Everything You Need to Know About Payroll Deductions

Updated on October 29, 2021

Payroll deductions are ways that your employer can withhold or take out money from your paycheck. In addition to withholding funds for federal, state, and local taxes, as well as your health care benefits plan, your employer might also have permission to take out money from your paycheck to pay for various types of loans or financing arrangements, as well as company-related payments such as business travel reimbursement. Using automated payroll software will help you manage all these taxes and deductions without any manual work. Here are the basics of payroll deductions that every employer should know about.

1) Federal Tax Withholding

The IRS requires employers to withhold federal income tax from their employee’s paychecks, except for taxes withheld on some forms of supplemental income. If your business is required to withhold taxes, you may choose to use either: (1) The wage bracket tables and instructions in Publication 15 (Circular E), Employer’s Tax Guide; or (2) A flat percentage of gross wages. Many small businesses choose a flat percentage method—such as 20 percent—to make calculating payroll easier. However, if you use a flat percentage method and fail to withhold enough taxes, your employees will owe additional taxes when they file their annual tax returns.

2) State Tax Withholding

It’s a good idea to keep a close eye on your employee’s payroll deductions. Make sure that you’re withholding enough money from their paycheck for federal and state taxes, but not too much. It can be tricky figuring out how much to withhold from each paycheck, especially when it comes time for an annual W-4 form, so make sure you work with a tax professional or read up on IRS guidelines. In addition, remember that if an employee quits or is fired, any money they haven’t already received in their paychecks will have to be sent directly to them in a check or transferred into a bank account. Keeping your records organized can save both you and your employees time in completing all of these tasks at once.

3) Local Tax Withholding

In order to determine how much you need to take out of each paycheck for taxes, your employer will ask you a few questions about your personal tax situation. That includes things like how many dependents you have and whether or not you’re eligible for a tax credit. Be sure to review your W-4 every so often, since it only takes a couple minutes and could save you a lot of money at tax time. If all of these withholding tables seem overwhelming, don’t worry—your employer will know what to do when they talk with their payroll department.

4) Social Security (FICA) Taxes

The Federal Insurance Contributions Act (FICA) is an act passed by Congress that mandates employers to pay 6.2% of their employee’s income into Social Security and 1.45% into Medicare. This tax, which is matched by employers, helps fund social security payments for retirees and Medicare benefits for people 65 or older. Employers are not allowed to deduct FICA taxes from their employees’ paychecks; instead, they must deposit these payments on a regular basis along with other payroll deductions like federal income tax withholdings and workers compensation insurance payments. Employers also have quarterly estimated payments due each April 15th, June 30th, September 30th and January 31st based on what they predict they will owe in FICA taxes during that year.

5) Medicare Taxes

Medicare tax is a deduction that an employer must take from his employee’s paycheck and send to Medicare. The amount depends on how much you make during a year. If you’re self-employed, you’re also responsible for paying your own Medicare tax. The amount of your deduction can vary depending on how much you’ve earned in a year. Employers are responsible for deducting it from their employees’ paychecks. What can I do if my employer doesn’t take out enough? In some cases, an employer may forget or not have enough money to withhold Medicare taxes from his employees’ paychecks. When that happens, it’s up to the employee to report her income and pay any missing amount herself.

6) Retirement Plans

The most common type of savings in retirement plans is an IRA. These are special accounts that you set up with a financial institution, then invest money into. They’re often tax-deferred—meaning you don’t pay taxes on your contributions until you withdraw them in retirement—and allow you to choose from a variety of investments. That means there are plenty of options out there for your hard-earned dollars, but not all are created equal. So be smart about where you put your cash and save more money now so later down the road you have more opportunities for growth.

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