Types of payroll deductions

There are several types of deductions that you’re required to make on your employees’ behalf. Understanding how these deductions work ensures that you can avoid errors and pay your workers the exact amount they’re owed. Deductions fall into the following categories:

• Pre-tax deductions: The money withheld for these deductions reduces an employee’s taxable income, which has an impact on how much you’re required to withhold for taxes.
• Income taxes: You’re required to withhold tax for your employees based on their taxable income and the number of deductions they’ve claimed on theirtax forms.
• Statutory deductions: In addition to taxes, workers must pay for their Social Security, Medicare and other federal and state programs. This is referred to as FICA and while it’s not technically a tax, it’s required to fund retirement programs and services later in life.
• Post-tax deductions: These deductions are removed from an employee’s pay after all taxes and statutory deductions have been paid. They can include child support or wage garnishments that the courts have ordered.
• Voluntary deductions: Your employees may ask to have extra contributions made to their taxes, retirement programs, or other programs that you offer as part of your benefits package. Some of these contributions are handled on a pre-tax basis, while others aren’t. Understanding the nature of each deduction ensures accuracy when running payroll.

Pre-tax deductions

Offering your employees benefits that reduce their taxable income can help your bottom line. When you withhold money on a pre-tax basis, you’re also reducing what you’re going to have to contribute to FICA and FUTA. Here are some examples of deductions that employees can have withheld before taxes.

Health Insurance

If you offer a group health plan, your employees’ portion of premiums can be withheld from their pay before taxes are considered. Many people would prefer this because it gives them an advantage annually when they file their taxes. You’re also able to offer an FSA to supplement your group health insurance, allowing employees to deduct a portion of their annual medical expenses from their taxes. To offer health insurance and supplementary savings programs on a pre-tax basis, you’re required to do so through a Section 125 plan.

Retirement plans

The way withholding is handled for a retirement account depends on the type of account and the federal limits on pre-tax contributions. The most popular retirement accounts include the following:

• 401 (k): Contributions to a 401 (k) account can be made on a pre-tax basis up to the IRS limit for that year. Employees are still required to pay FICA on income that is withheld into a 401 (k), but this money is not subject to federal or state income taxes.
• Roth IRA accounts: A Roth IRA is a special type of retirement account that allows employees to pay taxes on the money they contribute upfront and then withdraw it tax-free upon retirement. When withholding money for a Roth IRA, it’s to be treated as taxable income for the purpose of federal and state income taxes, FICA and FUTA.

Pay close attention to the withholding and contribution limits outlined by the IRS when managing your employees’ retirement accounts. Employer contributions to a retirement account are considered pre-tax deductions and aren’t taxable for the purpose of federal and state income taxes, FICA and FUTA. There’s often a limit on how much an employer matches annually, but employees may elect to contribute more voluntarily.

Life insurance

Premiums for term life insurance plans up to $50,000 of coverage may be withheld on a pre-tax basis, while anything more is considered a post-tax deduction. Many employers offer to cover the cost of the first $50,000 worth of coverage, but employees may feel that this isn’t sufficient or wish to add people to their policy. They’re not able to see any tax benefits for these voluntary deductions, however.

Income tax payroll deduction

When withholding taxes, you’re going to have to account for federal taxes, state taxes and local taxes in some places. For the correct tax payroll deductions, you need to have your employees fill outForm W-4and state their marital status, number of deductions they’d like to claim, whether they are filing taxes jointly or as the head of household. There are also two popular ways that businesses use to calculate withholding for taxes.

The first is the bracket method. To calculate withholding using this method, you’d determine which income tax bracket each employee falls into and apply taxes progressively as the employee passes through each bracket. The other method is the percentage method. Employers using this method withhold a predetermined percentage of their employees’ income after estimating their tax liabilities.

To review these methods and learn how to use them to calculate tax withholding amounts, you should refer toIRS Publication 15-T.

Statutory deductions

FICA contributions go into the Social Security and Medicare programs. These aren’t technically taxes since they’re paid back to taxpayers during retirement, but they are mandatory deductions that must be withheld from each employee’s pay. Social Security tax is 12.4% of an employee’s income up to a maximum of $137,000 per year. As an employer, you’re required to split the cost of your employees’ Social Security.

