A Deep Dive Into Payroll Deduction Types: Definitions, Examples, and How to Use Them

If you are looking to automate payroll deductions, Finch can help. Talk to sales. 

Payroll deductions refer to the money withheld from an employee's paycheck each pay period to cover taxes, benefit premiums, and other financial obligations. Whether you're a business establishing your payroll, a SaaS tool offering employee benefits, or an employee seeking clarity on paycheck adjustments, it's crucial to grasp the different types of payroll deductions and how they differ.

This article explores common payroll deductions, their legal requirements and addresses some frequently asked questions. Plus, for those involved in employee benefits, retirement, health insurance, and more, we have a bonus section that explains how to seamlessly adjust deductions within the employer's payroll system.

Now, let’s decode different types of payroll deductions one by one. 

What are payroll deductions? 

Payroll deductions involve subtracting money from an employee's total wages each pay cycle to cover both mandatory and voluntary employment expenses, including taxes, benefits, and garnishments. 

Each deduction has distinct calculations, regulatory requirements, and is applicable in different scenarios.

The deduction amount depends on multiple factors like federal or state tax laws, withholding information supplied by the employee in their Form W4: Employee’s Withholding Certificate, and the benefits programs the employee is subscribed to. The calculation process can be manual or automated.

Some types of benefits deductions are taken out of a paycheck based on the written approval of the employee. However, statutory deductions and garnishments are withheld by the employer as mandated by law.

Types of payroll deductions

Here are the common payroll deductions to keep in mind if you are working for an employee benefits or payroll company that does business in the United States. 

Mandatory deductions 

Mandatory deductions are commonly called withholdings. Some examples of statutory payroll deductions include state and federal taxes, wage garnishments, and FICA. 

• Income taxes: Employers must withhold federal and state income taxes each pay period. Federal taxes have seven brackets (ranging from 10% to 37%), applied incrementally. Taxable income depends on the employee's filing status (single, married, head of household) and claimed allowances in Form W4.  Based on which state the employer operates in, the state income tax rate changes as well. Some states follow federal tax brackets, while others have different local tax protocols. Some states charge progressively, while some charge none. Employers must follow local payroll laws to avoid penalties. Calculating taxes is a complex process and if you are doing it manually, it can be a nightmare.

• FICA (Federal Insurance Contributions Act): FICA includes Social Security and Medicare, with a standard rate of 7.65% per paycheck (6.2% for Social Security and 1.45% for Medicare). Social Security has an income-based upper limit, and employers are mandated to match this contribution. Medicare tax, on the other hand, pays for doctor’s fees, hospital care, and nursing care for 65 years or older as well as for those who receive social security benefits. Employees earning over $200,000 annually must pay an additional Medicare tax.

• Garnishments: Employees may owe a portion of post-tax wages to cover unpaid dues in areas like child support, alimony, defaulted loans, or tax obligations. Employers can be legally ordered to withhold these amounts by courts, government agencies, or the IRS. Failure to accurately handle these payroll deductions can hold employers financially responsible.

Voluntary deductions

Employees can choose from various employer-offered benefits programs and agree to deductions from their paychecks on either a pre-tax or post-tax basis. These programs encompass 401(k) and retirement plans, health insurance, health savings accounts (HSA) and flexible spending accounts (FSA), life and disability insurance, commuter benefits, wellness programs, college savings plans, and other common voluntary payroll deductions. 

Note: Employers need written authorization from the employee for the following deductions:

• Health insurance: Employees with employer-sponsored health, dental, or vision plans have premiums deducted on a pre-tax basis from each payroll, typically with employers sharing the cost.
• 401(k) & retirement benefits: The two most common employer-sponsored retirement benefits plans are 401(k) and Roth IRA contributions. 401(k) is deducted from payroll on a pre-tax basis but subject to FICA taxes. While Roth IRA contributions are deducted on a post-tax basis. As the complexity of the retirement benefits industry increases, more employers and plan providers are relying on 401(k) payroll integrations. This helps them automate payroll deductions, save time, and significantly reduce compliance risks. 
• HSA and FSA contributions: Health Savings Accounts HSA) and Flexible Spending Accounts (FSA) are both employee health benefits that are typically deducted from payroll on a pre-tax basis. Employees can opt to deduct a certain amount of their paychecks each payroll towards paying HSA to cover specific medical expenses like copay, prescriptions, dental or eye care. HSAs are called “triple advantaged” benefit plans, because 1) the money that employees contribute is tax-exempt, 2) the money isn’t taxed while it’s in the Health Savings Account, and 3) it is also tax-free when employees use the money for qualified medical expenses. This triple advantage makes HSAs one of the most popular payroll deduction types by employers. Unlike HSAs, FSAs cannot be transferred, and have a lower contribution limit.
• Commuter benefits: Employees can use tax-free funds from their paychecks for commuting expenses, including mass transport, ride shares, and qualified parking.
• Wellness programs: Employers may offer health promotion and disease prevention plans, like diabetes management, vaccination, weight loss plans, etc. Sometimes wellness programs include employee’s spouses as well. Wellness program-related payroll deductions can be calculated pre-tax if the employee does not have any unreimbursed medical payments related to the payment. 
• College savings plans: Employees can allocate a percentage of their paycheck to state-sponsored 529 plans (known as college savings plans or qualified tuition plans) for a beneficiary's education, which may be state tax deductible. Note: they are not federal tax deductible.
• Life and disability insurance: This includes employee contribution towards group life insurance plans and short or long term disability insurance premiums.
• Others: Voluntary payroll deductions also include U.S.Savings Bond purchases or any money owed to the company for tools, uniforms, loans, etc. 

