Demystifying payroll deductions: Everything you need to know

Understanding payroll deductions is essential for both employers and their team members to ensure compliance, avoid penalties, and maintain crystal-clear financial records. With so many out there, navigating the world of payroll deductions may seem like a daunting task—but it doesn’t have to be.

In this guide, we’ll demystify the different kinds of common payroll deductions you’ll likely encounter in everyday business operations, plus how to calculate them and what to do about unique tax situations.

What are payroll deductions? How do they work?

Payroll deductions refer to money withheld from a team member's gross earnings before they receive their take-home pay. These funds satisfy tax obligations and mandatory contributions to government programs like Social Security in the United States. They also simplify contributions to voluntary programs like employer-sponsored retirement plans.

Employers calculate and withhold the appropriate deductions based on factors like the team member’s personal tax withholding choices (often found on a form like the W-4 in the U.S. or a T4 in Canada), together with federal, state, and local tax requirements. After withholding the funds, the employer sends them to the relevant government agencies, benefit providers, or other entities on the team member’s behalf.

Inaccurate deductions can have mild or more severe consequences for both employers and team members, depending on the severity of the error. That’s why employers need to stay up to date with changes in tax laws and regulations to ensure accurate payroll deduction calculations and avoid mishaps like:

• Underpayment of salary or wages: Team members should always be paid on time. If they are consistently underpaid due to erroneous deductions, they may seek legal recourse to recover lost wages, which can be costly and time-consuming for the company. It can also affect the company’s reputation among job seekers.
• Government penalties: In the United States, the Internal Revenue Service (IRS) can impose fines for errors in federal income tax withholding and other deductions. Other countries have similar policies. State, local, and other jurisdictions may also enforce penalties for inaccurate withholding.

If you’re a business owner, creating a payroll breakdown is an effective way to fine-tune your understanding and provide an easy reference to ensure you apply deductions correctly and consistently for all team members. Regular payroll audits also help identify and correct discrepancies and errors, reducing the risk of compliance issues.

Types of payroll deductions

Payroll deductions are categorized into two main types: mandatory and voluntary. These primary categories are further divided into pre-tax deductions, which reduce a team member's taxable income, and post-tax deductions, which do not affect taxable income. Let’s explore each category in further detail:

Mandatory payroll deductions

By law, employers are required to withhold certain deductions from their employees' paychecks. These include:

• FICA taxes: In the U.S., these fund Social Security and Medicare programs, providing retirement, disability, and health insurance benefits to eligible individuals. Most countries have similar programs. Typically, both team members and employers contribute to FICA taxes, which are calculated as a percentage of the team member's gross earnings.
• Federal income tax: This is withheld based on the team member’s Form W-4 and the IRS tax tables.
• State, local, and other regional taxes: These taxes vary widely. Some states use progressive taxes, some use flat tax rates, and some don’t levy income taxes at all. Specific regions may require further deductions like contributions to a disability insurance program.

Voluntary payroll deductions

Team members opt for these deductions to cover elective benefits or to contribute additional amounts to retirement or savings plans. Common voluntary deductions include:

• Health insurance: Many team members participate in employer-sponsored health plans, with monthly premiums taken out of their paychecks.
• Retirement plan contributions: Team members can choose to contribute to employer- and government-sponsored retirement plans, such as 401(k)s or IRAs, using payroll deductions.
• Life insurance: Employers may offer basic life insurance coverage with the option for team members to purchase additional coverage for themselves and their dependents via deductions.
• Job-related expenses: Union dues or the cost of uniforms may sometimes be deducted from a team member's pay, depending on legal regulations and the employer's policies.

Pre-tax deductions

Pre-tax deductions are subtracted from a team member’s gross pay before calculating taxes, decreasing their taxable income. This leads to lower income tax for employees and reduced payroll taxes for employers.

• Traditional 401(k) contributions: Team members make voluntary contributions to 401(k) retirement plans with pre-tax dollars. ‍
• Health Savings Account (HSA) contributions: Team members with high-deductible health plans can contribute pre-tax dollars to an HSA to cover qualified medical expenses.‍
• Dependent Care Flexible Spending Account (DCFSA) contributions: Team members can set aside pre-tax funds to pay for eligible dependent care expenses, such as daycare or preschool.

Post-tax deductions

Post-tax deductions come from a team member’s net pay following tax deductions without reducing their taxable income:

• Charitable donations: Some employers offer programs that allow team members to make post-tax contributions to qualified charitable organizations directly from their paychecks.
• Union dues: Team members who are part of a labor union may have these fees deducted from their paychecks.
• Roth 401(k) contributions: These are voluntary contributions made with post-tax dollars to a retirement savings account. While they don't immediately reduce taxable income, qualified withdrawals in retirement are tax-free.
• Wage garnishments: These are court-ordered deductions from a team member's net for reasons such as child support, alimony, or debt repayment.

