Every time an employee receives their paycheck they might notice their take-home is less than their gross pay. There’s really no mystery, however. The reason is payroll deductions, or money that’s taken out of employee pay.
Here’s what employers and employees need to know about deductions.
What are payroll deductions?
A payroll deduction is money withheld from an employee paycheck. Deductions fund general government operations, federal social and retirement programs, and employee benefits.
Specific payroll deductions can include:
- Estimated federal and state income tax
- Employee portion of Social Security and Medicare tax
- Medical, dental, and vision benefit contributions
- Health savings account contributions
- Retirement savings plan contributions
- Union dues
- Payment of court-ordered judgments, known as wage garnishment
Some deductions, such as contributions to retirement plans, are pretax, because they are taken from an employee’s gross pay. This lowers the amount of income subject to taxation. Other deductions, such as union dues and court-ordered wage garnishments to satisfy legal judgments, are taken from after-tax pay.
Mandatory payroll deductions
Laws require employers to withhold Social Security, Medicare, and income tax from employee pay and send payments to the relevant government agencies. These mandatory or statutory payroll deductions include:
- Federal. Federal income taxes fund the US government’s operations and public services. The Federal Insurance Contributions Act (FICA) taxes pay for Social Security and Medicare benefits. Employers must collect and submit these taxes quarterly to the Internal Revenue Service.
- State. In the US, 41 states and the District of Columbia tax earned income. States use income tax revenue for public services, including education, health care, hospitals, roads, courts, and prisons. States typically require employers to submit withheld taxes monthly or quarterly. New Jersey, Alaska, and Pennsylvania also require employees to pay unemployment insurance tax.
- Local. Cities and counties may impose their own income tax. Some, such as New York City, impose the tax on residents only, while others also tax non-residents who work in the locality. Local taxes often are collected along with state income taxes; the state then sends the local portion back to the city or county.
- Other. Wage garnishments come out of after-tax income. A garnishment is ordered by a court to satisfy a judgment against an employee, typically for failure to pay taxes, alimony, or child support. Union dues may be a mandatory deduction, depending on the state.
Voluntary payroll deductions
Employees may opt for voluntary payroll deductions for additional services and benefits, such as employer-sponsored health and disability insurance and retirement plans. Employers must inform employees of these services and benefits and get their written consent before making deductions. Employers usually list current-pay period and year-to-date deduction amounts on each employee pay stub. Common employer-sponsored services include:
Many employers offer medical, dental, and vision-care insurance coverage, and may require the employee to pay part of the premium cost. These premiums usually are deducted from pretax income, thus reducing the employee’s taxable income. Employers also can deduct their share of the premium, lowering their taxable income as well. Because employers purchase insurance in bulk, these group policies cost less for employees than buying insurance on the open market.
Employers sometimes also provide a limited amount of term life insurance to employees at no cost through a group policy. Employees may choose to buy additional life insurance for themselves or for a dependent. These premiums are deducted from after-tax pay.
Employers may offer retirement savings plans funded primarily by the employee. The two most popular types are 401(k) plans and individual retirement accounts, or IRAs. Note that individuals can set up IRAs independently of their employer and fund them independently. “Payroll deduction IRAs” are a specific type of account funded by authorized payroll deductions.
A 401(k) plan is employer-sponsored, while a payroll deduction IRA is set up by the employee through a bank or financial services company; in both cases, the employer makes the deduction specified by the employee to fund the account. Some employers match employee 401(k) contributions up to a specific dollar limit.
Employee contributions to 401(k) and regular IRA accounts are made pretax. As of 2023, employee 401(k) contribution was an annual limit of $22,500, or $30,000 if the employee is 50 or older. The maximum annual IRA contribution is $6,500, or $7,500 for someone 50 or older.
These retirement accounts are not taxable during an employee’s working years. Withdrawals at retirement are then treated as taxable income. Both Roth 401(k)s or Roth IRAs are funded from after-tax pay, and withdrawals at retirement don’t require payment of income tax.
How to calculate payroll deductions
Calculation of payroll deductions shows how an employee’s gross income progresses down to net income, or take-home pay. The employer calculation depends on two things:
- Employee W-4 forms. This IRS certificate filled out by the employee indicates tax status (such as single or married), the number of dependents (such as young children), and an attached worksheet for estimating annual income tax liability, including whether the employee takes the standard deduction or itemizes deductions. States with income tax have similar forms. Employers must check that employees complete these certificates; employees can update them if their personal circumstances change.
- Tax withholding tables. The employer uses tax tables to determine federal income tax withholding and state income tax if applicable. Federal income tax is progressive, meaning the tax rate increases in step with taxable income within prescribed ranges known as brackets. The seven federal tax brackets start at 10% and reach a maximum of 37% as of 2023.
Using the employee’s W-4 information and tax tables to estimate annual tax withholding, the employer then divides the amount withheld by the number of pay periods, deducting the proportional amounts from each paycheck.
Let’s say an employee living and working in Virginia earns $72,000 a year. The employer pays workers monthly. The employee files jointly with a spouse. Here is what the employee’s monthly payroll deductions might look like:
|GROSS SALARY, $72,000 / 12 pay periods||$6,000|
|Retirement plan contributions, $6,000 / 12||-500|
|Medical/dental insurance, $2,400 / 12||-200|
|FICA, 7.65% of gross salary ($72,000 x 0.0765) / 12||-459|
|Federal tax est., using tax brackets, $4,113 / 12||-343|
|Virginia tax est., using brackets, $2,775 / 12||-231|
Payroll deductions FAQ
How do you calculate payroll deductions?
An employer first subtracts any employee pretax contributions for health insurance and retirement plans from gross pay. Then, using federal and state tax tables, and an employee’s W-4 estimated tax liability, the employer determines how much to withhold for income tax.
What is the employer’s role in managing payroll deductions?
The employer is responsible for mandatory tax withholding, court-ordered wage garnishments, and the employee’s voluntary deductions for health insurance and retirement-plan contributions. Employers determine withholding based on the information employees provide on the W-4 form about tax filing status (single, married, etc.) and any itemized deductions.
What are the three common deductions?
Common deductions fall into three categories:
- Pretax deductions, such as employee contributions to retirement plans and health insurance.
- Federal, state, and local income and payroll taxes.
- After-tax deductions and contributions, such as union dues and court-ordered wage garnishments.
How can I keep track of my payroll deductions?
Employees can easily track payroll deductions by examining the pay stub that many employers include with each paycheck or direct deposit. The stub should list all deductions for the pay period and for the year to date.