Ultimate Guide to Payroll Deductions: What, How & When (2024)

The purpose of this guide is to answer your questions regarding payroll deductions. This is to help you understand which deductions need to be included in payroll processing so you can stay compliant and pay your employees the correct amount.

Understanding Payroll Deductions

Payroll deductions are defined as wages an employer withholds from an employee’s total earnings to fulfill financial obligations like taxes, garnishments, and benefits. These deductions represent the difference between gross pay and net pay — the salary the employee receives after the deductions.

How do Payroll Deductions Work?

Payroll deductions need to be calculated and processed before each pay period. Depending on the employer’s payroll schedule, this can be weekly, bi-weekly, or monthly. The amount deducted depends on the applicable tax laws, garnishments, benefits the employee is rolled in, and the individual’s Form W-4 Employee Withholding Certificate.

While these deductions can be calculated manually, most businesses opt to automate them with payroll software. The automation minimizes the chances of human error, speeds up the entire process, and ensures all the required information is filed, and payments are made to the appropriate authorities on time.

Examples of Payroll Deductions

There are many different kinds of payroll deductions, but they can be broadly divided into two categories — mandatory (involuntary) and voluntary deductions. Another important categorization splits them into pre-tax and post-tax deductions.

Here’s a quick breakdown of the four major payroll deduction categories:

Mandatory Deductions

Mandatory deductions are the ones that employers are required by law to withhold from employees’ wages. They include the following:

  • Local income tax
  • State income tax
  • Federal income tax
  • Social Security and Medicare (i.e., FICA — Federal Insurance Contributions Act) taxes
  • Court-ordered child support payments

One thing worth noting is that if you work with contractors, you typically aren’t required to pay income and FICA taxes, given that these individuals pay their own self-employment taxes.

All mandatory payroll deductions are pre-tax.

Voluntary Payroll Deductions

Voluntary payroll deductions are optional, meaning the employees must be fully aware of the deductions and authorize them before they are applied. The written authorization must include the date, deduction reason, the amount of money deducted, and the employee’s signature.

These types of deductions typically cover the various benefits employees can access, and they can be both pre-tax and post-tax. Here are the most common examples of voluntary payroll deductions:

  • Health insurance premiums
  • Life insurance
  • Work uniform and/or tools
  • Tuition and/or certification deductions
  • Short-term disability plans
  • Retirement or 401(k) plan contributions
  • Workplace charity donations

Voluntary deductions are beneficial for both the employer and the employees. On the employer’s side of things, you can offer group rates and retain top performers by offering a variety of useful benefits at a lower cost. As far as employees are concerned, in addition to the benefits they receive, voluntary payroll deductions lower their taxable income, so they’re a win-win.

Pre-Tax Payroll Deductions

Pre-tax payroll deductions, as the name suggests, are deducted from the employees’ wages before any taxes are withheld. Put simply, they are excluded from gross pay for taxation purposes, meaning that they reduce the amount of income the employee has to pay taxes on.

Pre-tax payroll deductions typically include:

  • Health insurance premiums (group health insurance, dental insurance, vision insurance)
  • Health savings accounts (HSA) and flexible spending accounts (FSA)
  • Life insurance
  • Dependent care benefits
  • Commuter benefits and parking permits
  • Retirement plan contributions — 401(k), 403(b), Thrift Savings Plans

Post-Tax Payroll Deductions

Post-tax payroll deductions are applied and deducted from an employee’s paycheck after all the required taxes have been withheld, meaning they reduce net pay. Aside from wage garnishments, all after-tax payroll deductions are voluntary and can be declined by the employee.

Post-tax payroll deductions commonly include:

  • Garnishments — Issued by a court, a regulatory agency, or the IRS. These deductions must be withheld from an employee’s paycheck to cover unpaid taxes, child support, alimony, and/or defaulted loans.
  • Life insurance — For supplemental coverage or dependents
  • ROTH 401(k) savings — An employer-sponsored retirement savings account
  • Disability insurance
  • Charitable contributions

How to Calculate Payroll Deductions

Calculating payroll deductions may seem like a daunting task. However, it’s necessary to ensure that your business complies with all the applicable tax laws and regulations and that your employees are paid the correct amount.

The process involves the following steps:

  1. Withhold any pre-tax contributions from gross pay — This includes all health insurance premiums, retirement plans, and other benefits your business offers
  2. Refer to an employee’s filled-out W-4 Form and the IRS tax tables in Publication 15-T to calculate and deduct federal income tax
  3. Withhold Medicare and Social Security taxes up to the wage limit
  4. Withhold state income tax, following your state’s employer’s tax guide
  5. Deduct any wage garnishments and post-tax obligations to end up with the employee’s net pay

How are Payroll Deductions Reported

Depending on the employment status of your workforce, you may be required to file different forms to report your payroll deductions. The forms are all filed to the IRS (either mailed or filed electronically), and they include:

  • Form 940 — Reporting federal unemployment taxes withheld (unemployment compensation for workers who have lost their jobs); filed annually
  • Form 941 — Total amount of taxes withheld from your employees’ patches; filed quarterly
  • Form 944 — Total amount of taxes withheld for Social Security, Medicare, and federal income taxes, provided they are under $1,000; filed annually
  • W-2 — Total amount of income earned and taxes withheld for the tax year; filed annually for each employee for whom income, Social Security, and/or Medicare tax was withheld

Conclusion

Processing payroll is a rather complex ordeal, with many different calculations that must be taken into account. As a business, you must pay the correct amount of payroll taxes to avoid penalties and hefty fines. Additionally, you need to ensure that all your employees are paid the correct amounts on time to avoid payroll disputes, ensure job satisfaction, and retain your workforce.

The best way to go about calculating payroll deductions and processing payroll is to either hire a payroll professional or utilize a payroll software solution to automate and simplify the process. We recommend doing both — hiring an accounting professional as a core part of your team and having them rely on payroll software to ensure the accuracy of all payroll and tax calculations and streamline tax filing and payroll processing.

FAQs

What are examples of incorrect payroll deductions?

What are payroll deductions for insurance?

When can an employee change their voluntary deductions amount?

What are the 4 paycheck deductions?

What is the standard deduction for the payroll taxes?

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Aleksandar Stevanovic
Software Reviews Expert

Aleksandar Stevanovic spent 10 years honing his craft as a freelance content writer. He has a degree in Economics, and extensive experience in software, crypto, and cybersecurity industries. He covers a multitude of topics, writing factual and informative articles, helping individuals better understand the intricacies of the online world. Over the last two years, his research focus shifted more towards tech and software content, as evidenced by his publications on CEX.IO, Business2Community, and Techopedia. He believes in simplifying complex topics and bringing them closer to like-minded individuals. His work is as detail-oriented as it is creative, and is designed to…