support, tax levies or student loans. "The most important thing to remember with any garnishment is to carefully read the garnishment order," Hofmann 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, failure to garnish means that the business (not the employee) ends up responsible for the full balance of the garnishment.
There are also voluntary payroll deductions that an employee may ask you to withhold from their check. Common voluntary deductions include contributions to retirement accounts, payments for loans and payments for insurance premiums. But various regulations apply: For instance, medical and other benefit deductions (dental, vision, etc.) 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 all 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," Hofmann says. "All deduction information should be shown on the employee's pay stub Ñ this makes it easy for them to see what has come out of their paycheck and what has been withheld year-to-date. Keep thorough records in case of an inquiry from an employee or an auditor." This is why it's important to be aware of all federal and local requirements about employee wage statements and payroll records. States also have rules about what must be included on each statement.
Managing payroll may seem daunting, but it doesn't have to be a struggle, "as long as a business owner is organized; keeps good records in accordance with federal, state and local rules; and understands how and when taxes and deductions need to be withheld and paid," Hofmann says.
See part five of Payroll 101: Is It Time to Get Help With Payroll?
If you are unsure about what your state or federal law requires, you should check with your tax and legal counsel.