The small business owner’s guide to payroll deductions
We’re going to go out on a limb and assume you didn’t start a business because of a passion for navigating payroll. And we don’t blame you: It has a reputation for being tedious and complex — particularly the deductions and withholdings part of it.
Alas, there are a lot of legal obligations you’ve got to meet, so managing payroll deductions and withholdings is critical to running your business and staying compliant. But don’t stress yet: We’re going to break it all down for you.
Read on to learn more about:
Payroll deductions 101: Key definitions
Mandatory vs. voluntary deductions
First up, what are deductions? Payroll deductions are wages you — the employer — withhold from your employees’ paychecks. There are two different types of deductions: mandatory and voluntary.
Mandatory deductions are withheld from an employee’s paycheck before they even receive it, and are sent to a tax agency or other third party on their behalf (this is required by law).
These deductions include:
Federal income tax
State and local income tax
State unemployment insurance, social security and medicare
Court-ordered garnishment and payment to creditors (we’ll define these later)
Voluntary deductions are not required by law to be taken out of employees’ paychecks, but employers often provide benefits that employees can elect which involve payroll deductions.
This includes:
Health, life and disability insurance payments
Retirement accounts
401(k) contributions
Flexible spending account or health savings account contributions
Voluntary deductions can be either pre-tax or post-tax.
Gross pay vs. net pay
Deductions make sense? OK, now let’s chat about gross pay and net pay.
Gross pay is the amount of money an employee will make before all deductions (such as taxes, benefits, Social Security, retirement savings, etc.). It reflects the employee’s salary or hourly wage plus bonuses, expenses and overtime. It’s usually the amount negotiated at the time of the hiring.
Net pay is the employee’s gross pay minus all payroll deductions. It includes mandatory and voluntary deductions (we’ll get back to those in a bit). Net pay is also called the employee’s “take-home pay” because it is the amount of the employee’s paycheck.
Withholdings vs. deductions
You may have also heard the term “withholdings,” but this is not the same as deductions. Both are subtracted from employees’ gross pay, but are not subject to the same rules.
Withholdings are taken from the employee's paycheck every pay period to pay federal and state income taxes. Most of the time, you — the employer — are required to withhold those amounts to pay the proper government agencies on behalf of your employee. The W-4 form (filled out by the employee at the time of the hiring) determines the amount of taxes to be withheld from the paycheck.
Deductions — on the other hand — are usually voluntary and determined by the employee, like contributions to healthcare or retirement plans.
Pre-tax vs. post-tax deductions
A pre-tax deduction is withheld from employee wages before you withhold taxes. That means employees have to pay taxes on a lower amount of income. Again, healthcare and retirement deductions are likely pre-tax, but this also could include flexible spending accounts (FSAs) or commuter benefits.
Post-tax deductions are withheld from employee wages after you withhold taxes. These deductions do not affect an employee’s taxable income. Common post-tax tax deductions include disability insurance, life insurance and garnishments.
Wage garnishments are deducted from employees’ checks to pay things like child support payments, defaulted student loans, taxes, unpaid court costs and more. It’s important to note that while wage garnishments are an attempt to collect a debt from an employee, it’s the employer’s responsibility to comply with the court order.
Failing to garnish wages in accordance with an order can lead to severe consequences. Employers could be required to pay fines, penalties and even the entire amount of the employee’s debt, so it’s critical to be aware of these.
Understanding mandatory federal payroll withholdings
Federal income tax based on W-4 information
The federal government requires employers to deposit their employees’ withheld taxes. These include federal income tax, Social Security tax, and Medicare taxes for employees, as well as the employer’s share of Social Security and Medicare taxes.
Once a deposit frequency has been set, companies must make those tax payments based on that particular schedule. If a company strays from that schedule, the employer may be fined for non-compliance.
Federal Unemployment Tax Act (FUTA)
The Federal Unemployment Tax Act (FUTA) is filed annually and requires all businesses to contribute towards unemployment benefits for workers who have been terminated. Form 940 is used to report a company's annual federal unemployment tax.
We’re going to throw a few numbers at you.
The basic FUTA rate is 6%. However, companies could receive a tax credit of up to 5.4% for paying state unemployment taxes, bringing the net FUTA rate down to .6%.
Additionally, FUTA only applies to the first $7,000 a business pays its employees — the FUTA wage base. A wage base limit is the amount of an employee’s income that can be taxed through a calendar year.
Federal Insurance Contributions Act (FICA) tax
FICA taxes are the federal Social Security and Medicare taxes that employees and employers pay. Employees and employers pay the same percentages when it comes to FICA:
The Social Security rate is a flat 6.2%
The Medicare rate is set at 1.45%
Employers use Form 941 to report income taxes, Social Security tax and Medicare tax withheld from employees’ paychecks, as well as to pay the employer's portion of Social Security and Medicare tax. This form is filed quarterly, but the IRS often requires companies to pay these taxes more frequently than that — typically on a monthly or semiweekly basis — which is called depositor status.
Before the beginning of each calendar year, a business owner must determine which of the two deposit schedules the company will use depending on something called a lookback period, which is the 12 months (July 1 - June 30) of the prior year.
If during that lookback period, the total taxes due are:
$50,000 or less = paid monthly
more than $50,000 = paid semiweekly
The IRS has several rules around when and how employers submit these payments. For more details, check out this cheat sheet or reference the IRS’ website.
Understanding mandatory state and local withholdings
State unemployment insurance (SUI) tax
SUI is a state program — funded by employers — that provides short-term benefits to workers who have lost their jobs. Unemployed workers can get this help to subsidize their basic needs while they’re looking for a new job. The SUI rate changes based on many factors and can change, unlike the FUTA, which has a fixed rate each year.
