What Are Payroll Deductions? A Comprehensive Guide for Small Businesses

Running payroll correctly means understanding exactly what to deduct from each employee's paycheck and why. This guide breaks down everything small business owners need to know about payroll deductions, from mandatory tax withholdings to voluntary benefits.

Let's start with the basics.

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What is a payroll deduction?

A payroll deduction is money that comes out of an employee's paycheck before they get paid. Some deductions, like taxes and wage garnishments, are mandatory. This means you have to withhold them by law, and you could be liable for any missing amounts. Other deductions are voluntary, like health insurance or retirement plans, and require written authorization from your employee.

You can take out these voluntary deductions either before taxes (pre-tax) or after taxes (post-tax), which affects how much taxable income your employee has. Understanding these differences is crucial for processing payroll correctly and staying compliant with tax laws.

How do payroll deductions work?

Payroll deductions are processed every pay period using tax laws and information from a few different sources: your employee's W-4 form, state withholding certificates, benefit selections, and any court orders. The amount you withhold depends on all these factors plus where your business operates, since tax requirements vary by state.

The process starts with an employee's gross pay, then subtracts mandatory deductions like taxes, followed by any voluntary deductions they've chosen. What’s left is their take-home pay, also called net pay.

You can calculate these deductions manually, but most businesses use payroll software or services because it's more reliable. Automation can help you prevent expensive mistakes and send all deducted money to the right places on time (like the IRS or insurance companies).

Types of payroll deductions

Payroll deductions fall into two main categories: mandatory and voluntary. With voluntary deductions, you'll need to know which are pre-tax and which are post-tax, as this affects your employee's taxable income and your payroll tax obligations.

Pre-tax vs post-tax deductions

Pre-tax deductions are taken from an employee's gross pay before taxes are calculated. This reduces their taxable income, which means they pay less in federal income tax, state income tax, and FICA taxes. For example, if an employee makes $4,000 per month and has $500 in pre-tax deductions, they only pay taxes on $3,500. This tax advantage benefits both employees and employers, as it also reduces your payroll tax obligations.

Post-tax deductions happen after taxes are taken off the full gross pay. These deductions don't reduce taxable income, but some offer other advantages. For instance, Roth 401(k) (which is an employer-sponsored retirement savings plan) contributions are made with after-tax dollars, but qualified withdrawals in retirement are completely tax-free. Post-tax deductions include voluntary benefits employees choose and mandatory deductions like wage garnishments.

Statutory payroll deductions

Statutory deductions are mandated by federal and state governments to fund public programs and services. You have to withhold these from every employee's paycheck and you can’topt out. If you fail to withhold these correctly, your business could be liable for the missing amounts plus penalties.

Here's what you need to know about each required deduction:

Federal income tax

Federal income tax uses seven tax brackets, ranging from 10% to 37%. The amount you withhold depends on your employee's W-4 form, which shows their filing status (single, married filing jointly, or head of household) and any other withholding they've requested. Each bracket applies progressively, meaning employees pay higher rates only on the portion of income that falls within that bracket.

You can calculate withholding using either the wage bracket method or percentage method, both found in IRS Publication 15-T. Most payroll software, like Homebase, can also handle these calculations automatically.

FICA taxes

FICA taxes fund Social Security and Medicare programs. You have to withhold 6.2% for Social Security (up to the annual wage base limit) and 1.45% for Medicare (no limit) from each paycheck. As an employer, you match these amounts, making the total contribution 15.3%.

For high earners making over $200,000 annually, you'll need to withhold an additional 0.9% Medicare tax. You don't match this extra amount. Keep in mind that the Social Security wage base limit changes yearly with inflation.

State income tax

State income tax systems vary a lot across the country. Some states use a flat rate for all income, others have progressive brackets like federal taxes, and nine states have no income tax at all. Your withholding obligations depend entirely on where your employees work, not where your business is located.

Check with each state's department of revenue for specific requirements, as states often have their own withholding forms and payment schedules.

Wage garnishments

Wage garnishments are court-ordered deductions that take priority over voluntary deductions. They can be for child support, unpaid taxes, student loans, or other legal obligations. Each garnishment order will specify the exact amount or percentage to withhold from disposable earnings.

The Consumer Credit Protection Act limits how much can be garnished and protects employees from termination due to a single wage garnishment. Multiple garnishments require careful attention to priority and legal limits.

Voluntary payroll deductions

Voluntary deductions are benefits and services that employees choose to pay for through payroll. Unlike statutory deductions, these require written authorization from your employees. The timing of these deductions—whether they come out before or after taxes—can significantly impact your employees’ take-home pay.

