Managing payroll is a challenging responsibility for any organization, regardless of size or status. It involves more than just calculating the number of hours an employee works and compensating them accordingly.
There are several other factors to consider, such as mandatory and voluntary deductions, pre and post-tax withholdings, and other related aspects.
These deductions are crucial in determining the final payroll amount and avoiding potential issues with employees or government agencies like the IRS. Therefore, comprehending these deductions is essential for ensuring smooth payroll management and avoiding legal or financial complications.
What Is a Payroll Deduction?
A common sense place to start is with some basic terminology. Payroll deduction refers to monies withheld from pay to cover specific expenses, such as:
- Taxes: Federal, state, and local
- Insurance, health, or life
- Medicare and social security
- 401K or another retirement plan
- Health savings account
Payroll deductions are the difference between gross pay, or the actual amount owed to the employee, and net pay, the amount due after deductions.
Other key terms that apply to payroll deductions include:
- Mandatory – Deductions everyone must incur, such as taxes
- Voluntary – Deductions requested by the employee, such as 401k
- Pre-tax– Deductions calculated before the withholding of taxes. This might include 401k or retirement savings. The benefit of pre-tax deductions is the employee doesn't pay taxes on that money until they use it.
- Post-tax – These are deductions taken after tax withholdings. The employee pays taxes on this money before getting it.
- Taxable income – This is the amount of the payment after pre-tax deductions.
Mandatory or Involuntary Deductions
Federal Income Tax
Federal income tax is a prepayment of the money owed to the IRS at the end of the year. This deduction varies from person to person and even paycheck to paycheck for many. On average, federal income tax ranges from 10% to 37% of their annual income. The federal income tax deduction is meant to estimate what they owe.
Employers base these withholdings on the amount earned and the information supplied on the employee's IRS W-4. Employees get credit for federal income tax withholdings when they file their taxes.
State Income Tax
State income tax is similar to federal, but the money goes to the state. Each state has its own tax tables to use when doing calculations. Some states do not require withholdings at all. This variation is why payroll software is often better than manual calculations.
FICA stands for the Federal Insurance Contributions Act. This is money that goes to maintain Medicare and Social Security.
Tax Levies or Wage Garnishments
Involuntary payroll withholdings could include court-mandated deductions such as wage garnishments or child care. The employee may arrange with the IRS for a deduction to pay back taxes.
Wage garnishments are court-ordered deductions that pay off a debt, such as defaulted tax agreements, back taxes, or student loans. A wage garnishment could also pay off a settlement from a lawsuit.
Voluntary deductions go toward paying a voluntary option for the employee.
Insurance Policy Deductions
Insurance policy deductions typically refer to health insurance. This would be the employee's portion of the monthly premium. Other types of insurance employees may opt to contribute to include long-term care, pet, and life.
Withholdings that go into an IRA, 401k, or another retirement plan. These are typically pre-tax, and the employer only deducts the contribution limit for the year.
Other Payroll Withholdings
Technically, an employer and employee can agree on any voluntary payroll deduction. The employee may contribute to charity, have a certain amount automatically deposited in a saving account, or even pay back a loan from the employer.
They can also be for health or flexible spending accounts. The employee contributes, and the employer matches all or part of it. Health or flexible spending accounts would be pre-tax and have a contribution limit.
Deductions, when done incorrectly, can cost businesses. Each year, companies pay millions for miscalculated payroll deductions, violating federal and state laws such as the Fair Labor Standards Act (FLSA), or making late payments.
One way to make payroll processing more accessible and efficient and avoid penalties is by using payroll software. CAVU HCM provides access to online payroll software that allows you to manage your payroll confidently.