Each state’s rate is based on the wage base limit for that state and the number of employees who have filed for unemployment benefits.
The SUI rate usually ranges from 0.1 to 15%, depending on the aforementioned factors. Wage base limits can be as low as $7,000 or as high as $59,100.
Local taxes
Local taxes don’t apply in all states, but the federal government allows local governments to tax individuals and businesses when necessary. Typically, that’s in the form of an income tax on employees at a flat percentage (such as 2%), or a flat dollar amount owed each week (such as $5 per employee).
Many states and local tax agencies also levy state disability insurance (SDI) and municipal services taxes. Some states will replace SUI with SDI, while others will tax both.
Very important to note: Businesses need to check with their local taxing agency to ensure they know when this money is due. You should do the same for any locations where you are conducting business. Connecting with an accounting or legal professional with any questions you have is always a good idea. You may also consider outsourcing your payroll to a trusted provider.
Voluntary payroll deductions overview
Retirement plan contributions (SEP-IRA, SIMPLE-IRA, 401(k))
Not all withholdings are required: Your employees can opt into having money withheld from their paycheck for a retirement fund. There are many different small business retirement options that you can offer them:
401(k): Generally, any business is eligible to establish a 401(k): a retirement plan to which employees and employers can both contribute. Employees can contribute up to $23,000 (an additional $7,500 for employees aged 50+) or up to 100% of their income a year. Employers can also choose to partially match employee contributions, up to a certain percentage of their annual salary contribution. These amounts are adjusted annually.
Simple IRA: These apply to employers with 100 or fewer employees. The contribution can reach $16,000 (an additional $3,500 for employees aged 50+).
SEP IRA: This is designed for self-employed individuals and small business owners. Employers can contribute up to 25% of employee salary ($69,000 max).
Health benefits for employees
Health insurance deductions will vary based on the options the employer provides and the plan the employee will select. Insurance coverage may include prescriptions, medical, dental and vision.
Life and disability insurance options
Employees can opt into a life or disability insurance plan and have insurance premiums deducted from their paychecks to fund those. This type of insurance covers the employee during unexpected events, such as death, illness or disability.
IRC Section 125 benefits
Section 125 — also called a cafeteria plan — is an employee benefit plan that allows employees to take taxable benefits and convert them into nontaxable benefits. Deducted directly from an employee's paycheck before taxes are paid, cafeteria plans are particularly useful for those with regular medical and childcare expenses.
Special considerations in payroll deductions
Uniforms and minimum wage considerations: Uniform costs cannot be deducted from an employee’s wages if it brings the employee’s pay below the minimum wage.
529 Education savings plans and tax-deferred savings: A 529 education savings plan is an investment account that allows tax-free withdrawals to finance qualified education expenses. It offers federal and sometimes state tax benefits, depending on where the plan owner lives.
When should I outsource payroll?
Since every small business is different, it’s tough to pin down a defining moment. But, if you’re experiencing frequent payroll mistakes, getting hit with payroll tax penalties or managing employees who are frustrated with late or inaccurate paychecks, it may be time for change. Look for a payroll processor with a steady and stable track record, who can easily automate complex payroll tasks, like tax withholdings and deductions, deposits and reporting.
If you’re ready to get your time, money and peace of mind back, we’re ready to help. To learn more about Heartland’s payroll processing solution, check out our website or drop us a line.
FAQs
What are payroll taxes and who is responsible for them?
Payroll taxes are the amount of money withheld from employees’ wages by their employer. Some deductions are mandatory and others voluntary. All employers are required by law to collect, withhold and file tax and income reports from their employees' paychecks.
How do I calculate gross income for my employees?
The gross pay is calculated differently depending on whether the employee is compensated on a salary or hourly basis. Hourly gross pay = the pay rate multiplied by the hours worked. Salary gross pay = the gross yearly salary divided by the number of pay periods in one year.
What is the difference between pre-tax and post-tax deductions?
Pre-tax deductions are withheld from employee gross pay before tax deductions. Post-tax deductions are withheld from employee wages after tax deductions.
How can I determine the correct amount of federal income tax to withhold?
The best way for employers to calculate the amount of federal income tax withholding is to refer to the employee’s Form W-4 and the IRS’s federal income tax table. This information should help you determine the taxes withheld from your employee’s paycheck.
Are all businesses required to withhold state and local taxes?
Employers in states with an income tax have state payroll tax withholding, payment and reporting obligations. Reciprocal agreements between states may also govern multistate employment withholding. In addition, several states have mandated disability or sick or family leave programs that put payroll tax responsibilities on employers.
What are state-specific requirements, and where can I find accurate information?
States have various payroll tax requirements such as income tax withholding, SUI, SDI, paid family leave, paid sick leave. Specific information for your state can be found via the website of the state taxing authority, or by consulting an attorney or tax advisor.
What are FICA taxes, and how much should I withhold?
The Federal Insurance Contributions Act (FICA) is a federal payroll tax deduction that helps fund Social Security and Medicare programs. The current tax rate for Social Security is 6.2% for the employer and 6.2% for the employee, or 12.4% total. The current rate for Medicare is 1.45% for the employer and 1.45% for the employee, or 2.9% total. For more information, refer to Publication 15 (Circular E), Employer's Tax Guide.
Disclaimer: The information provided in this document does not, and is not intended to constitute legal advice; instead, all information, content, and materials available are for general informational purposes only. Information provided may not constitute the most up-to-date legal or other information, and readers of this information should contact their attorney to obtain advice with respect to any particular legal matter in the relevant jurisdiction. All liability with respect to actions taken or not taken based on the contents here are hereby expressly disclaimed.
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