Your Small Business Guide To Payroll Deductions

Understanding payroll deductions is critical for both employers and employees, especially in a small business setting where you may lack certain resources or specialist HR or accounting colleagues to walk you through it.

This guide aims to demystify the concept of payroll deductions, helping you gain insights into mandatory and voluntary deductions, as well as pre-tax and post-tax options. After reading, consider signing up for Homebase to make your payroll process more streamlined and error-free.

Let’s dive in.

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What are payroll deductions?

Payroll deductions are wages subtracted from an employee's total paycheck by an employer, set aside for taxes, benefits, and garnishments.

These deductions may include various taxes, insurance premiums, and contributions toward retirement funds. Essentially, payroll deductions are categorized as either mandatory or voluntary and can be further classified as pre-tax or post-tax deductions.

How do payroll deductions work?

When you hire an employee in the United States, they will typically fill out a W-4 form, which provides the necessary information to calculate certain deductions like federal income tax. Employers must then use this and other relevant data to determine the exact amount to be deducted from the employee's paycheck each pay period.

To accurately calculate payroll deductions, you’ll want to make sure you’re using time clock software to track employee work hours because this data will serve as the basis for both wages and associated deductions.

The amount deducted could vary based on multiple factors such as income level, number of dependents, and additional income sources. Employers are responsible for withholding the correct amounts and paying these to the appropriate authorities or organizations.

Pre-tax versus post-tax deductions

​​As the name would imply, pre-tax deductions are subtracted from an employee’s gross pay before taxes are calculated.

This effectively reduces the taxable income and thereby the amount of taxes paid. Examples include contributions to retirement accounts like 401(k)s or health savings accounts (HSAs).

Post-tax deductions are the inverse: they come into play after taxes have been calculated and withheld. These deductions won’t impact an employee's taxable income. Post-tax deductions may include union dues or charitable donations.

Let’s look at a couple of simple examples.

Pre-tax deductions example

Imagine Emily earns $4,000 per month and decides to contribute $200 to her 401(k) retirement account and $50 to her Health Savings Account (HSA). These contributions are pre-tax, meaning they are deducted from her gross pay before calculating income tax.

So, rather than paying taxes on the full $4,000, she’ll be taxed on $3,750 ($4,000 - $200 - $50). If her tax rate is 20%, she would pay $750 in taxes instead of the $800 she would owe without these pre-tax deductions. Over a year, this could lead to significant savings for Emily.

Post-tax deductions example

Now let's consider John, who also earns $4,000 per month. He’s part of a union that requires monthly dues of $30, and he also chooses to donate $20 to a charitable organization through a payroll deduction. Both of these are post-tax deductions.

In John's case, his income is taxed at a 20% rate on the full $4,000, leading to $800 in taxes. After that, the union dues and charitable donation are deducted, leaving him with a net income of $3,150 ($4,000 - $800 - $30 - $20).

By understanding how pre-tax and post-tax deductions impact your employee’s take-home pay and tax liabilities, you can make sure you pay them accurately and that you’re compliant with laws and regulations.

For employees, understanding the difference between pre and post-tax deductions means they can make more informed decisions about contributions and financial planning. Which is important when you’re setting aside money for retirement or supporting a cause you care about.

The different types of payroll deductions

Navigating the landscape of payroll deductions can be daunting, especially if you're not usually a finance person. But, especially if running a small business, you likely often find yourself wearing HR and finance hats.

It's essential to understand these deductions, not just to ensure compliance with legal obligations, but also to maintain employee satisfaction and trust.

Deductions can be broadly categorized into two types: mandatory and voluntary. Each has its own set of rules, tax implications, and benefits.

We’ll explore these different types of payroll deductions in more detail below, providing you with the knowledge you need to manage your business payroll effectively. Whether you're an employer wanting to clarify what gets deducted from your employees' earnings or an employee keen on understanding your paycheck better.

Mandatory Deductions

These are deductions required by law, which employers have no choice but to withhold:

Federal income tax

The Internal Revenue Service (IRS) mandates that federal income tax be withheld from employee paychecks based on their W-4 form.

It’s applicable to:

• salaries
• cash gifts from employers
• tips
• gambling income
• bonuses
• unemployment benefits

State and local taxes

In addition to federal taxes, many states and some local municipalities require additional income tax withholding. You should check your state and local law, but you should note there are some states that don’t levy state income tax.

As of October 2023, Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming don’t levy state income taxes. New Hampshire doesn’t tax earned income but does tax dividends and interest.

Social Security and Medicare

Also known as FICA taxes, these are withheld at a fixed rate: 6.2% for Social Security and 1.45% for Medicare.

Wage garnishments

In cases where an employee owes a debt, a court may order wage garnishment, forcing the employer to withhold a portion of the employee’s salary. This could be applied to hourly wages, salaries, commissions, bonuses, or pension and retirement plan payments.

An employer may subtract from an employee’s salary to pay off overdue debts, including:

• unpaid taxes
• alimony
• delinquent child support payments
• defaulted student loans

Voluntary deductions

While not required by law, employees often have the option to enroll in these deductions:

Health and life insurance payments

Employees may choose to have premiums for health, dental, or life insurance deducted directly from their paychecks.

Retirement or 401(k) contributions

These are often pre-tax deductions that employees can elect to contribute towards their retirement savings.

Simplify your paycheck deductions

Understanding and managing payroll deductions can be complex but it’s completely manageable. Whether you're an employer or an employee, familiarizing yourself with the types of deductions and the laws that govern them can save you time, effort, and money.

As an employer, you can make your life easier by getting a reliable, simple-to-use software tool for managing payroll. For instance, our payroll solution eliminates hassle by automating the entire process. With just a few clicks, your timesheets are instantly converted into precise hours and wages, making payroll a breeze.

But the convenience doesn't stop there. Homebase goes above and beyond by also handling your tax calculations and payments. Not only are wages accurately calculated, but all requisite taxes are also automatically withheld.

Homebase ensures that the correct payments are sent to your employees, the state, and the IRS, saving you the burden of manual calculations and the risk of errors. Additionally, we take care of your year-end tax obligations by automatically processing your tax filings and issuing 1099s and W-2s to the relevant parties. With Homebase, you can streamline your payroll operations and stay compliant without breaking a sweat.

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