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You are required by law to withhold payroll taxes on behalf of your employees, but getting withholdings and all those other payroll deductions right can be tough. Among US workers, 82% report finding an error in their paycheck at some point. And when Uncle Sam finds something wrong, it can mean a 15% penalty or more!
While the math you have to do to calculate deductions and withholdings isn’t very complex, it can be daunting to keep all the moving parts straight. That’s why we’ve put together this detailed guide with everything you need to know. And if you’re looking for more specific examples of how to calculate payroll, check out our detailed guide.
Gross pay vs. net pay
Deductions and withholding make up the difference between gross pay and net pay. Gross pay is the total amount your employee earns from their salary or hourly wage plus any bonuses, commissions, and other forms of compensation. For example, if you pay employees twice a month, a salaried employee who makes $48,000 per year will earn $2,000 in gross wages each pay period. This gross pay is where most calculations start for the IRS’s “wages subject to withholding” for employee paychecks.
Some payroll withholdings are mandatory payroll taxes; other deductions are voluntary, meaning your employee has the option to not pay them. Many voluntary deductions like health insurance or 401(k) contributions are pre-tax deductions that have the effect of reducing an employee’s taxable gross pay. Once withholdings and deductions have been made, the remaining net pay is what you pay to your employees.
Withholding vs. Deductions
Withholdings and deductions are often treated as synonyms on your pay stubs. Technically, though, the term withholding refers specifically to federal or state taxes that you take out of your employees’ paychecks and send to the government. All withholdings are mandatory.
Deductions are usually voluntary, and they include opt-in retirement savings, health insurance, or donations. There are also some involuntary deductions, like when wages are garnished to pay back taxes or child support. Some deductions are pre-tax, meaning they reduce your gross wages for tax calculations. Others are taken after taxes have been withheld. Don’t worry if this is confusing — we’ll take a closer look at specific deductions below.
Withholdings and deductions have two crucial elements in common: taking out the correct amount for each employee and then sending these funds to the proper tax agency or service provider.
Mandatory payroll withholdings
Federal income tax
It’s your responsibility as the business owner to withhold and pay federal income tax for your employees. First, remember that income tax relies on two factors: 1) the gross pay or wages you pay an employee and 2) the withholding information that employees provided on their W-4 form. You already know their pay rate. Their W-4 form will tell you if you need to withhold taxes for them at the married or single rate, how many dependents they claimed, and any additional amounts the employee wants to be withheld from those earnings.
State and local income tax
Just like federal income tax, you will use gross pay as the base for the amount of state and local income tax to withhold. Each state sets these rates individually (some states have no income tax at all), so you will need to become familiar with the rules that apply to your location and employees. You should also make sure you’re up to date on the latest payroll tax rates.
FICA, the Federal Insurance Contributions Act, requires employers to withhold Social Security and Medicare taxes from employees’ wages. You must not only withhold a percentage of the employee’s taxable gross pay but also match that contribution up to the maximum wage base limit. These percentages do change, so always be sure you are withholding and matching the correct amount for the tax year. For 2023, the FICA rate for employers breaks down to 6.2% for Social Security and 1.45% for Medicare, or 7.65% total for each (which ends up being the same as 2022.) Read more about how FICA and withholding in detail here.
State Unemployment Insurance (SUI)
Each state sets its own unemployment insurance rate, so there is no standard across the U.S. When you register with your state as an employer, they will also require you to sign up with the state unemployment agency as well. The important thing to remember when calculating SUI is that you must pay these taxes based on where your employee lives, not where you operate your business. If you have a team of remote workers, this can get a bit complicated, but most states have online resources to help you find your way.
State Disability Insurance
Currently, five states have some form of state disability insurance that is withheld from employee paychecks: California, Hawaii, New Jersey, New York, and Rhode Island. Each has different requirements for withholding rates as well as how they define wages and more.
Paid and family leave
Paid and family medical leave, or PMFL, is a type of benefit that some states offer and regulate. These programs count on payroll taxes, which are collected (and fund) the programs that allow an employee who is unable to work to receive regular payments as a way to make up for a portion of their lost income.
In most cases, it can be used for reasons such as illness, childbirth, pregnancy, child adoption, or if an employee needs to provide care for a family member. Depending on the state, the payroll tax is paid only by the employer (and in some cases, both the employer and employee might be responsible). For more information, we have a comprehensive resource that details states with paid family leave, including links to each one so you can find more information on how payroll deductions work.
Federal Unemployment Tax (FUTA)
This tax funds unemployment benefits for employees who lose their jobs. As an employer, you will need to calculate 6% of the wages each employee earns to determine how much you owe in federal unemployment taxes. However, FUTA is not withheld from the employee’s wages, so don’t make that mistake.
Employers are required by law to pay unemployment taxes until an employee reaches $7,000 in taxable wages for the calendar year. After that, your liability for the year for them is met. Federal unemployment taxes are paid quarterly. Not sure if you are required to pay FUTA? Take a detailed look at federal unemployment taxes.
