What Are Payroll Deductions & How Do They Work?

Payroll
Article
6 min. Read
Last Updated: 11/02/2023

An owner of a micro-business could gain the full amount of the tax credit available to larger businesses if the RISE Act becomes law.

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Payroll deductions are withheld from an employee's gross earnings for income taxes, benefit payments, or other permissible reasons. Some payroll deductions are mandatory while other payroll deductions may be voluntary.

What Is a Payroll Deduction?

Payroll deductions are amounts withheld from an employee's paycheck to account for certain designated expenses, such as taxes or benefits plans, and savings initiatives, such as retirement plans. Payroll taxes, for example, are deducted from the gross amount of pay an employee has earned before they receive their paycheck for a given pay period. Employers are obligated to remit or deposit these withheld amounts to the appropriate agencies and designees.

Other common payroll deductions that may be taken from an employee's paycheck include benefits premiums to cover the employee's portion of any medical insurance or other insurance electives, union dues, retirement savings plans, or other optional deductions such as charitable donations. Payroll deductions can be a significant part of processing an employee's paycheck, but they are also a necessary step for business owners to help employees meet their obligations, such as child support payments.

How Do Payroll Deductions Work?

Employers receive information about an employee's deductions from different sources that are a part of the payroll process. Payroll taxes are typically based on the employee's W-4, a required form that assists payroll departments when calculating tax withholdings for an individual. Benefit elections might come from authorization forms filled out by an employee, or selections made through an online portal. Payroll departments may also receive court orders directing them to withhold a set amount of employee's wages for garnishments.

The payroll department should set up a standard procedure for gathering payroll deduction information. Employers with staff in multiple geographic locations may need to adjust their payroll process to withhold for a number of different state and local tax rates. As complexity increases, a small business may need a more sophisticated payroll system or consider outsourcing their payroll to a trusted provider.

Types of Payroll Deductions

Some typical payroll deductions may be mandatory for every employee, while others require employee written authorization. Payroll departments must remove some amounts from gross pay prior to calculating payroll taxes, known as pre-tax deductions. Some types of payroll deductions fit into more than one category — for example, health care can be both voluntary and pre-tax. Each deduction should be reviewed to ensure it’s properly handled throughout the payroll process.

Mandatory Payroll Deductions

Some deductions will be calculated and withheld from employee paychecks without a need for an individual's authorization. Mandatory payroll deductions typically include all payroll taxes. Employers are obligated to withhold these amounts and may face fines or penalties if they fail to do so. Examples of mandatory payroll deductions include:

FICA: In compliance with the Federal Insurance Contributions Act (FICA), employers must deduct funds from paychecks for the employee's share of Medical and Social Security payments. Employers also pay a portion of FICA taxes.
Federal income tax: Employees complete a Form W-4 to determine the amount of federal income taxes that must be withheld from their paychecks.
State and local income tax: In some states and cities, employers must withhold funds to cover the employee's anticipated state and local tax liability.
Wage garnishments: Employers may be required to hold funds from an employee's paycheck under a court order or at the direction of the IRS for the purposes of recovering unpaid debts, child support, or taxes.

Other mandatory deductions include funds for state-specific requirements such as a state unemployment tax or a state-funded disability program.

Voluntary Payroll Deductions

Employers may also permit employees to request a deduction from their gross pay to cover certain payments or expenses associated with voluntary items, such as benefit plans. Depending on the type of deduction, it may take effect on a pre-tax or after-tax basis. Employees should provide authorization for benefit deductions as part of the annual enrollment process. Examples of voluntary payroll deductions include:

Health insurance: The employee's share of healthcare premiums may be deducted on a pre-tax basis if employees enroll in a company-sponsored plan. Employees may also contribute to a health savings account or a flexible spending account on a pre-tax basis.
Retirement plans: Employee contributions to retirement plans, such as a 401(k), may be deducted from their paycheck voluntarily.
Life insurance and disability plans: This includes premiums or contributions made by the employee toward group life plans, or coverage for short- and long-term disability.
Other voluntary payments: Other voluntary deductions may include charitable giving, or funds deducted for wellness programs, like a discounted gym membership. - where permissible under state law.

