Payroll Deductions: The Ultimate Guide for Business Owners

Here's everything small-business owners need to know about payroll deductions, including which ones are required by law.
Randa KrissFeb 4, 2021

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Payroll deductions are the specific amounts that you withhold from an employee’s paycheck each pay period. There are two types of deductions: voluntary deductions, like health insurance and 401(k) deductions, and mandatory deductions (those required by law), like federal income taxes and FICA taxes. Although you’ll withhold payroll deductions from each employee, the specific deductions and amounts will vary based on your employee’s withholding allowances, state or local taxes and the benefits your business offers.

Payroll processing is significant for the tax implications it has — for both you and your employees. Not only does your business have to pay payroll taxes, but as an employer, you’re also responsible for payroll deductions, withholding specific amounts from your employees’ paychecks. It’s important to understand the different types of payroll deductions and how to take the steps necessary to process your payroll accurately and efficiently — as well as ensure you’re in compliance with government payroll regulations.

Basics

When you run payroll, you’re responsible for ensuring that the proper payroll deductions are taken from each employee.

When an employee receives their paycheck, they’re getting their net pay, as opposed to their gross pay. Gross pay is the total amount before payroll deductions, whereas net pay (also called take-home pay) is the pay the employee actually “takes home” after deductions. Your employees should see a break out of their payroll deductions for each pay period with their paystub, which is typically generated automatically if you use payroll software.

There are two different types of payroll deductions: mandatory and voluntary. Mandatory payroll deductions are required by law, like federal and state income taxes. Voluntary, on the other hand, are payroll deductions your employees can elect to have, such as insurance or retirement plans.

Considering the two different types of deductions and the specifics involved with each, payroll deductions will vary from employee to employee and business to business. Payroll deductions are specific to employees — meaning you’re not responsible for payroll deductions for independent contractors, only your employees.

Mandatory payroll deductions

Mandatory payroll deductions are those that are required by law, whether by federal, state or local government. These deductions are used for tax purposes — as the employer, you withhold these mandatory payroll deductions from your employees’ paychecks and submit them to the IRS (or appropriate local agency) for payroll taxes.

Because these deductions contribute to your payroll tax liability, it’s important to ensure that you consistently withhold the correct amounts when you run payroll. If you neglect to withhold these deductions, you’re responsible for the error, and failure to comply with the law can lead to fines and penalties.

Federal income tax

As an employer, you’re responsible for deducting federal income taxes from each of your employees’ paychecks every pay period. Federal income taxes are regulated by the federal government and are used for national programs like defense, education and community development.

The payroll deduction amount that you withhold from an employee’s paycheck depends on their gross pay, as well as the allowances they claim on their W-4. Overall, the amount of federal income tax an employee pays from this deduction will range from 10% to 37% of their wages.

If you use an automatic payroll service, the system will be able to calculate the appropriate federal income tax payroll deductions per pay period based on the relevant employee information (W-4, pay period, gross pay). However, if you need to calculate this deduction manually, the IRS provides instructions in Publication 15 on how to do so.

FICA tax

The next mandatory payroll deductions you must withhold from employees’ pay are FICA taxes. Like federal income taxes, FICA taxes are regulated by the federal government. These taxes are comprised of three individual taxes.

FICA taxes are made up of social security taxes, Medicare taxes and, if applicable, the Medicare surtax. FICA taxes fund the social security and Medicare programs. With this payroll deduction, you’re responsible for withholding the appropriate amount from your employees and paying an employer portion as well.

Unlike federal income tax, FICA tax payroll deductions are calculated using a flat rate that’s designated by the government. For the social security tax portion, you must withhold 6.2% of an employee’s annual wages, up to $132,900. For the Medicare tax, you must withhold 1.45% of an employee’s annual wages. The Medicare surcharge tax only applies once an employee’s wages reach $200,000, then you must withhold 0.9% of their wages that exceed this amount.

Therefore, excluding the Medicare surcharge, you’re responsible for withholding a total of 7.65% of your employees’ pay from their check each pay period to comply with the FICA tax mandatory payroll deduction.

State and local taxes

Similar to federal taxes, individual states and municipalities might also require that employees pay income or other specific taxes and that you, as the employer, withhold the appropriate payroll deductions from their wages.