Health insurance premiums

Health insurance is usually the largest voluntary deduction from employee paychecks. These premiums cover medical, dental, and vision insurance costs, and when offered through a Section 125 (cafeteria) plan, they're deducted before taxes are calculated. This means your employees save on income and FICA taxes, while you save on payroll taxes.

Employees can change their health insurance elections during annual open enrollment or after qualifying life events like marriage, birth, or job status changes. As an employer, you'll need to track these changes carefully and keep records of all enrolment forms and election changes.

Retirement plans

Traditional and Roth 401(k)s offer different tax advantages for retirement savings. With traditional 401(k)s, contributions reduce current taxable income. Roth contributions are made after taxes but grow tax-free for retirement.

The IRS sets annual contribution limits ($23,500 in 2025) that apply to combined traditional and Roth contributions. Many employers offer matching contributions as an incentive, typically matching 50% of employee contributions up to 6% of salary.

FSA/HSA contributions

Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs) let employees set aside pre-tax money for healthcare and dependent care expenses. FSAs are "use it or lose it" accounts with annual contribution limits ($3,300 for healthcare FSAs in 2025), while HSAs are only available to employees with high-deductible health plans.

HSAs offer unique triple tax advantages: contributions are pre-tax, the money grows tax-free, and withdrawals for qualified medical expenses are tax-free. Unlike FSAs, HSA funds roll over year after year and stay with employees even if they change jobs.

Life insurance

Employer-provided group term life insurance is a common benefit that can be offered pre-tax for coverage up to $50,000. This coverage is often provided as a base benefit at little or no cost to employees, making it an attractive part of your benefits package. The premiums for this basic coverage are excluded from employees' taxable income.

Any coverage above $50,000 becomes a post-tax benefit, and the cost of extra coverage has to be included in the employee's taxable income as "imputed income." Check with the IRS for the most updated tables to calculate this imputed income based on the employee's age and coverage amount.

Disability insurance

Disability insurance protects employees' income if they become unable to work due to illness or injury. While some employers provide basic coverage, employees can often purchase additional protection through payroll deductions.

The cost varies based on factors like age, salary, and coverage level. Paying with post-tax dollars means any benefits received will be tax-free, which can be crucial since benefits typically replace only a portion of regular income.

Union dues

Union members pay regular dues to support union activities and representation. These payments are typically calculated as a percentage of wages or a flat fee, as specified in your collective bargaining agreement.

While union dues are deducted post-tax, some portions may be tax-deductible if the employee itemizes their tax return. As an employer, you're required to deduct and remit these payments based on your labor agreement.

Common challenges with payroll deductions

Running payroll is one of the most complex responsibilities for small business owners. Even seasoned business owners can struggle with the complexities of payroll deductions and their calculations.

Let's break down the most common challenges small business owners face with payroll deductions, and more importantly, how to handle them.

Keeping up with changing regulations

Tax laws and compliance requirements change frequently. Without a system in place to track updates, it's easy to miss important changes that could affect your payroll calculations and reporting requirements.

Benson Varghese, lawyer and Managing Partner of Varghese Summersett, explains: "Failure to comply with federal and state payroll regulations can result in expensive fines or legal conflicts. Employers have to stay on top of calculating deductions based on employee classifications, earnings, and hours worked, often balancing shifting tax levels and contribution restrictions."

Common compliance issues:

• Missing updates to tax rates and regulations
• Incorrect garnishment calculations
• Late tax deposits
• Missing or incomplete documentation
• Employee classification errors affecting deduction rates

Employee confusion about deductions 

Clear communication about deductions isn't just good practice, it's essential for maintaining trust with your employees. It also reduces the time you’ll spend on explaining the same concepts repeatedly. After all, they might not know how pre-tax options can lower their taxable income or why their take-home pay seems different from one month to the next.

Common communication problems:

• Unclear explanations on pay stubs
• Poor communication about deduction changes
• Limited resources for employee questions
• Insufficient explanation of tax implications
• Confusion about benefit deductions

Managing payroll across multiple states 

Operating in multiple states multiplies the complexity of payroll deductions. Each state has unique tax rates, filing requirements, and deadlines that need careful tracking and management.

Yair Bennett, founder of BOI Agent, explains: "In states without income taxes, like Texas, deductions are simpler. Municipal taxes complicate them. Employers have to be aware of federal and state garnishment regulations to avoid serious compliance issues."

Common multi-state issues:

• Incorrect state tax withholding rates
• Missing local tax obligations
• Late state tax deposits
• Wrong jurisdiction assignments
• Incomplete multi-state documentation

Benefits administration requires constant attention to detail

Managing employee benefits involves tracking multiple plans, rates, and eligibility requirements. Changes in employee elections or benefit costs need to be accurately reflected in payroll deductions to avoid errors and maintain employee satisfaction.