Pre-Tax Payroll Deductions

Pre-tax deductions are applied to an employee's paycheck before any taxes are calculated and withheld. Pre-tax deductions reduce the amount of taxable income, thus reducing the amount of taxes owed by the employee. Common examples of pre-tax deductions include 401(k) contributions, healthcare and dental insurance premiums, health savings account (HSA), or dependent care flexible spending account (DCFSA) contributions. As a business owner or HR manager, it is important to know which deductions are applied before taxes are calculated so that you do not inadvertently overcharge or undercharge your employees when it comes to tax obligations.

After-Tax Payroll Deductions

Some amounts deducted from an employee's paycheck occur on an after-tax basis. The payroll department will withhold all applicable pre-tax deductions, such as payroll taxes, before using the earnings amount remaining to cover these after-tax payments.

After-tax payroll deductions may include the following items:

Some life insurance or disability insurance payments
Wage garnishments
Charitable giving
Union dues

Get Help With Your Payroll Process

Understanding different types of payroll deductions will help you build an accurate, efficient payroll process that complies with the requirements in your jurisdiction(s). As your company grows and the payroll process increases in complexity, you may want to consider using professional payroll services. Allowing payroll experts to process paychecks on your behalf can give you peace of mind and allow you to focus on what you do best — running your business.

Payroll Deduction FAQs

Still have questions about payroll deductions? Check out these frequently asked questions.

What Are Some Examples of Incorrect Payroll Deductions?
What Are Some Examples of Incorrect Payroll Deductions?
With so many different types of deductions, it's easy to make a mistake. Withholding too much or too little from a paycheck can cause financial hardships for employees who may be subject to penalties from the IRS. Furthermore, taking deductions that aren't in compliance with federal, state, or local payroll laws can result in fines and penalties for the employer. Here are some of the more common examples of incorrect payroll deductions:
- Non-compliant deductions: Many jurisdictions have laws restricting the types of deductions that can be taken, whether those deductions require an employee’s consent, and if they must be taken pre- or post-tax. Taking any kind of deductions directly from an employee's payroll that are not in compliance with applicable payroll laws can have negative consequences for the employer.
- Incorrect tax calculations: Calculating payroll taxes is a complex process, but it's important to make sure it is done correctly to avoid penalties. Deducting an amount as post-tax when it should be pre-tax (or vice versa) can cause you to withhold too much or too little in taxes from an employee's paycheck. The calculated tax amount can also be incorrect if overtime or bonuses are not taxed properly or if the employee's tax status has changed but did not get updated in the payroll system.
- Incorrect deduction amounts: For many voluntary deductions, employees have options on how much to deduct or there are other factors that impact the deduction amount, such as who in their household is covered by a benefit plan. If any of these variations are documented incorrectly, it can result in the wrong amount deducted from an employee's paycheck.
How Do You Report Payroll Deductions?
How Do You Report Payroll Deductions?
To report payroll tax deductions, employers will need to file a quarterly tax return using Form 941 with the IRS (or, if eligible, using Form 944 on an annual basis). This form will report the total amount of taxes that have been withheld from employees' paychecks for the quarter. In addition, employers must also file the following on a yearly basis:
- Form 940 — for reporting federal unemployment taxes withheld
- W-2 — for each employee that outlines the total amount of income earned and taxes withheld during the tax year
In addition to federal reporting requirements, employers may have state or local reporting obligations. These can vary significantly depending on the jurisdiction, but in general, states with an income tax require employers to withhold state (and sometimes local) income taxes from their employees’ wages. These withheld amounts must then be reported on the appropriate state tax forms and submitted to the relevant tax authorities. Employers may also be required to deduct, remit, and report payments for other state-specific programs, such as disability insurance or state-operated workers’ compensation funds.
When Can an Employee Change Their Voluntary Deduction Amounts?
When Can an Employee Change Their Voluntary Deduction Amounts?

The most common type of voluntary deduction is for benefits premiums, which are often handled through a Section 125 plan. These plans must be set up by the employer and can help employees set aside pre-tax money on a voluntary basis to cover expenses such as childcare or certain medical costs. Employees can typically only change or cancel the deduction amounts for benefits during the employer's annual open enrollment period, which varies from employer to employer. However, if the employee experiences a qualifying life event, such as the birth of a child or getting a divorce, they may have the option to update their benefits deductions outside the standard open enrollment period. Remember that employees can change their tax withholding status at any time by completing a Form W-4 or a state form and can change deposits to other accounts (e.g., savings accounts).