What are payroll deductions and how do they work? Complete guide

More than simply subtracting payments from your employees’ paychecks every pay period, payroll deductions play an important role in keeping your employees financially healthy and your organization compliant. 

For many employees, however, withholdings, payroll deductions, and payroll taxes represent a decrease in their gross pay. Understanding the nuances of different deductions and calculating them correctly matters a great deal in maintaining the confidence of your workforce.

What are payroll deductions? 

Payroll deductions are amounts that an employer withholds from an employee’s wages to cover specific payments, such as income taxes, health benefits, garnishments, or retirement savings. 

Example: Alex earns a monthly salary of $3,000. Their employer withholds $250 in federal income taxes and $150 to cover Alex’s health insurance expenses. After these deductions, Alex receives $2,650 in net pay.

Example: Chris’ earnings for the first week of August amounts to $1,000. Their employer withholds $100 in union dues and garnishes $200 for a court-ordered child support payment. Chris’ net pay after payroll deductions is $700.

While some sources use the terms ‘payroll deductions’ and ‘withholdings’ interchangeably, these are actually two distinct but related concepts. It's important to differentiate between them, especially when communicating with employees, for clarity and transparency.

Payroll deductions refer to any amount deducted from an employee’s gross pay. These can be voluntary, as in the case of retirement savings, or involuntary, as in the case of debt garnishments.

Withholdings are a specific type of payroll deduction related to federal, state, and local income taxes, as well as programs like Social Security and Medicare. They are mandatory, and employers are responsible for calculating the correct amounts and making regular payments to the IRS. 

How do payroll deductions work? 

Employers are required to calculate payroll deductions and withhold them on behalf of employees based on information from multiple sources. It’s a significant responsibility that requires a clear internal process to avoid time-consuming and expensive errors.

To correctly calculate mandatory withholdings and voluntary deductions, you’ll need to know an employee’s gross compensation and whether the employee has chosen to participate in employer-sponsored benefit and retirement savings plans. 

For information about an employee’s tax situation, you’ll consult the Form W-4, Employee’s Withholding Certificate that they completed at the time of hire. Employees use form W-4 to share personal information about dependents, additional jobs, and other factors affecting their withholding amounts. 

If an employee is subject to wage garnishment, the court or federal agency will provide a copy of the official order specifying the amount to be withheld. 

Businesses that operate in multiple states will need to consider different state requirements for withholding and deductions. Working with a payroll service provider or purchasing specialized payroll software can relieve the administrative burden and minimize the risk of human error. 

3 types of payroll deductions 

In most states, employers are required to issue payslips that itemize payroll deductions by type and amount. If your employees have questions, it’s important to understand the difference between mandatory payroll deductions, voluntary payroll deductions, and wage garnishment.

Mandatory deductions

Mandatory deductions are non-optional payroll deductions employers must make on behalf of their employees. Typically, these deductions cover employees’ federal, state, and local taxes.

• FICA taxes bundle many employees’ Social Security tax and Medicare tax payments into a single payroll deduction.
• Income tax withholdings help ensure that employees meet their annual federal, state, and sometimes local tax obligations by proactively deducting a portion of each paycheck.
• Additional Medicare tax applies only to certain high-income earners and goes to support the Medicare healthcare program.

Depending on the state, mandatory deductions might also include employees’ contributions to state disability and unemployment insurance programs. 

Voluntary deductions 

Voluntary deductions are amounts that employees choose to deduct from their pre-tax pay to cover specific expenses or contribute to employer-provided savings plans. 

• Life insurance. These post-tax deductions cover payments for employer-sponsored health benefits.
• Retirement plan contributions allow employees to automatically deduct a pre-set amount from each paycheck for deposit in an employer-sponsored savings plan. Depending on the type of plan, these may be pre-tax deductions or post-tax deductions.
• Health savings accounts give employees with high-deductible insurance plans the option to make a pre-tax contribution to a special savings account dedicated to medical expenses. 
• Flexible spending accounts are similar to health savings accounts and allow employees to make a pre-tax contribution towards healthcare expenses for themselves or their dependents.  
• Tuition reimbursement and educational savings plans are another way for employees to make pre-tax contributions to dedicated savings accounts.

Mandatory deductions

Employers sometimes must withhold amounts from employees' paychecks to cover specific private obligations. This process is known as ‘garnishment’ and requires an order from a court or a government agency.

• Child support payments may be garnished following a court order.
• Student loan and credit card debt payments can be deducted from employees’ wages if ordered by a court.
• Unpaid taxes are also subject to garnishment if ordered by the IRS. 

How to calculate payroll deductions? 

The process of calculating payroll deductions involves converting gross pay to net pay. The specific steps will vary depending on the states and countries where you employ your workers but will usually include the following:

• Step 1. Modify gross pay by withholding any pre-tax contributions to retirement plans, flexible savings accounts, health savings accounts, and 401(k) retirement plans. 
• Step 2. Use tables published by the IRS to calculate and deduct the correct amount of federal income taxes based on the employee’s Form W-4.
• Step 3. Now that you have the employee’s adjusted gross pay, withhold the applicable tax rate (7.65% as of August 2024) for Medicare tax and Social Security tax. If the employee earns more than a threshold amount ($200,000 as of August 2024), withhold a further tax rate (.09% as of August 2024) in Additional Medicare tax.
• Step 4. After withholding FICA taxes, calculate and withhold any applicable state income taxes in accordance with state law. 
• Step 5. Subtract any garnishments or Roth IRA contributions and other post-tax deductions, such as child support, to arrive at the employee’s net pay.  

Payroll deductions penalties 

If your organization miscalculates payroll deductions on behalf of employees or submits payments after the deadline, you may be subject to an IRS penalty. Penalties are typically monetary fines but can extend to liens against property and civil or criminal sanctions.

The specifics of the penalty will depend on several factors, such as the size of your business, the type of error, and, in the case of late payment, whether you made an effort to pay but missed the deadline or failed to make a deposit altogether. Generally speaking, the longer you wait to address a penalty, the more your business will have to pay.

Rippling: automated payroll deductions for your employees

A comprehensive HR, finance, and IT software solution that streamlines multiple people operations functions across your business, Rippling’s payroll solution automatically calculates withholdings and deductions, completes mandatory tax forms, and manages quarterly and annual tax payments. 

• Powerful automations with custom workflows and event-based triggers remove the administrative burden and busy work of payroll.
• Comprehensive reporting tools ensure that decision-makers access the information they need in realtime.
• Automatic alerts and updates keep your business ahead of the curve for compliance. 

FAQs on payroll deductions

What are some examples of incorrect payroll deductions?

With so many mandatory and involuntary payroll deductions, it’s important to understand what can and cannot be withheld from an employee’s compensation. For example, the following taxes and expenses are an employer’s responsibility and not payroll deductions: federal unemployment tax (FUTA), state unemployment tax, and workers’ compensation insurance. 

Are payroll deductions recorded as liabilities?

Yes, payroll deductions are recorded as liabilities on your organization’s balance sheet. Because the employer holds the amounts due to the IRS and state revenue authorities for a period of time before paying them out but cannot benefit from or use the funds. 

H3: How do I report payroll deductions?

Employers report payroll deductions to the IRS by filing a Form 941 each quarter or, if eligible, an annual Form 944. The Form 941 summarizes the total payroll taxes withheld each quarter. Additionally, employers must file a Form W-2 reporting wages and taxes withheld each year for every employee. 

This blog is based on information available to Rippling as of August 12, 2024.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.