Pre-tax and post-tax deductions

Voluntary and mandatory payroll deductions can be further classified as pre and post-tax deductions. 

Pre-tax deductions are subtracted from an employee's gross paycheck before any state or federal taxes are withheld, lowering the taxable income. Common examples include health insurance, commuter benefits, group term life insurance, health savings accounts (HSA), flexible spending accounts (FSA), and retirement benefits plans. While participation is optional, it is generally beneficial for employees. Note that there's an annual limit set by the IRS on how much can be contributed to these pre-tax plans, such as 401(k).

Conversely, post-tax payroll deductions are adjusted from an employee's paycheck after taxes have been withheld. Examples include Roth IRA retirement contributions, charitable donations, disability insurance, and garnishments. These deductions don't reduce an employee's tax burden. Employees can choose not to contribute to these plans, except for wage garnishments.

How do payroll deductions work?

Employers typically rely on benefits partners to inform them about various deduction details. These deductions are then processed through a payroll provider to determine an employee's net take-home pay. Payroll providers also ensure that necessary payments are made to the appropriate government entities on time. 

The payroll deduction process follows a standard sequence:

• Deduct pre-tax contributions (e.g., health insurance, 401(k) retirement benefits, and other eligible voluntary payroll deductions) from the gross pay.
• Calculate and withhold federal tax deductions based on the employee's W4 and IRS tax bracket requirements.
• Withhold 7.65% for FICA and an additional 0.9% for Medicare tax if the applicable threshold is met.
• Determine and deduct state tax according to state tax regulations to arrive at the net pay.
• From the net pay, withhold garnishments, dues, and post-tax contributions for other employee benefits such as Roth IRA and disability insurance.

As you can see, to successfully manage payroll deductions, there’s a lot of information exchange required between the employer, payroll provider, and benefits plan partners. Manual processes can render this experience even more redundant and error-prone. Tools like Finch help automate payroll deductions to ensure a seamless experience end-to-end. Learn more.

FAQs about common payroll deductions

What are some examples of wrongful payroll deductions?

With so many deduction types, mistakes can happen. Common errors include:

• Inaccurate deduction amount: Employees often make choices about voluntary benefits plans, like how much to defer from their paycheck or which plan to enroll in. Any error in documenting these details can lead to incorrect premium deductions.
• Incorrect tax calculations: Misclassifying deductions as pre-tax or post-tax can result in employees being assigned the wrong tax brackets. Errors in adjusting these deductions can lead to overpayment or underpayment of taxes. Also, if an employee's filing status (single, joint) or employment details change but are not updated in the systems, it can cause inappropriate tax liability for the employee.
• Getting employee details wrong: Whenever an employee experiences a qualifying life change like the birth of a child, getting married or divorced—employees get the option to update their benefits deduction details mid-year. With multiple benefits providers involved, employers might miss these updates, leading to inaccurate payroll calculations.
• Other common payroll mistakes include non-compliance with local payroll laws, miscalculations of pay or overtime wages, and filing delays. 

Automating payroll deductions is highly beneficial as it captures changes and updates employee information, employment status, and contribution details promptly between systems, reducing errors in deduction calculations. Learn how Finch's automated deductions can reduce deduction errors altogether.

What happens when payroll deductions are calculated incorrectly?

If payroll is calculated with incorrect deduction details it can result in employees being enrolled into the wrong tax brackets. This can result in higher taxes, penalties, or lost interest for employees. 

If withholding calculations are not compliant with state and federal laws, employers need to compensate for back payments, not the employees. 

What is the difference between core benefits and fringe benefits?

Core benefits are the primary benefits employees receive for being employed by an organization. This includes retirement benefits, health insurance, etc. Fringe benefits are the extra perks that some employees get like free meals, childcare (up to $5,000), gym memberships, mental health benefits, group term life insurance, employee discounts, etc. 

While most core benefits are mandated by federal and tax laws, employers offer fringe benefits to retain talent and infuse a positive work culture. The fringe benefits that are translated into cash form are usually deducted from employee wages. 

How do you simplify payroll deductions for employers?

Finch is committed to making payroll deductions easy and automated for employers. It aims to do this by helping innovative SaaS tools in the retirement, benefits, and insurance sectors build solutions that can be integrated with 200+ HR and payroll systems using a single unified employment API. By allowing benefits providers to fetch data from the employer’s source of truth, Finch ensures data accuracy and timely contribution updates to payroll. 

Streamline deductions management: Finch eliminates the need for flat files, SFTP, or manual data entry to fetch employee census data and contribution details. It automates the entire process of payroll deductions by connecting the employer’s payroll systems with the benefit providers' tool. 

Enhance accuracy through automation: Today, every employer is looking for automated deductions management. It frees up employer admin time as they don’t have to manually enter data into the provider’s system each time employment status changes. 

Similarly, all contribution details can be written back into the payroll system without manual intervention. Automated adjustments increase data accuracy and help employers avoid the common payroll deduction mistakes we discussed earlier.

If you are a SaaS tool looking to automate payroll deductions, reach out to us, we’d be happy to help.