Depositing Mandatory Payroll Taxes
After you complete payroll, you must deposit the federal income taxes, social security, and Medicare funds that you withheld with the IRS. There are two deposit schedules – semi-weekly or monthly – for these payments. Learn more about the correct schedule for your business in IRS Publication 15-T. Remember to file your quarterly report on Form 941 or annually on Form 944 showing the wages you’ve paid, the tips your employees have reported to you, and your employment taxes. You will also need to comply with state tax deposit rules.
Voluntary payroll deductions
Retirement plan contributions
As an employer, you have a few options for retirement saving plans for small business employees: SEP-IRA, SIMPLE-IRA, or a traditional 401k. Most retirement contributions are pre-tax and are often matched by the employer up to a specific percentage. For 2023, employees can contribute up to $22,500 to a 401k plan (which is up from $20,500 for 2022.) Workers over age 50 can add an additional catch-up contribution of $7,500 to get them to $30,000 annually.
Small businesses with fewer than 50 full-time equivalent employees are not required to provide health benefits to their employees, but it is the top benefit employees seek out. Most often, collecting healthcare benefits costs is done as a pre-tax payroll deduction. Remember that health plan payroll deductions including payments for flexible spending accounts or health savings accounts should be set up as a dollar amount and not a percentage or the employee’s pay.
Life insurance or disability insurance
Many employers offer group life insurance programs as well as short-term and long-term disability coverage to ensure that employees still receive a portion of their salary even if they become disabled. Like healthcare plans, these programs are often administered by a large insurance company that can handle registrations for you. You will need to ensure that the proper deductions are made and paid for each employee that opts into the program.
Parking or commuting
Commuter benefits allow you to deduct the cost of parking or transit fees on a pre-tax basis for your employees. Please note, these funds cannot be used to offset the costs of biking-related expenses, fuel, or car insurance. As of 2023, the IRS limit on transportation or parking expenses is $300 per employee per month, and contributions are no longer tax deductible for the employer.
Health & wellness
These programs can be a way to help promote wellness in the workplace and often include payroll deductions for discounted gym memberships, weight loss programs, smoking cessation programs, and preventative health screenings. They can also have payouts for hitting certain goals. Benefits can be tax-free, but reimbursements and rewards for employees are not. Subsidies for gym membership expenses can be deducted by employers as business expenses for the tax year in which they were paid.
If your business requires uniforms and charges employees for them, remember that payroll deductions to cover the cost cannot reduce a worker’s hourly pay rate below the minimum wage of $7.25 per hour or impact their overtime pay under the Fair Labor Standards Act. However, you are allowed to prorate the deduction over a period of time so long as their hourly rate isn’t reduced.
Union dues are usually calculated as a predetermined percentage of the worker’s gross wages and paid regularly to your local union. The 2018 Supreme Court ruling Janus v. American Federation of State, County, and Municipal Employees (AFSCME) changed the rules for collecting fees from non-union employees working in union shops. Now, non-union employees must actively opt-in to have these dues collected. Most unions also have specific requirements for pay scales and payroll, so take the time to review the rules and regulations with your union partner. Union dues do not qualify as pre-tax deductions.
529 education savings plans
Nearly all states now have some form of tax-deferred 529 education savings plan that offers a convenient way for employees to save. Some state plans do have minimum contribution requirements along with other 529 plan rules. Most are managed by large investment companies, but each state has a useful website full of information about 529 payroll deductions.
Workplace giving or charitable contributions
Automatic giving allows employees to support their favorite cause by having a pre-selected amount deducted from their paycheck throughout the year. Remember to get a written or electronic opt-in for this type of deduction and work with a reputable partner like United Way.
While employees do not have to consent to orders for garnishment of their wages, they are still considered voluntary since they are not part of mandatory government tax withholdings. A court of law may require that an employer garnish wages for non-payment of debt or child support, or other reasons. Typically, a garnishment order will come with instructions on how you will need to send these payments.
Extra credit! Exempt vs. Non-exempt employees
The Fair Labor Standards Act established the current minimum wage, overtime rules, and other labor standards that you need to be familiar with to get payroll right. It also defined employee categories that primarily relate to overtime protections.
- “Non-exempt” employees can earn overtime pay at a rate of 1.5 times their regular hourly rate and are required to be paid at least the federal minimum wage of $7.25 per hour.
- “Exempt” employees (those exempt from earning overtime) must be salaried, earn at least $455 per week, and perform job functions such as executive, administrative or professional duties.
Understanding this distinction is essential for your payroll (and ultimately your deductions) because you must calculate overtime pay as part of gross pay for non-exempt employees. Not to mention that violations can be expensive; employers who violate the FLSA minimum wage or overtime compensation laws may be legally liable for both the wage shortfall and damages. The government offers this handy guide to help ensure you are compliant. Remember to check your state overtime requirements here as well.
How does this factor into payroll deductions? Under certain circumstances, employers may deduct pay when exempt employees miss work.
That’s (finally) all, folks!
Payroll deductions may not always be fun, but getting them right is an important part of running your business successfully. We hope this guide has been helpful to you as you plan your next payroll run and build the team that will help you achieve all your goals.