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Deductions are of two types, statutory and non-statutory. Statutory deductions are federal and state income tax, any local county tax, and compulsory contributions to social security and Medicare. Voluntary deductions are deductions authorized by the employee, and can include 401(k) plans, cafeteria benefits, additional insurance, loans, check-out payments, and others. In addition, a third category of wage garnishments deductions may also apply. The important consideration when adding deductions to a payroll system is to understand the hierarchy of deduction, or placing the deduction in its correct place.
The first consideration before adding deductions to a payroll system on a routine basis is to make any payroll adjustments, such as withholding of excess payments. Such adjustments should be as negative entry.
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The first deduction to a payroll system is cafeteria benefits, or the deduction allowed under Section 125 of the US tax code. Cafeteria benefits entails providing the employee the option to choose from a host of benefits. Common options include accident and health insurance, health flexible spending amounts, adoption assistance, group term life insurance, and dependent care assistance. Make a provision in the payroll for all available schemes and an option to fix the amount of the deduction.
Section 125 deductions are exempt from income tax and not deemed as income for tax computation and FICA (social security and Medicare) purposes.
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Social Security and Medicare
The second in the hierarchy when adding deductions to a payroll system is social security and Medicare, based on the Federal Insurance Contribution Act (FICA).
Social Security deductions are 6.2 percent of the gross pay subject to an annual cap, and Medicare deductions are 1.45 percent of the gross pay, without any cap. Since these deductions remain constant, the best approach is to calibrate the payroll system to make such deductions automatically.
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401(k) plans, or employer sponsored retirement savings, allow the employee to transfer up to 15 percent of wages before tax but after social security and Medicare to a retirement fund. An important point to consider is that this is an optional deduction.
Traditional 401(k) deductions take place before deduction taxes, and Roth 401(k) or retirement savings scheme deductions take place after deducting taxes.
Refer to your program guidelines to identify the fixed amount or the percentage deduction, as appropriate.
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Next in line when adding deductions to a payroll system are federal income tax deductions. Federal income tax is applicable on gross pay including basic pay, overtime, tips, and commission, excluding benefits under section 125 and 401(k).
To determine the tax amount, obtain the filing status and number of withholding allowances from the employees W-4 form. Without a W4 form, set the withholding allowance as zero. The IRS Publication 15 Circular E lists the amount of withholding allowance. Taxable income is gross pay less the amount specified in Publication 15 multiplied by the number of withholding allowances.
Many states have state income tax. The amount varies from state to state, and requires hard coding into the system as appropriate. The exact amount and procedure for each state is obtainable from each state's Department of Revenue.
Besides the federal and state tax, many cities and counties charge local taxes as well.
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Next in line in payroll deductions are the optional, voluntary, or company-specific deductions. These usually include:
- Health insurance such as medical and dental benefits, and life insurance premiums outside 401(k) and cafeteria benefits
- Contributions to company-specific savings plans
- Recovery of dues or fines
- Repayment of loan installments
- Deduction for meals, uniforms, union dues, or other work related expenses based on agreement with employee or company policy
Such deductions depend on the employee instructions and the company rules, subject to legal compliance.
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At times, the court may order garnishing a percentage of employees disposable income. Disposable income is determined as the net income after taxes and FICA insurance payments but before voluntary deductions 401(k) plans.
The accuracy of the payroll system is of critical importance for any organization, and employers would do well to automate the payroll processing to ensure that adding deductions to a payroll system remains correct and hassle free.
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- Internal Revenue Service. Publication 15. http://www.irs.gov/pub/irs-pdf/p15.pdf. Retrieved 10 March 2011.
- "Payroll." http://en.wikipedia.org/wiki/Payroll. Retrieved 10 March 2011.
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