Payroll DeductionsWhy your net pay is lesser than your gross pay

If you’re someone who receives a salary or a wage, you’ve probably already noticed that the pay you receive isn’t the same as what you’re stated salary or wage is on your contract.

For example, let’s say that your contract says that your monthly salary is $5,000 but you only receive $4,200.

And before you think that your employer is stealing from you, they most probably don’t do so.

In fact, employers are required to withhold a certain amount of their employees salaries or wages.

For what reason?

Well, one reason is to cover payroll taxes as well as income tax.

Sometimes, employers withhold a portion of an employee’s salaries or wages to cover benefits such as health insurance.

We refer to these deductions as payroll deductions.

Basically, these payroll deductions reduce the actual pay you receive.

However, you’re still actually earning the stated salary or wage on your contract.

In our above example, you’re still earning a $5,000 monthly salary even if what you actually receive is $4,200.

In this article, we will be discussing what payroll deductions are.

Why do employers make such deductions?

Are all payroll deductions mandatory?

Can an employee opt out of payroll deductions?

How do payroll deductions affect an employee’s taxable income?

Let’s try to answer these questions as we go along with the article.

What Are Payroll Deductions?

Payroll deductions refer to the amount that employers withhold from an employee’s total earnings (salaries or wages).

The employer will then use this amount to cover for the employee’s taxes, garnishments, and benefits (e.g. health insurance).

Deducting the payroll deductions from an employee’s gross pay will result in that employee’s net pay.

Payroll deductions can either be mandatory or voluntary.

While an employee can opt out of voluntary payroll deductions, s/he can’t do so on mandatory ones.

Mandatory payroll deductions include the following:

• Federal Income Tax
• State and Local Income Tax
• Social Security and Medicare (a.k.a. FICA Taxes)
• State Unemployment Insurance (only for specific states)
• Court-Ordered Garnishments and Payments to Creditors

Voluntary payroll deductions are usually payments for the benefits of the employee.

The law does not require employers and employees to make such deductions, but some will still opt for them as they are often for their benefit.

Just note that an employer cannot make these deductions without authorization from the employee.

Some examples of voluntary payroll deductions include the following:

• Health Insurance Premiums for Medical, Dental, and Vision Plans
• Life Insurance Premiums
• Retirement or 401(k) Plan Contributions
• Union Dues
• Uniform and/or Tools
• Flexible Spending Account (Pre-Tax) or Health Savings Plan Contributions
• Job-Related Expenses

Aside from being mandatory or voluntary, payroll deductions may either be pre-tax or post-tax.

Pre-tax deductions are withheld from an employee’s pay before any taxes are withheld.

Pre-tax deductions reduce the taxable income of the employee.

On the other hand, post-tax deductions are withheld after accounting for taxes.

They reduce the employee’s net pay rather than their gross pay.

As such they don’t reduce the employee’s taxable income.

Voluntary payroll deductions are either pre-tax or post-tax deductions.

Mandatory Deductions (or Statutory Deductions)

Mandatory deductions (a.k.a. statutory deductions) are payroll deductions that are mandated by government agencies.

Employers and employees cannot choose to opt out of these deductions.

Mandatory payroll deductions include the following:

• Federal Income Tax
• State and Local Income Tax
• Social Security and Medicare (a.k.a. FICA Taxes)
• State Unemployment Insurance (only for specific states)
• Court-Ordered Garnishments and Payments to Creditors

Federal Income Tax

The federal income tax is applicable for almost all types of income.

This, of course, includes the salaries and wages that employees receive.

Employers will withhold a portion of the employee’s salaries/wages to pay for his/her federal income tax liability.

The amount that the employer will withhold will depend on various factors: how much the employee is earning, and the employee’s information on his/her From W-4.

There are two ways to calculate the amount to withhold for federal income tax for each pay period: the wage bracket method, and the percentage method.

State and Local Income Tax

Some states may have their own tax laws.

Some charge a fixed rate while others use tax brackets to calculate taxes.

A select few don’t charge income tax at all.

As such, we recommend employers consult with the state governments where their business operates to ensure that they’re compliant with their income tax laws.

The following states don’t charge income tax on salaries/wages:

• Alaska
• Florida
• Nevada
• New Hampshire
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

Employers don’t have to make state income tax payroll deductions for employees that work in these states.

Social Security and Medicare (a.k.a. FICA Taxes)

FICA (Federal Insurance Contributions Act) covers two statutory deductions: social security contributions, and Medicare contributions.

Under FICA, employers have to withhold 6.2% of the employee’s earnings as their social security contribution.

The basis for this contribution is capped at $147,000 (as of 2022).

This means that the maximum amount of social security contribution an employee has to make is $9,114. Any amount beyond that is voluntary.

The other component of FICA is the Medicare contribution.

Employers will have to withhold 1.45% of the employee’s earnings as their Medicare contribution.

Unlike social security contributions, there’s no cap for Medicare contributions.

Additionally, there’s an extra 0.9% deduction if earnings exceed $200,000 (the extra deduction only applies to earnings in excess of $200,000).

Together, FICA taxes amount to a total of 7.65% of the employee’s earnings (this does not account for the excess 0.9%).

State Unemployment Insurance

State unemployment insurance is mostly an employer-only expense.

However, it may be an employee payroll deduction in the following states:

• Alaska
• New Jersey
• Pennsylvania

Court-Ordered Garnishments and Payments to Creditors

Courts, regulatory agencies, and even the IRS may require an employer to withhold a portion of an employee’s post-tax pay to cover certain liabilities.

These could include the following:

• Unpaid federal and/or state taxes
• Alimony
• Delinquent child support payment
• Defaulted student loans
• Other monetary obligations and fines

The garnishment order will usually specify how much of the employee’s earnings should be withheld by the employer.

Also, it will include where the employer should send payments.

Employers will have to comply with garnishment orders as they are liable for back payments, not the employee.

Voluntary Deductions

In addition to mandatory deductions, employees may opt to have more money deducted from their pay to cover the cost of certain benefits.

We aptly refer to these deductions as voluntary payroll deductions.

They can either be pre-tax or post-tax deductions.

Pre-tax deductions are most beneficial as they reduce the taxable income of the employee (and that is on top of the benefits that the employee enjoys for opting for the voluntary deduction).

Since these payroll deductions are voluntary, there must be express authorization from the employee before the employer can deduct them from the employee’s pay.

Some of the common voluntary deductions include the following:

Health Insurance

An employer may enroll an employee into a health insurance plan.

These plans cover the medical, dental, and vision expenses of the employee.

These plans can be attractive for current and new employees if the cost doesn’t become too burdensome.

Health insurance premiums can be pre-tax or post-tax payroll deductions.

It’s usually more beneficial to make them a pre-tax deduction.

Do note that by doing so, the employer and employee will have to comply with the requirements of the IRS (meaning that there’s a limit to the amount of contribution).

Group-Term Life Insurance

The IRC section 79 provides an exclusion for up to $50,000 of basic term life insurance.

Some employers may provide this benefit to their employees.

There will be no tax liabilities for the first $50,000 of coverage.

However, if employees want to add additional coverage, the deductions to cover it will be post-tax deductions.

Retirement Plans

An employer may offer its employees a retirement plan.

There are several retirement savings options, with the two most popular among them being 401(k) and Roth IRA (individual retirement accounts).

401(k) plans defer the income tax liabilities of the employee.

On the other hand, IRA plans are typically post-tax deductions.