Medicare contributions are deducted at a rate of 1.45% with an added 0.9% after an employee’s income exceeds $200,000 per year. You’re not required to match Medicare contributions. FICA isn’t considered a pre-tax deduction, so it’s calculated after you’ve made all of the deductions required to your employee’s taxable income. Many businesses are able to save money on their legal obligations by offering Section 125 plans and other ways for employees to reduce their taxable income because it reduces the required FICA matching.

Post-tax deductions

Some employees have financial obligations that must be met due to a court order. When this occurs, you’re required to withhold the mandated portion of the employee’s income after you’ve withheld money for insurance, FSA accounts, retirement, taxes and FICA. Here are the post-tax deductions that the courts may mandate.

Wage garnishments

If someone has unpaid debts and has defaulted on payment, the creditor may request a wage garnishment. If granted, the person’s employer is required to withhold the portion of their wages that the court requires. Since this is for repaying a debt, the employee cannot claim the money withheld as a tax deduction.

Child support and alimony payments are considered forms of garnishment as well. The courts, a regulatory agency, or the IRS may request a garnishment if the employee hasn’t kept up with required payments or shown financial responsibility.

The types of income that may be garnished include the following:

• Salaries
• Annual bonuses
• Hourly pay
• Sales commissions
• Pension payments

There are two things that you must consider when garnishing an employee’s wages. The first is adherence to the Credit Protection Act, which limits how much of an employee’s income may be withheld as garnishment. It also protects the employee by making it illegal for that worker to lose their job due to a single debt.

The next consideration is that if you don’t follow the provisions of the garnishment order precisely as written, your business could be responsible for paying whatever is owed in back payments. Therefore, the order you receive should include the amount of garnishment you must withhold, where to send payment and how to report the deductions.

Voluntary deductions

Voluntary deductions are for programs or expenses that your employees have chosen to contribute to. Not all of these deductions qualify as pre-tax deductions, so it’s important that you understand the difference. Examples of voluntary deductions include deducting more than the required amount for taxes by request, contributing to a retirement account, enrolling in your group health insurance program and job-related expenses.

Job-related expenses may be tax deductions in some states. However, other states won’t allow you to consider these as pre-tax contributions, so you’ll need to be aware of which local laws apply. Examples of job-related deductions include the cost of travel, work supplies, uniforms and business meals.

Deductions for Independent Contractors

If you employ independent contractors, there are some key differences to consider when withholding money from their pay. You’re not required to withhold taxes or FICA from their pay, but you do need to report their income to the IRS. They’re responsible for making their own tax payments and are subject to self-employment taxes.

If you’re confused about whether a worker is to be treated as an employee or as an independent contractor, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment and Income Tax withholding. After filing this form, you’ll receive a response that lets you know how to treat that worker’s tax withholding and what tax forms need to be filed each year.

How to perform payroll deductions

The most efficient way to handle withholding is to perform each payroll deduction in order from pre-tax contributions through post-tax deductions. Follow this order when you’re calculating what to withhold:

1. All pre-tax deductions, such as Section 125 plans, insurance, 401 (k) contributions and voluntary deductions that qualify as pre-tax income.
2. Use the information provided on each employee’s tax forms to determine their federal income tax and make deductions using their tax bracket as guidance.
3. Calculate FICA and Medicare taxes by withholding 7.65% of the adjusted gross pay. The adjusted gross pay is the amount left over after you reduce it by the amount of pre-tax contributions you’ve withheld. As a result, you only need to deduct FICA up to $137,000 in annual income.
4. Add an additional 0.9% to Medicare withholding once an employee surpasses $200,000 income for the year.
5. Deduct any required state income tax. If your employees live in a location that requires city or county withholding, withhold the required amount here as well.
6. Withhold post-tax deductions such as wage garnishments, voluntary contributions that aren’t tax-deductible and contributions to Roth IRA accounts.
7. Itemize all of these deductions so that your employees can understand them and keep accurate records.
8. Issue the paycheck once you’ve determined your employee’s net pay.

Many businesses use a human resource information system to help them manage payroll. You may also consider outsourcing this task to a service provider specializing in human resources or tax accountingif you’re concerned about accuracy and compliance. Businesses areoutsourcinghuman resources functions because of the time and expense that is often required to ensure that payroll and other human resources functions are handled correctly. You can focus your attention on what matters most to your business when you choose this route.