These requirements will vary based on the state or local government. Only seven of the 50 states do not have a state income tax, so this is the state-mandated payroll deduction that you’ll most often see.

The way you calculate a state income tax payroll deduction will also depend on the state, with some states having a flat income tax (like the FICA taxes), whereas others have a progressive income tax system (with brackets based on income, like the federal system).

With the large variation in this type of mandatory payroll deduction, you’ll want to consult your state or local tax agency to ensure that you’re complying appropriately with their regulations.

Court-ordered deductions

The last types of mandatory payroll deductions are court-ordered. These deductions will not apply to every employee. Court-ordered deductions are only required for employees who are required by a court to pay for a particular reason. Typically, these deductions are withheld for employees who are court-ordered to pay child support or pay back a debt they owe.

If either of these scenarios applies to one of your employees, you’ll be responsible for withholding the proper amount from their wages, according to the specific requirements laid out in the court order.

Voluntary payroll deductions

Voluntary payroll deductions are not required by law, but are based on the fringe benefits your business offers and if your employees opt into these withholdings. Therefore, when it comes to voluntary payroll deductions, you only are responsible for withholding a certain amount from an employee’s paycheck if they’ve authorized you to do so. As an example, if an employee opts into a commuter benefits plan with a $100 per month deduction, you’ll withhold this amount from their paycheck to cover the cost of that plan. Not all employees will decide to utilize the different voluntary payroll deductions that your business offers, making it important to properly organize and manage your payroll process.

It’s worth noting that there are pre-tax and after-tax deductions, depending on the specific benefit. With pre-tax benefits — typically health insurance, life insurance, certain 401(k) plans — you withhold the appropriate amount from your employee’s pay before withholding federal employment taxes.

With after-tax benefits (some 401(k) plans, disability insurance, life insurance), you deduct the appropriate amount after withholding government payroll taxes.

Let’s explore some of the most common voluntary payroll deductions.

  • Health insurance premiums and FSA accounts: Depending on the business health insurance options you offer (medical, dental, vision) and the specific plan your employee chooses, they may elect to have funds deducted from their paycheck to contribute to their health insurance or FSA account.

  • Retirement plans: If your business provides retirement plans, like 401(k)s or IRAs, an employee can choose to have money withheld and deposited into their specific retirement fund.

  • Life insurance: Although many businesses offer standard life insurance that they pay for, an employee may decide to increase their coverage, in which case, you would deduct the appropriate amount from their pay.

  • Disability insurance: Similar to life insurance, some companies cover a standard disability insurance policy. However, if you don’t, or if your employee elects for greater coverage, you would deduct the funds for this benefit from their paychecks.

  • Commuter benefits: For employees who commute to work, you might offer a plan that allows them to deduct their commuting costs directly from their paycheck. If your employee opts into this type of plan, you’ll withhold a specific amount based on the details of the employee’s commute.

  • Stock plans: If you give your employees the ability to purchase stock in your business, you can withhold the corresponding deduction from their pay.

  • Job-related expenses: Job-related expenses may include union dues, meals or uniforms — and employees may elect to have these costs deducted directly from their paycheck.

  • Tuition or professional certification: If you have a program for your employees to take classes or receive professional certifications, they may also choose to have the respective costs taken from their pay.

Once again, the voluntary payroll deductions you’re responsible for are entirely dependent on the benefits you offer and the elections your employees make. Similarly, the specific amount you deduct from an employee’s paycheck per pay period will also depend on the specific benefit (IRA vs. job-related expenses, for example), as well as which of the voluntary deductions the employee has authorized.

Tips for small-business owners

Understanding and implementing the appropriate payroll deductions for your employees can be a complex process. However, there are certain actions you can take and tips to keep in mind that can help your business manage payroll compliance.

1. Use payroll software

Using payroll software or working with a payroll service is perhaps the most influential action you can take to streamline your payroll deductions and ensure your processes are in compliance with government law.

With payroll software, you’ll be able to input all of your employee information, including tax withholdings, benefit elections, pay amount and frequency — and each time you run payroll, the system will automatically calculate the proper deductions and issue employee paychecks accordingly.

