Payroll Deduction Definition
Payroll deduction is the process of withholding different amounts from the salary of an employee which are utilized for a league of payments such as retirement fund, tax payments, etc. The deductions may be mandatory or voluntary.
- Payroll deduction involves withholding different amounts from the salary of an employee to pay for taxes and employee welfare contributions. The deductions may be voluntary or involuntary.
- The deductions can be pre-tax or post-tax and they form the difference between Gross Pay and Net PayNet PayEmployees' net pay, often known as take-home pay, is their salary after all deductions..
- Voluntary payroll deductions may include deductions for Health insurance, life insurance retirement plans, other job-related expenses etc.
- Involuntary deductions may include garnishment, state-local taxes, federal taxes, FICA Tax etc.
How Does Payroll Deductions Work?
Employers conduct payroll deductions to make payments for tax obligations arising out of an employee’s salary payments. Tax payment could be for medical tax, social security tax, etc.
The other part of payroll deductions corresponds to employer’s payment towards employee welfare contributions like employer-sponsored retirement fund 401(k), pension plans, saving plans, healthcare plans and other voluntary contributions.
For accuracy and ease of calculations, payroll deductions tables and online calculators come in handy. Employers often utilize payroll deductions tables to ascertain correct values for federal tax and other deductions. The gross pay gets converted to net pay by deducting the voluntary and involuntary deductions in the process. The following steps may be followed to do the same.
- Gross pay to be adjusted by deducting pre-tax contributions to voluntary benefits like health insurance plans, life insurance plans, retirement plan, etc.
- 7.65% of adjusted gross pay is deducted for Medicare tax and Social Security tax. Company’s Social Security with a 6.2 % rate and Medicare tax with a 1.45 % increase to the 7.65% deduction.
- Deduct .09% for additional Medicare tax up to the maximum limit.
- Deduct the federal income tax based on employee’s Form W-4 and the IRS tax tables for that year.
- Deduct state tax and local tax based on the tax applicable on the specific state.
- To arrive at net pay garnishments, retirement plans, Roth IRA Contributions and other post-tax dues are to be deducted.
Source – adp.com
If wages are being garnished, the maximum limit of deduction will be lesser of the following:
- 25% of disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes., or
- the amount that the income exceeds 30 times the federal minimum wage.
Employees sometimes take the help of an online payroll deductions calculator to understand how the employer arrived at the amount of the net pay.
Voluntary Payroll Deductions
Payroll deductions which require employees’ consent and for which the employee has to opt for are the voluntary kind. They are as follows:
- Health Insurance Premium: The deduction for health insurance premium depends on the plan selected by the employee. Deductions occurring in favor of health plans range from health, dental or vision. premiums. Employer-sponsored health insurance plan is tax-free. Employers’ contribution towards employees’ health insurance premiums is tax-exemptTax-exemptTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only. if the organization has established a Section 125 cafeteria plan.
- Life Insurance Premium: An employee may opt to deduct an amount from the paycheck to go towards the life insurance premium. Employer-sponsored insurance is much sought after as the cost of acquiring the insurance cover gets shared between the two parties. Different life insurance plans are offered, and they provide varying tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. to both the employer and the employee. For group term life insurance, the employee can upgrade the basic insurance cover to include educational allowance, accidental demise, etc. by opting for voluntary deductions.
- Retirement Plans: The employees may opt to have money deducted to contribute to any retirement plan provided by the employer. 401K and Roth Individual Retirement Accounts (IRA) are the two popular retirement benefits employers provide.
- Expenses: Meals, travel, uniform, union fees, firm-sponsored charity plans are some examples of job-related voluntary deductions that the employees may sign up for.
Involuntary deductions are statutory payroll deductions that employers are required to deduct and submit to tax agencies. Following are the involuntary deductions:
#1 – Fica Tax
As per the Federal Insurance Contributions Act (FICA), paying FICA taxes are compulsory for most employees and employers. These deductions go towards Social Security and Medicare. Social Security Tax comes especially in aid of the retirees and disabled. Paying social security tax enhances creditsEnhances CreditsCredit enhancement is a strategy used by businesses to increase their creditworthiness through a variety of internal and external measures. The fundamental goal is to obtain better debt repaying terms, hence lowering investors' risk of specific structured products in the financial market. for social security benefits.
The contributions for employer and employee towards Fica tax is equal. The payroll deduction for FICA is 7.65% from an employee’s paycheck. , 6.2% goes in favor of Social Security Tax while 1.45% goes in favor of Medicare Tax.
#2 – Federal Income Tax
The mandatory payroll deductions towards federal income tax are based on the information on W4 and the employee’s gross pay. IRS’s Publication 15-T ‘s Income tax withholding tables can be used to calculate the amount withheld from an employee’s paycheck. The wage bracket method or the percentage method is the 2 federal income tax withholding methods in each pay period. They can be found in IRS Publication 15-T.
#3 – State & Local Tax
Involuntary withholding comes in the form of the following:
- State Income Tax
- State Unemployment Tax
- State Disability Insurance
- City and County Taxes
The amount deducted for state and local taxes depends on the tax structure of each state.
#4 – Garnishments
Wage garnishments are compulsory involuntary deductions which include the following.
- IRS levies
- Child Support and Alimony
- State Tax Levies
- Student Loan Garnishments
- Garnishment by Creditors
Wage garnishments deductions will be made if the employee has unpaid debts. The employer will receive more information regarding this deduction from a court order or government agency orders.
Are Payroll Deductions Before or After Tax?
Deductions from employee paychecks after tax deductions are known as post-tax deductions. They reduce the net pay but not the overall tax burden.
- Deductions for Garnishments, Roth IRA retirement plans, disability insurance, union dues and charitable donations may be a post-tax deduction.
- Deductions from employee paychecks before tax deductions are known as pre-tax deductions. They reduce the overall tax burden since they are excluded from gross pay.
- Deductions for medical and dental benefits, 401(k) retirement plans (for federal and most state income taxes), transportation deductions, health insurance deductions, and group-term life insurance may be pre-tax deductions.
This has been a guide to payroll deduction and its definition. Here we discuss how it works along with voluntary and involuntary deductions. You may learn more about financing from the following articles –