What Is a Payroll Deduction Plan?
A payroll deduction plan refers to when an employer withholds money from an employee's paycheck for a variety of purposes, but most commonly for benefits. Payroll deduction plans may be voluntary or involuntary. One common example of an involuntary payroll deduction plan is when an employer is required by law to withhold money for Social Security and Medicare.
A voluntary payroll deduction plan happens when an employee opts for—and gives written permission to—an employer to withhold money for certain purposes, such as a retirement savings plan, healthcare, or life insurance premiums, among others.
- A payroll deduction plan subtracts money from an employee's paycheck to pay for taxes or certain services.
- Voluntary payroll deductions are commonly used to pay for union dues, health and life insurance premiums, or retirement savings.
- Involuntary payroll deductions can include wage garnishments, child support payments, and taxes.
- Some deductions, such as for health care or retirement savings, are deducted before taxes. Since this money is not taxed, there is an additional incentive to participate.
- Some employers may also deduct industry-related expenses, such as licensing, certification fees, or the cost of equipment.
How a Payroll Deduction Plan Works
Payroll deduction plans offer employees a convenient way to automatically contribute income toward an ongoing expense or investment. For example, it is common for employees to deduct a set percentage of income and contribute it to their traditional Individual Retirement Account (IRA) or Roth IRAs. An employee may also choose to have the premiums from an insurance policy deducted from their pay, ensuring that payment is never missed.
Some payroll deduction plans may also involve the voluntary, systematic payroll deductions to purchase shares of common stock. In such cases, the employee opts into their employer's stock purchase plan and a portion each paycheck goes to buying shares of their employer's stock, generally at a discounted price.
In an example provided by the Securities and Exchange Commission (SEC) regarding the Employee Stock payroll Deduction Plan at Domino's Pizza, Inc., eligible employees may opt to allocated 1-15% of their paycheck to buying company stock priced at 85% of fair market value of the date the option is exercised.
Examples of Payroll Deduction Plans
Some common voluntary payroll deduction plan examples include:
- 401(k) plan, IRA, or other retirement savings plan contributions
- Medical, dental, or vision health insurance plans
- Flexible spending account or pre-tax health savings account contributions
- Life insurance premiums (often sponsored by the employer)
- Charitable to employer-sponsored charitable giving plans
- Short-term disability insurance plans
- Payment for job-specific items, such as clothing, uniforms, or tools
- Union dues
- U.S. Savings Bond purchases
- Payments for purchases of company merchandise (computers or other retired equipment)
- Tuition or professional certification fee deductions
Some common involuntary payroll deduction plan examples include:
- Federal income tax withholding (federally mandated)
- FICA taxes (for Social Security and Medicare contributions and premiums)
- State income tax withholding (mandated by states that impose a tax on income)
- Local taxes (imposed by cities, counties, and towns for disability or unemployment insurance)
- Wage garnishments
- Child support payments (when ordered by a court)
Pre-tax deductions are subtracted from an employee's gross salary before taxes and social security are calculated. These deductions are commonly used to pay for health insurance, life insurance, health savings accounts, or retirement plan contributions. You may also be eligible to deduct up to $260 for commuting expenses.
Since the income to pay for these deductions is not taxed, they can reduce the employee's overall tax burden and provide an additional incentive to participate in these programs.
Traditional vs. Roth IRA
Contributions to a traditional IRA are made with pre-tax income, lowering your overall tax burden. Roth IRA contributions use post-tax income, but you will not have to pay taxes on distributions.
How to Calculate Payroll Deductions
There are two types of payroll deductions: pre-tax and post-tax. To calculate an employee's take-home pay, the first step is to subtract any pre-tax deductions from their gross income, such as insurance deductions or certain retirement contributions. The difference is the employee's taxable income.
Next, calculate the employee's tax withholding, based on their taxable income. This includes federal, state, and local taxes, as well as Social Security and Medicare withholdings.
Finally, subtract the employee's after-tax deductions, such as union dues, certain employee expenses, or any wage garnishments. Roth IRAs are also post-tax, meaning contributions are made with taxable income. After all these deductions, the result is the employee's net income, which should be reflected in their final paycheck.
Payroll deductions are a little more complicated when it comes to tipped income. Tips must be recorded on a daily basis, and if you earn more than $20 in tips in a month, that sum must be reported to your employer on Form 4070: Employee's Report of Tips to Employer. The combined tips and wages are subject to payroll taxes and deductions, just like any other employee's salary.
In addition, employers in tipped industries are also responsible for ensuring that employee tips are equal to at least 8% of the business's total revenue for the same period. If tips do not equal 8% of total revenue, the employer is responsible for paying the difference to their employees. Employers can also request a lower percentage, but no lower than 2%.
The Bottom Line
Payroll deduction plans are used to support employee benefits by subtracting the payments directly from an employee's paycheck. Although the calculations for these deductions can be confusing, they also simplify the process and ensure that healthcare, retirement, and insurance payments are made promptly and without delay. In addition, some deductions are also made with pre-tax income, which can have a sizeable impact on employee tax burdens.
Payroll Deduction FAQs
What Does FICA Stand for in the Payroll Deduction Process?
FICA, or the Federal Insurance Contributions Act, is a federal payroll tax that is used to fund Social Security and Medicare.
What Does FIT Stand for in the Payroll Deduction Process?
FIT, or the Federal Income Tax, is a tax levied by the Internal Revenue Service on personal or corporate income. This is typically the largest deduction on the average person's income statement.
What Is an OASDI Payroll Deduction?
OASDI, or the Old-Age, Survivors, and Disability Insurance, is the official name for the Social Security benefits program. The OASDI tax is considered part of the FICA tax.
When Do Social Security Payroll Deductions Stop?
The Social Security tax, or OASDI tax, charges 6.2% of net earnings, but only for earnings below the Social Security Tax Limit. As of 2021, the tax limit was $142,800, meaning any income above that level was not taxed.
What Is a Section 125 Deduction for Payroll?
A Section 125 Plan, also known as a Cafeteria Plan, is an employer-sponsored benefit that allows employees to pay for their expenses with pre-tax income. These plans may be used to cover medical costs, child care, or other recurring expenses. Since Cafeteria Plans reduce tax burdens for both employees and employers, there are clear advantages to having such a plan.