What Is Payroll Deduction? (A Practical Guide for Small Business Owners)

🌟 KEY TAKEAWAYS

A payroll deduction plan takes away money from an employee’s paycheck to pay for taxes or other certain services.

Voluntary payroll deductions are commonly used to pay for things like health and life insurance premiums or retirement savings.

Involuntary payroll deductions can include taxes, wage garnishments, and child support payments.

Some deductions are taken away before taxes. Since this isn’t taxed, there is an additional incentive to voluntarily deduct your payroll.

A payroll deduction is any amount withheld from an employee’s paycheck by their employer, either because it’s legally required or because the employee has opted in. A payroll deduction plan is the setup behind those withholdings: what comes out, how much, and when.
As the employer, that setup is on you. You’re responsible for ensuring the right amounts get withheld each pay period, making sure mandatory deductions like federal income tax, Social Security, and Medicare are correct, and honoring the elections your employees make. Get it wrong, and you may be liable to make up the missing amounts.
It can feel like a lot. Some deductions come out before taxes and some come out after. Each employee’s Form W-4 affects how much is withheld. And one paycheck can include taxes, an insurance premium, a retirement contribution, and a wage garnishment all at once.
The good news? The logic follows a clear order, and once you know it, you can let payroll software handle the calculations. Here’s how it works.

What is a payroll deduction plan?

A payroll deduction plan is when an employer withholds money from an employee’s paycheck. This can be for a variety of reasons, but it is most commonly used for benefits. Payroll deduction plans can be either involuntary or voluntary. 

A common example of an involuntary payroll deduction plan is when the law requires that an employer withholds money for Medicare and Social Security. These are mandatory and any employer that fails to accurately withhold these deductions may be liable to make up the difference of the missing amounts. 

A voluntary payroll deduction plan occurs when an employee opts for an employer to withhold money for certain purposes. Examples include healthcare, a retirement savings plan, and life insurance, among other things. For this to happen, there needs to be written permission from the employee. 

How a payroll deduction plan works

Payroll deduction plans allow employees to automatically contribute income towards an ongoing investment or expense. For example, it’s common for employees to set aside a percentage of their income and contribute it to their Individual Retirement Account (IRA) or their Roth IRAs. An employee could also choose to have their insurance policy premiums deducted from their pay, this is a good way to make sure that you never miss a payment. 

Some payroll deduction plans can also involve voluntary, systematic payroll deductions with the intent of purchasing shares of common stock. In these cases, the employee will opt into their employer’s stock purchase plan. This would mean that each month, a portion of the employee's paycheck goes into buying shares of their employer’s stock. This is commonly at a discounted price. 

The amount that is withheld for each employee will depend on the individual’s Form W-4 Employee’s Withholding Certificate, the local and state withholding certificate, benefit selections, and other relevant details. 

Payroll deductions become slightly more complicated when it comes to employees that receive tipped income. Tips have to be recorded on a daily basis and if you earn more than $20 in tips in a month, the sum has to be reported to your employer. This is done via Form 4070: Employee’s Report of Tips to Employer. 

The combined wages and tips are then subject to payroll taxes and deductions. This then becomes the same as any other employee’s salary. 

In addition to this, employers that work in tipped industries are responsible for making sure that any employee tips are equal to at least 8% of the total revenue of the business for the same period of time. If the tips do not equate to 8% of total revenue, the employer is obligated to pay the difference to each employee. However, employers can request to pay a lower percentage, but this number cannot fall below 2%. 

How to calculate payroll deductions

There are two forms of payroll deductions:

These calculations can either be done manually, or you can automate the process by using a payroll service provider. Many businesses will choose to automatically calculate payroll deductions as it reduces the chance of human error and makes sure that the payments are filed on time. 

If you choose to manually calculate your employee’s payroll deductions, then you can use the following method: 

In order to calculate an employee’s take-home pay, the first step is subtracting any pre-tax deductions from the employee’s gross income. For example any retirement contributions or insurance deductions. The difference will be their taxable income.

The next step is to calculate the employee’s tax withholding. This is based on their taxable income. This will include local, state, and federal taxes, as well as Medicare and Social Security withholdings. 

The final step is to subtract the employee’s after-tax deductions. This includes certain employee expenses, union dues, or wage garnishments. After all of these deductions, you should be left with the employee’s net income. This should be reflected in their final paycheck. 

Setting up deductions in FreshBooks Payroll

If you run payroll with FreshBooks Payroll, powered by Gusto, you can set up post-tax deductions and garnishments for your employees in the same place you run payroll.

There are two types of deductions you can add:

Here’s how it works:

That last part matters more than it sounds. Each payroll run leaves a clear record of what was withheld, along with year-to-date totals. So when year-end comes around, you’re not piecing it together from memory or a separate spreadsheet. It’s already in FreshBooks, right alongside the rest of your financial data.

Examples of payroll deduction plans

There are a number of common examples of voluntary payroll deduction plans. These include:

There are also examples of involuntary payroll deduction plans. These include:

Pre-tax deductions for payroll

Common pre-tax deductions include:

Keeping payroll deductions organized

A payroll deduction plan covers everything that comes out of an employee’s paycheck between gross pay and net pay. Some deductions are required by law, like federal income tax, Social Security, and Medicare. Others are voluntary, like retirement contributions, insurance premiums, and union dues. And some come out before taxes, which can lower an employee’s taxable income.

Keeping track of it all is where things add up. Even with a small team, you might be handling voluntary benefits for some employees, a garnishment for another, and a one-time deduction for someone else. Each one has its own amount, schedule, and limit.

Deductions come out of every payroll run on a schedule you can predict, which makes them easy to plan for when you can see them clearly. FreshBooks Payroll keeps post-tax deductions and garnishments organized in the same place you manage the rest of your money. Every run records what was withheld, and the Payroll Journal report keeps a running total, so you know exactly where that money is going without a separate tracking spreadsheet.

See how FreshBooks Payroll works.

FAQs on payroll deduction plans

What Is a Section 125 Deduction for Payroll?

A Section 125 plan is an employer sponsored benefit. It allows employees to use pretax money in order to pay for their expenses. It can be used to cover expenses such as child care, medical costs, or any other expense that is recurring. The Section 125 Plan helps to reduce the tax burden for both employers and employees. It is also commonly known as a Cafeteria Plan.

What Is a Traditional IRA vs. a Roth IRA?

A Roth IRA means that you contribute after-tax dollars. Your money will also grow tax-free, and you can make tax and penalty-free withdrawals after the age of 59 years and 6 months. This is compared with a traditional IRA that contributes pre- or after-tax dollars.

What Percentage of FICA Tax Is Paid?

Federal Insurance Contributions Act (FICA) taxes support the Medicare and Social Security systems. The cost is shared by the employer and employee. The employer cut is 6.2% for Social Security and 1.45% for Medicare. The same will be collected from employees. This will equal 7.65% in FICA taxes for each employee’s paycheck.

What are Wage Garnishments?

Wage garnishments are money that is held back through a court, regulatory agency, or IRS order. This is predominantly to cover things such as child support, unpaid taxes, alimony, or any loans that have been defaulted on.