Payroll deductions outside the U.S.

Around the world, many countries implement various payroll deductions designed to fund social welfare programs, retirement savings, and infrastructure projects. Here's a glance at how six different nations approach these deductions:

• Australia's Superannuation Guarantee requires employers to contribute 10.5% of an employee's earnings (set to rise to 12% by 2025) into a superannuation fund that ensures retirement savings. 
• Brazil’s Contribution to the National Social Security Institute (Contribuição para o Instituto Nacional do Seguro Social) is a mandatory payroll deduction that funds pensions, sickness and maternity benefits, and other social welfare programs, with rates based on income.
• Germany’s Solidarity Surcharge (Solidaritätszuschlag), an income tax introduced in 1991 after the fall of the Berlin Wall, finances the costs of integrating the former East Germany and rebuilding its infrastructure after German reunification.
• India's Provident Fund, a government-backed retirement savings initiative, mandates employees to allocate 12% of their earnings; employers equally match their contributions.
• South Africa’s Unemployment Insurance Fund (UIF), funded by employer and employee contributions, provides short-term relief to workers who become unemployed or cannot work due to maternity, adoption leave, or illness, ensuring a safety net for individuals who are unable to earn an income temporarily. 
• The United Kingdom’s National Insurance, funded by payments from workers and employers, supports state benefits like pensions, unemployment benefits, and healthcare, with rates depending on income and job status.

How to calculate payroll deductions

Once you’ve learned the primary categories of payroll deductions, understanding how to calculate them is all the easier. The process follows five key steps:

1. Calculate gross pay based on the team member’s salary, hourly rate, or other compensation arrangement.
2. Subtract pre-tax deductions, such as traditional 401(k) contributions and health insurance premiums. (Again, this often reduces the team member’s taxable income.)
3. Withhold mandatory taxes, such as FICA taxes and federal, state, and local income taxes.
4. Deduct post-tax items, such as wage garnishments or charitable donations.
5. Determine net pay, which is the final amount of money the team member receives after all deductions.

For example, suppose you have a team member based in the U.S. who earns a gross salary of $5,000 per month, is single, and lives in a state with no income tax. They contribute $500 to their traditional 401(k) and pay $200 for their portion of the company-sponsored health insurance premium, leaving a pre-tax income of $4,300. Additionally, they donate $50 per month to a qualified charitable organization through a payroll deduction program.

Based on 2023 federal income tax rates, the team member would owe $554.95 in federal income tax and $382.50 in FICA taxes (6.2% for Social Security and 1.45% for Medicare). Assuming they have no other deductions, their net pay would be calculated as follows:

1. Calculate gross pay

We know the team member’s monthly gross pay is $5,000.

2. Subtract pre-tax deductions

$5,000 - $500 401(k) contribution - $200 health insurance premium = $4,300

3. Withhold mandatory taxes

$4,300 - $554.95 federal income tax - $382.50 FICA taxes = $3,362.55

4. Deduct post-tax items

$3,362.55 - $50 charitable donation = $3,312.55

5. Determine net pay

After subtracting pre- and post-tax deductions and mandatory taxes, the team member’s net pay is $3,312.55 a month.

Certain scenarios can complicate the process of calculating payroll deductions. Some of the most common are:

• Team members with multiple jobs: When a team member works more than one job, each employer must withhold taxes separately. The team member may need to coordinate their withholdings across all their jobs to ensure enough taxes are withheld throughout the year.
• Significant life events: Milestones like getting married, having a child, or starting a second job impact a team member’s tax liability and, consequently, the amount that needs to be withheld from their paychecks. Team members should promptly update their W-4 and other relevant tax documents when such events happen to avoid complications.
• Supplemental wages and bonuses: Special withholding rules often apply to supplemental wages such as bonuses, commissions, and overtime pay. In the U.S., employers can opt to withhold taxes on supplemental wages at a flat rate or add the supplemental wages to the team member's regular wages and withhold taxes using the standard tax tables.

If you need help handling a particular payroll deduction scenario, consider using dedicated payroll management software or consulting a certified tax professional to ensure compliance and accuracy and avoid mistakes and penalties.

Simplify global payroll with Oyster

Managing payroll for an international team can quickly become time-consuming, especially when it involves different currencies, tax requirements, and local regulations across multiple countries. Oyster simplifies the process with a user-friendly platform that makes global payroll easy.

With Oyster, you can effortlessly pay your distributed team in more than 180 countries while ensuring full compliance with local laws. The platform lets you simultaneously manage salaries, bonuses, and expense reimbursements. You'll also have access to comprehensive payroll reports and the ability to sync data with your existing accounting software.

Learn more about how Oyster can help you streamline your international payroll today.

About Oyster

Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.