What is a payroll deduction plan? – Forbes Advisor
The first thing you need to understand is that there are two basic categories of deductions:
- Pre-tax deductions: The deductions to be made on the gross salary before the calculation of taxes are the pre-tax deductions. Pre-tax deductions help employees reduce their taxable income.
- Deductions after taxes: The deductions that are made after the taxes are calculated are the post-tax deductions. They do not reduce the tax burden of employees.
The salary calculated after deductions before and after taxes is the employee’s net or net salary. The pay stub you generate with each payment should contain full details of the deductions that were made.
Payroll deductions can be categorized into lump sum deductions, wage garnishments, and benefit deductions.
Standard payroll deductions
Standard payroll deductions are deductions imposed by government agencies to pay for public programs and services. They constitute pre-tax deductions.
- Federal income tax: Federal income tax has seven brackets ranging from a minimum of 10% to a maximum of 37%. The amount withheld from an employee’s pay depends on the employee’s earnings and the information provided by the employee on the W-4 form. Form W-4 includes information about an employee’s tax filing status, number of dependents, income from other employment, and any adjustments to the standard withholding amount.
- FICA taxes (Federal Insurance Contributions Act): FICA deductions relate to health insurance and social security for employees. Medicare costs 1.45% of gross salary, while Social Security costs 6.2%. As an employer, you must match employee contributions at 100%. For 2022, you must withhold and pay Social Security taxes on the first $147,000 of an employee’s gross pay. There is no Social Security tax on earnings over $147,000. You must collect Medicare taxes on all employee earnings. Additionally, once an employee earns $200,000 in a calendar year, you must begin deducting an additional 0.9% health insurance tax from the employee’s pay.
- State income tax: All but nine states levy taxes on employee earnings. They either have a flat rate on all income or several brackets. Your payroll software should be able to support state income tax for all of your employees, based on their area of residence or employment, as applicable.
If an employee has an unpaid debt, a court or government agency can issue a wage garnishment order. Wage garnishments are after-tax deductions.
Here are some examples of wage garnishments:
- Student loans
- Credit card debt
The garnishment order will contain details of the amount you must deduct from the employee’s wages, where the deductions should be sent. There are limits to the amount that can be garnished, and these vary depending on the employee, applicable state and federal laws, and the type of debt. You have to be very careful when deducting the correct amount because if you don’t, you are potentially liable for the debt.
Deductions from benefits
If you offer benefits like health insurance and a 401K plan, you’ll need to deduct employee costs or contributions from their pay. These voluntary deductions can be before or after tax, depending on the type of deduction.
Here are some examples of benefit deductions you could make:
- 401(k): A 401(k) is a retirement plan funded by employee contributions. The taxman has increased the annual 401(k) contribution limit to $20,500 in 2022. Employees age 50 and older can make an additional catch-up contribution of $6,500. An employer can also contribute matching funds to employees’ 401(k) accounts. Employee 401(k) contributions are subject to FICA taxes but not income tax.
- Individual Retirement Account (IRA): In this type of retirement plan, the employee sets up a traditional or Roth IRA with a financial institution. The employer deducts the employee’s desired IRA contribution each pay period and forwards it to the financial institution. It’s simpler and easier for the employer than a 401(k) plan, but it’s likely to be less popular with employees because there’s no employer match and the limit of annual IRA contribution is only $6,000 ($7,000 for ages 50 and older).
- Medical, dental and visual insurance: As health insurance costs have skyrocketed, most employers now require employees to contribute to the cost of company-sponsored insurance plans. These contributions are before tax (and the employer’s contribution is not taxed) if the insurance is offered as part of a Section 125 Regimealso known as the cafeteria plan.
- Other advantages of the cafeteria plan: In addition to health insurance, your company’s cafeteria plan may offer benefits such as disability insurance, health savings accounts, and flexible spending accounts. These benefits are generally pre-tax.
- Group term life insurance: The cost of group term life insurance plans may or may not be taxable, depending on the specific plan and coverage amount.
- Work-related equipment such as uniforms: Federal law prohibits you from deducting the cost of uniforms if doing so would cause the employee to earn less than minimum wage. Some states further restrict or prohibit these deductions, so be sure to check state laws before starting them.