Tsvetelina Nasteva shares more of her insights: "Benefits are a crucial part of compensation, but many employees overlook valuable options because they don't understand how they work. Providing clear information about benefit deductions helps employees make better financial decisions."

Common benefits challenges:

• Delayed updates to benefit changes
• Incorrect deduction amounts
• Missed enrollment deadlines
• Wrong effective dates
• Poor tracking of eligibility requirements

Manual calculations can result in expensive errors

Payroll calculations involve multiple variables that can become overwhelming very quickly. When you do calculations by hand, it's surprisingly easy to make mistakes. One wrong number, a misplaced decimal point, or an outdated tax rate can spiral into bigger problems. These mistakes can escalate to unhappy employees and potential compliance issues.

David Kindness, a CPA and personal finance writer at Best Money, shared his experience: “Getting the calculations right is critical. Even small errors can cause big headaches—for both the employer and the employee. Many businesses use payroll software to handle this. These tools not only crunch the numbers but also keep up with changing tax laws."

How to calculate payroll deductions

While it might seem overwhelming to juggle multiple tax rates, contribution limits, and deduction orders, breaking it down into steps makes it manageable. Whether you choose to calculate manually or use payroll software, understanding this process helps you spot errors and ensure payroll accuracy.

Here's a clear breakdown of how to handle payroll deductions, from initial calculations to final paychecks:

Step-by-step process: How to do it yourself.

If you're handling payroll manually, following a consistent process helps prevent mistakes. While it takes time and attention to detail, understanding these steps is valuable even if you use software.

Here's how to calculate deductions properly:

1. Start with gross pay: Calculate the employee's total earnings for the pay period, including regular wages, overtime, bonuses, and commissions.
2. Apply pre-tax deductions: Subtract any pre-tax voluntary deductions in this order—Health insurance premiums, 401(k) contributions, FSA/HSA contributions and other pre-tax benefits
3. Calculate taxes: Using the adjusted gross pay (after pre-tax deductions), calculate federal income tax using W-4 information and IRS tax tables. Then, calculate Social Security (6.2%) and Medicare (1.45%). Finally, apply state and local tax rates as required
4. Apply post-tax deductions: Subtract remaining deductions starting with wage garnishments (these have priority), then Roth 401(k) contributions, insurance premiums, union dues and other voluntary deductions
5. Verify calculations: Make all deductions were taken in the correct order, check that deductions don't exceed gross pay and verify tax calculations match current rates

The final amount after all deductions is the employee's net pay (take-home pay).

Use a payroll deduction calculator.

While manual calculations are possible, using a payroll calculator reduces errors and saves time. Many free online calculators can help you:

• Estimate tax withholdings
• Calculate FICA taxes
• Determine net pay after deductions

However, these calculators may not account for all state-specific requirements or special deductions. For complete accuracy, consider using comprehensive payroll software.

Simplify payroll deductions using Homebase.

Managing payroll deductions manually can be tedious and prone to mistakes, but Homebase takes the burden off your shoulders. By automating the entire process—from calculating gross pay to applying deductions and filing taxes—Homebase ensures your employees are paid accurately and on time. With real-time updates and error checks, Homebase keeps you compliant with federal, state, and local regulations, so you can focus on running your business.

With Homebase, you don’t have to worry about errors or missed deadlines. It handles year-end tax filings, including W-2s and 1099s, and sends payments to employees and tax authorities automatically. Learn more about how Homebase can help you manage payroll deductions and maintain compliance while saving time on calculations.

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FAQs

What are payroll deductions?

Payroll deductions are amounts subtracted from an employee's gross pay before they receive their paycheck. These include mandatory deductions like taxes and voluntary deductions like health insurance premiums or retirement contributions, which can be taken either before or after taxes are calculated.

What must be withheld from a paycheck?

By law, employers must withhold federal income tax, Social Security tax (6.2%), Medicare tax (1.45%), state income tax (where applicable), and any court-ordered garnishments. These mandatory deductions must be processed before any voluntary deductions like health insurance or 401(k) contributions.

What is the average payroll deduction?

The average employee loses about 30% of their gross pay to deductions, though this varies significantly based on income level, location, and chosen benefits. Federal income tax typically ranges from 10-37%, plus 7.65% for FICA taxes, and state taxes and voluntary deductions add to this total.

How do I calculate payroll deductions?

Start with gross pay, then subtract pre-tax deductions like health insurance and traditional 401(k) contributions. Calculate taxes on the adjusted amount, including federal, state, and FICA taxes. Finally, subtract any post-tax deductions like wage garnishments or Roth contributions to arrive at net pay.