This article aims to explain the pretax deduction and the payroll deductions, in general. The subject requires you to understand the terms clearly as it follows certain regulations set by the law of the state that need to be abided by. So, let’s begin and understand the different topics the article entails:
- What are Payroll deductions?
- How do Payroll deductions Work?
- What are Pretax Deductions?
- Statutory deductions
- Post-tax deductions
- How to calculate payroll deductions
- Payroll deduction FAQs
What are Payroll Deductions?
An employer withholds payroll deductions from an employee's salary to pay taxes, garnishments, and other benefits, such as health insurance. The withholdings may be made from gross pay or net pay based on these factors:
- Child support payments
- 401(k) contributions
- Social security tax
- Wage garnishments
Employees can choose to have payroll deductions taken out of their paychecks pretax or post-tax through written authorization. Employers who fail to correctly withhold taxes and wage garnishments may be held liable for the amounts that aren't remitted.
How do Payroll Deductions Work?
Your employees or a court order determine whether withholding is to be deducted from your employees' salaries based on the applicable tax laws. A payroll service provider can automate the process or you can perform the calculations manually. Business owners utilize automation as it ensures the elimination of errors. Moreover, they also ensure that payments are submitted on time to the appropriate authorities.
According to the form W-4 Employee's Withholding Certificate, state and local withholding certificates, benefit selections, and other factors, you will withhold a different amount for each employee.
Payroll deductions vary based on where your employees work and where your business is located. The reason for this is that not every state collects income taxes.
What are Pretax Deductions?
A pretax deduction refers to the amount that is deducted from a paycheck before taxes are withheld. Due to their exclusion from gross pay for taxation purposes, pretax deductions reduce taxable income and taxes owed to the government bodies. As a bonus, your Federal Unemployment Tax (FUTA) and state unemployment insurance fees are lowered.
In addition to health insurance and group-term life insurance, pretax deductions may include retirement plans. It is not mandatory for employees to participate, however, it is often in their best interest. Contributions before taxes can save them quite a bit of money when compared to benefits and other services after taxes.
The amount employees can contribute to a pretax account is usually capped and therefore, it is not possible to save indefinitely. A 401(k)-retirement plan is regulated by the IRS as to the amount that can be deferred pretax each year.
What are Statutory Deductions?
Governments have a lot of services planned and designed for the welfare of the general public. The government indicates to make mandatory deductions to fund its programs and services which are known as Statutory deductions. The deductions may include the Federal Insurance Contributions Act (FICA) tax (Medicare and Social Security) and state income tax.
You must deduct taxes if someone is a bona fide employee. It is usually not necessary to withhold income tax, Medicare tax, or Social Security tax from the wages of independent contractors. The reason here is that the contractors pay their taxes on their own.
The next few sections take us to the details of the deductions like the FICA tax, Federal Income Tax, and State & Local Taxes.
SSA and Medicare are funded by FICA taxes. Social Security taxes are deducted at a rate of 6.2% based on wages, and Medicare tax deduction rate is of 1.45% without a cap. Until the Social Security wage base is met, you will be liable to match 7.65% of FICA taxes per paycheck.
Additionally, there may be a Medicare tax for some employees. If an individual's earnings exceed $200,000 during a pay period, you must begin retaining 0.9% of that individual's wages until the end of the year. There is additionally a medical tax imposed on certain railroad retirement income levels and self-employment income levels. It is not mandatory that you match this deduction.
Federal Income Tax
A federal government's seven tax brackets encompass the ranges from 10% to 37%. As a result of these progressively applied rates, an employee's wages are first charged according to the lowest rate until they reach the threshold of the bracket. The tax rate is increased if the taxpayer's gross income reaches the maximum tax bracket.
The taxable income in each bracket also depends on the individual’s filing status as noted on Form W-4. Their status on the form, whether single or married filing separately, married filing jointly, or head of household are considered. The IRS will adjust tax bracket thresholds for inflation on an annual basis.
There are two options provided to withhold the federal income tax for every period. These are the Wage Bracket method and the percentage method. For further knowledge or assistance, one can easily visit the IRS Publication 15-T.
State and Local Taxes
There are numerous taxes under this category. Some of these are very simple to understand whereas some are complicated. There is a category that charges a fixed rate on all income and then there’s another that is divided into tax brackets. Also, there is a category that does not charge anything. Therefore, it is imperative that you check with all state governments where you operate to ensure your payrolls comply with local laws.
What are Post-tax Deductions?
A post-tax deduction refers to the deduction that is taken from a paycheck after all the required taxes have been taken. Post-tax deductions reduce the net income of a person. The individual's tax obligation does not decrease since the gross pay isn't reduced.
The most common examples are:
- Roth IRA retirement plans
- Dues to the Union
- disability insurance
- Contributions to charities.
All post-tax deductions, except wage garnishments, can be declined by employees.
An employer may be ordered by the court to cover the unpaid taxes of an employee such as child support or alimony, for example. One can garnish the types of income that include:
- Hourly wages
- Pensions and retirement plan payments
Withholding amounts and where payments should be sent are typically specified in a garnishment order. It is important to familiarize yourself with this document. If you deduct garnishments incorrectly or fail to pay them entirely, your business could be liable for the back payments, not the employee.
A garnishment order must include compliance with Title III of the Consumer Credit Protection Act (CCPA). The law not only restricts the amount of the salary of an employee that can be garnished per week but also prevents the employer from firing the employee if their pay is garnished for any of the debts.
As there are multiple benefits that the employees are entitled to if there are deductions on their paychecks, they can opt to increase their paycheck deductions to cover benefits. These are called Voluntary deductions. Payroll deductions can be withheld on a pretax or post tax basis depending on if Section 125 of the Internal Revenue Code permits them.