When it comes to mandatory deductions like federal income and state taxes, the necessary calculations are complicated, requiring several different considerations and varying based on the individual employee. By using a payroll software you won’t have to worry about any of these complexities, as long as you’ve set up your payroll and employee information correctly.

Payroll software is also beneficial in that it can generate employee pay stubs, allowing employees to see their breakdown of pay and payroll deductions, without you needing to create these documents yourself.

Moreover, many payroll software systems include payroll tax capabilities, helping you calculate and pay the payroll taxes that your business is responsible for.

2. Optimize your onboarding process

The next payroll tip is to optimize your onboarding process. The majority of the information you’ll need to accurately complete payroll deductions for your employees will be based on the information they provide — from W-4 tax withholdings to elections for health insurance and commuter benefits.

In order to ensure that you’re withholding the correct amount from your employees’ paychecks from the beginning, you’ll want to create a clear and detailed onboarding process — allowing you to collect the necessary details from your employees’ new hire paperwork as soon as they join your company.

By getting all of this information as soon as possible, you’ll be able to deduct the proper amounts from your employee’s first paycheck, as well as have time to ensure that everything is inputted correctly and completely.

Payroll software may offer another benefit here, as some systems provide an employee portal that allows your employees to input their tax and benefits information directly into the platform

3. Make organization a top priority

When it comes to payroll deductions, organization is key. Payroll deductions vary based on a number of factors — mandatory vs. voluntary deductions, state and local laws, employee elections and more — and it can be easy to make an error or miss an important step in this process.

Ensure you stay as organized as possible throughout your onboarding, payroll and the whole of your HR operations. You’ll want to have a process established for each step involved in setting up your payroll, adding employee information, calculating paychecks and adjusting deductions as necessary.

Additionally, you’ll want to have a secure and standardized way to store employee information and data, so you can refer back to tax forms or deduction authorizations if need be. Although this may seem like a simple tip, with a process as involved and detailed as payroll, it’s nevertheless something to keep in mind.

4. Don’t forget payroll taxes

Payroll taxes are tied directly to payroll deductions, for your employees and for your business. Remember that in addition to the taxes you must withhold from your employees’ paychecks, you have your own business payroll tax responsibilities as well.

You’ll need to pay federal unemployment taxes and FICA taxes on top of those from your employees, and you’ll need to report payroll taxes on a quarterly basis. FICA and income taxes are reported to the IRS using Form 941 and FUTA taxes are reported using Form 940.

One of the most common payroll mistakes that small businesses make is missing payroll tax deadlines, as they’re due quarterly, instead of annually. Ensure that part of your payroll process involves managing your business’s payroll tax responsibility, as well as the payroll deductions you must withhold from your employees.

Once again, using a payroll software program with tax functionality is a great way to help you streamline and stay on top of this process.

5. Take time to review your procedures

Remember to take time, whether on a quarterly (when you file your payroll taxes, perhaps), semi-annual or annual basis to review your payroll processes and make sure everything is accurate and working properly as well as looking for areas for improvement.

Even if you use payroll software, don't assume that everything is running automatically and that you never need to look through the system again. Since mandatory payroll deduction errors can lead to fines and penalties from the IRS, it’s important to monitor your processes.

If through your review processes you find an error, are unsure of something or simply think you could benefit from outside input, you should never hesitate to ask for help. You can consult a payroll or HR expert, business accountant or tax advisor, depending on the kind of assistance you need. When in doubt, these professionals will be able to answer your questions or point you in the right direction to ensure your payroll deductions process are in the best shape possible.

 Payroll software

Gusto
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on Gusto's website

Gusto Payroll Plans start at $39 per month (base) and $6 per person per month. Read review.

ADP
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on ADP's website

RUN Powered by ADP Plans start at $59 per month (base) and $4 per person per month. Read review.

OnPay
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on OnPay's website

OnPay Payroll Plans start at $36 per month (base) and $4 per person per month. Read review.

Square
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on Square's website

Square Payroll Plans start at $35 per month (base) and $5 per person per month. Read review.

QuickBooks
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on QuickBooks's website

QuickBooks Payroll Plans start at $45 per month (base) and $4 per person per month. Read review.

Wave Payroll Plans start at $20 per month (base) and $6 per person per month.

Providers may offer lower promotional pricing.

A version of this article was first published on Fundera, a subsidiary of NerdWallet.