When you hire employees for your small business, your workload lightens. But, your employer responsibilities, like payroll management, increase. As an employer, you need to run payroll and withhold payroll deductions before you can pay your employees.
Understanding payroll deductions can help you streamline your employer responsibilities, comply with IRS requirements, and pay employees legally. To find out more about paycheck deductions, read on.
What Are Payroll Deductions?
Payroll deductions are amounts that you withhold from an employee’s wages each pay period before giving them their paycheck.
An employee’s gross pay is their earnings before deductions are subtracted. Net pay is an employee’s take home pay, or the money left over after payroll deductions.
Deductions can be mandatory or voluntary. Mandatory payroll deductions include taxes. Here are the employment taxes you are required to withhold from an employee’s gross wages:
- Federal income tax
- State and local income tax (if applicable)
- FICA tax (Social Security and Medicare taxes)
Voluntary deductions include benefits. These are the payroll deductions that employees elect to have taken out of their wages. You will either withhold these deductions before or after taxes. Check out these pre-tax vs. post-tax deductions:
- Retirement plans
- Health insurance
- FSAs and HSAs
You need to understand payroll tax deductions as well as voluntary deductions if you offer them to employees.
Payroll Tax Deductions
Taxes are inevitable for working individuals. As an employer, you are responsible for withholding taxes from employee paychecks.
Federal Income Tax
The amount of money you need to withhold for federal income tax depends on Form W-4, Employee’s Withholding Allowance Certificate.
When an employee is hired at your business, they must fill out Form W-4 to claim withholding allowances. The number of withholding allowances an employee claims will determine how much you withhold.
Employees can claim as many allowances as they want on Form W-4. The more an employee claims, the less you withhold for federal income tax. For example, an employee who claims 3 allowances will have less taken out than if they claimed 2.
Once an employee fills out Form W-4, you will use the IRS’s Publication 15 to calculate the amount to withhold from their gross wages. There are two tax withholding tables (wage bracket and percentage methods) that correspond with the number of claims the employee marks.
For example, you use the wage bracket method table for an employee (single) who makes $505 each week in gross wages. They claim 1 on their Form W-4. Using the wage bracket table, you would withhold $48 each week from their wages for federal income tax.
Employees can update their claims on Form W-4 at any time. When an employee adjusts Form W-4, you need to adjust their payroll deduction.
State and Local Income Tax
Depending on where your business is, you might need to withhold state and local income tax. Typically, local income tax is a flat percentage of employee wages. State income tax works similarly to federal income tax.
If your business is in a state that has state income tax, you will need to have employees fill out a state tax withholding form. States use different forms, so check the U.S. Bureau of Labor Statistics for a list of state forms.
Keep in mind that the following states do NOT have state income tax:
- New Hampshire
- South Dakota
Another mandatory payroll deduction is FICA tax. FICA tax is made up of Social Security and Medicare taxes. You will withhold a percentage from each employee’s pay for FICA tax. And, you will contribute a matching amount. FICA tax is 7.65% of the employee’s wages.
Social Security tax makes up 6.2% of FICA tax. You must withhold 6.2% of each employee’s gross wages (you also contribute the matching portion).
You will do this until the employee earns $127,200. Then, you no longer need to deduct Social Security tax from the employee’s wages.
Medicare tax makes up 1.45% of FICA tax. Withhold 1.45% of each employee’s pay (and contribute the matching portion).
After the employee earns above $200,000, you will withhold an additional 0.9% of their wages. Keep in mind that you don’t need to pay the additional 0.9%.
For example, let’s say you pay an employee $700 each week. You must withhold $53.55 for FICA tax ($700 X .0765) weekly. And, you would also contribute $53.55 for that employee each week.
Payroll Deductions: Benefits
Many employers decide to offer employees benefits. More than 65% of employees have access to an employer-sponsored retirement plan and an employer-sponsored health insurance plan.
Benefits are a voluntary payroll deduction because employees can decide if they want to contribute. You must have employees either accept or deny participation in each benefit you offer. When the employee is hired, you need to give them benefits forms.
You can use Publication 15-B to find out which benefits are pre-tax and which are post-tax deductions. You will deduct pre-tax deductions before you tax the employee’s income. Post-tax deductions are those taken out after taxes.
Health insurance is a payroll deduction that employees can elect to receive. If the employee opts to receive insurance, you are required to withhold premiums for each of the employee’s paychecks.
Retirement plans are a great way for an employee to put money into an account that they can use when they reach a certain age.
You will deduct money from the employee’s wages and set it aside in their account. Most retirement plans are pre-tax deductions, except for Roth plans.
FSAs and HSAs
Another great health benefit is an FSA or HSA plan. FSAs (flexible spending accounts) and HSAs (health savings accounts) are health care plans. They are both pre-tax, so they reduce an employee’s income tax liability.
With FSAs and HSAs, you deduct money from the employee’s pay and put it into an account that can be used to pay for medical expenses.
Payroll Deductions Example
You have an employee, Rob. Take a look at the following information about Rob to determine payroll deductions:
- Rob earns $1,000 each week
- Rob is a single-filer and claims 0 on Form W-4
- Your business is in Florida, so no state income tax
- FICA tax is 7.65%
- Rob has a 401(k) plan and contributes $50 each week
First, you need to subtract the pre-tax deduction from his pay (401(k) contribution), lowering his taxable liability. Keep in mind that 401(k) plan contributions are exempt from federal income tax but not FICA tax.
- Rob’s weekly gross pay: $1,000
- Rob’s weekly 401(k) contribution: $1,000 – $50 = $950
- Rob’s federal income tax (using the wage bracket method in Publication 15 for $950, since the 401(k) contribution is not taxable and 0 claims): $146
- FICA tax: $1,000 X .0765 = $76.50 (don’t forget to pay a matching $76.50)
- Rob’s net pay: $1,000 (gross wages) – $50 (retirement contribution) – $146 (federal income taxes) – $76.50 (FICA tax) = $727.50 (net wages)
Rob takes home $727.50. He has $272.50 in payroll deductions that you must withhold each week.
One More Employer Responsibility
When you take payroll deductions out of an employee’s wages, you need to keep records. Records should show how much the employee’s gross pay, deductions, and net pay are.
It’s also a good idea to give each employee a pay stub. Many states require employers to give employees pay stubs.
A pay stub is part of a paycheck that details gross and net wages as well as deductions. It lets employees know how much they earned before taxes and other deductions as well as their take home pay.
Calculating Payroll Deductions
Business owners can manage payroll deductions in one of three ways: by hand, hiring a professional, or using software.
Calculating payroll deductions by hand saves money. But, this can be time consuming and leave room for errors. If there is a mistake in the taxes you withhold and remit, you might face costly penalties.
You can also hire a professional, like an accountant, to handle payroll on your behalf. This method saves business owners the most time, but it is also the most costly.
Payroll software is another option for business owners. It is a good middle ground between calculating payroll deductions by hand and hiring a professional. Using software saves both time and money for employers.