In light of voluntary deductions being optional, they should be explained well to employees. Ensure that your employees are aware of these deductions. If you wish to withhold insurance premiums or other benefits from an employee's pay, obtain their written consent. In addition, make sure every pay statement displays the current deduction.
Document every deduction accurately. This documentation and record will come in handy when an employee or auditor asks about it. Moreover, recordkeeping is mandated by many states.
Payroll deductions that are voluntary include:
- Retirement Plans
- Health Insurance
- Group-term Life Insurance
- Job-related Expenses
Out of the many retirement plans offered by the employers, Roth Individual Retirement Accounts or IRA and 401(k) remain the most sought after plans. IF an employee chooses the 401(k) plan, their contributions are deferred for the federal income tax along with most states income tax. However, they are still not exempted from the FICA tax.
On the other hand, if an employee chooses an IRA, then their contributions are withheld based on the post-tax.
Health insurance is one of the ways in which companies look for retention as well as attracting skillful people. In the process, however, they are also looking to make it hassle free as well as less burdensome for themselves. Therefore, most times the contributions are made by both the employer as well as the employee on a pre-tax basis. When this is to be done, the contributions are to be made through the Section 125 plan, according to the IRS.
Group-term life Insurance
Basic term life insurance up to $50,000 is sometimes offered at no cost by employers to their employees. For amounts above $50,000, income is deemed imputed. The costs of supplemental insurance or life insurance for dependents are typically deducted from employees' pay post-tax.
You may have to pay for your employee's membership in the union and any tax-deductible benefits they receive. The following types of job expenses are also deductible from payroll: uniforms, meals, and travel. But as it has been discussed, depending on the state, these deductions may be prohibited.
How to Calculate Payroll Deductions?
The process of calculating payroll deductions involves the conversion of gross pay to net pay. Here are the steps for calculating it:
- Withhold pre-tax contributions to health insurance and 401(k) retirement plans from gross pay.
- Calculate and deduct federal income tax using the Form W-4 and the IRS tax tables for that year.
- Medicare and Social Security tax are withheld from your adjusted gross pay at 7.65%.
- Whenever your year-to-date income exceeds $200,000, subtract 0.9% for Additional Medicare tax.
- According to each state's tax code or guide, you must withhold income tax in states that charge income tax.
- Calculate the net pay by subtracting garnishments, contributions to Roth IRA retirement plans, and other post-tax liabilities.
Payroll Deduction FAQs
The journey of payroll deductions is a tough one and one needs to be extremely careful and mindful about the deductions and the related laws pertaining to it. While at it, you may have a certain set of questions. We shall try to address those frequently asked questions in this section.
How do payroll deductions for insurance work?
Employer-sponsored health insurance is commonly purchased by Americans with their payroll deductions. A Section 125 plan can withhold premiums from employees' wages on a pretax basis, which offers considerable cost savings. In the process, the employees actually reimburse the amount to their employer instead of directly paying to the insurance provider. The employer then forwards the amount to the provider.
How can incorrect payroll deductions be identified?
It is common for employers to charge their employees for benefits and services they should pay for themselves; and this results in incorrect payroll deductions. In some states, withholding income to cover uniforms, shortages in cash registers, and job-related expenses is subject to additional rules. Among these deductions are:
- Federal unemployment tax (FUTA)
- Personal protective equipment required by OSHA
- Workers’ compensation insurance
- State unemployment tax
- Tools necessary to perform work
What is the reporting process for payroll deductions?
Employers typically use the following forms to calculate employee withholdings and the amount of employer tax they must pay to the government:
- Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return
- Form 944, Employer's Annual Federal Tax Return
- Form 941, Employer’s QUARTERLY Federal Tax Return
State regulations for reporting payroll deductions may vary, so it is advised to check with your local authorities. Paper or electronic submissions of these documents are both acceptable.
How does LTD affect paychecks?
LTD stands for Long-term disability. An employee who is injured or too sick to work for an extended period of time is entitled to a deduction of a certain percentage of their wages for long-term disability.
Pre-tax deductions for LTD reduce employee premiums, but any benefits received are subject to federal income tax. Those receiving LTD benefits after tax, however, receive slightly less take home pay per pay period, but their benefits aren't taxed again if they use them. It is often taxed the same way as short-term disability or the STD.
Can the Pre-tax deductions be claimed?
Items that were already included in pre-tax deductions cannot be deducted on an employee's income tax return. So, the answer here is No, it cannot be claimed. You've already received a tax benefit by not paying tax on the deductions, since their amount is not included in your gross income. Then you'll be claiming it twice on your taxes.
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Let’s revisit the major points from the post:
- An employer withholds payroll deductions from an employee's salary to pay taxes, garnishments, and other benefits, such as health insurance.
- Employees can choose to have payroll deductions taken out of their paychecks pretax or post-tax through written authorization.
- A pretax deduction refers to the amount that is deducted from a paycheck before taxes are withheld. Due to their exclusion from gross pay for taxation purposes, pretax deductions reduce taxable income and taxes owed to the government bodies.
- The government indicates to make mandatory deductions to fund its programs and services which are known as Statutory deductions.
- FICA taxes, Federal Income tax, and State and Local Tax come under statutory deductions.
- A post-tax deduction refers to the deduction that is taken from a paycheck after all the required taxes have been taken. Post-tax deductions reduce the net income of a person.
- Wage garnishments form a part of the post-tax deductions.
- As there are multiple benefits that the employees are entitled to if there are deductions on their paychecks, they can opt to increase their paycheck deductions to cover benefits. These are called Voluntary deductions.
- Retirement Plans, Health insurance, job-related expenditure, and group-term life insurance are all a part of Voluntary Deductions.