Payroll Deductions Explained – Pre-Tax & Post-Tax
Payroll Deductions Explained - Pre-Tax & Post-Tax
By law, employers are required to withhold payroll taxes from their employee’s paychecks. Payroll deductions include voluntary and mandatory tax withholdings that can be subtracted from an employee’s paycheck before or after taxes.
TABLE OF CONTENTS
Key Takeaways:
- Tax withholdings are always mandatory and refer specifically to the federal and state taxes that the employer is responsible for withholding from their employee paychecks to pay to the IRS or government.
- Tax deductions are usually voluntary, but there are examples of involuntary tax deductions as well. These deductions can be withheld from an employee’s paycheck before or after taxes.
- The mandatory pre-tax payroll deductions include FICA taxes, federal income tax, and state and local taxes. A wage garnishment is a mandatory post-tax deduction. The voluntary payroll deductions include health insurance, group-term life insurance, retirement plans, and job-related expenses.
- The three IRS forms that are usually used when filing the required employer tax payments and reporting employee tax withholdings to the IRS are Form 940, Form 941, and Form 944.
- 82% of U.S. workers report an error in their paycheck at some point in time.
What Are Payroll Deductions?
Payroll deductions are the amounts of money withheld from an employee’s wages for every paycheck. There are both mandatory and voluntary payroll deductions that can be subtracted from an employee’s paycheck either before tax or after tax.
Gross Pay vs. Net Pay
An employee’s gross pay is the sum of all the wages, bonuses, commissions, and any other financial compensation they earned. Once the mandatory and voluntary taxes have been withheld from their wages, the resulting sum that the employee receives on their paycheck is the net pay.
Some of the withholdings that make up the difference between gross pay and net pay include:
- 401k Contributions
- Child Support Payments
- Income tax
- Social Security Tax
- Medicare Tax
- Wage Garnishments
Withholdings vs. Deductions
Both withholdings and deductions must be accurately subtracted from an employee’s paycheck and sent to the IRS for payment. However, while the two terms are often used synonymously when referring to your paychecks, there are distinct differences.
Withholdings
All withholdings are mandatory, referring specifically to the federal and state taxes that the employer is responsible for withholding from their employee paychecks to pay to the IRS or government.
Deductions
Deductions, on the other hand, are usually a voluntary portion that the taxpayer elects to be taken from their paychecks. Voluntary deductions may be used for health insurance, a retirement plan, or charitable donations. Some deductions are involuntary, such as wage garnishments for unpaid back taxes or child support fees. Deductions can also be withheld from a paycheck before or after taxes, known as pre-tax or post-tax deductions.
Pre-Tax vs. Post-Tax Deductions
Tax deductions can be subtracted from an employee’s paycheck before tax or after tax, which can impact their tax liability differently.
Pre-Tax Deductions
Pre-tax deductions are subtracted from an employee’s paycheck before any tax is withheld. Pre-tax deductions reduce an employee’s total taxable income and the amount they owe to the government because the deductions are subtracted from their gross pay. Pre-tax deductions can also reduce what an employee owes in Federal Unemployment Tax (FUTA) taxes and State Unemployment Insurance (SUI) dues.
Some examples of pre-tax deductions include:
- Health Insurance
- Group-Term Life Insurance
- Retirement Plans
Deducting these payments before tax usually results in savings compared to paying for the same benefits and services after tax. There is usually a limit as to how much employees can contribute to pre-tax deductions, such as with 401k retirement plans.
Post-Tax Deductions
Post-tax deductions are subtracted from a worker’s paycheck after the taxes have been withheld. Post-tax deductions impact the net pay instead of the gross pay, so they do not impact the total taxable income.
Some examples of post-tax deductions include:
- Charity Donations
- Disability Insurance
- Roth IRA Retirement Plans
- Union Dues
- Wage Garnishments
A wage garnishment is the only type of post-tax deduction that is mandatory – all other post-tax deductions are considered voluntary.
Types of Payroll Deductions
Mandatory Payroll Deductions
FICA Taxes
Federal Insurance Contributions Act (FICA) tax is the Social Security and Medicare taxes that are owed to the IRS. The total FICA tax deduction that the employee is responsible for paying comes out to a total of 7.65% of their taxable income.
The Social Security contribution is 6.2% with a wage-based contribution limit and the Medicare contribution is 1.45% with no contribution limits. Employers are also responsible for matching the 7.65% contribution for their employees.
Federal Income Taxes
The income tax owed to the federal government is determined using the information provided by the employee on form W-4, and their gross pay. The income tax withholding tables in the IRS’s Publication 15-T highlight the seven income tax brackets and the corresponding tax rates. Tax brackets vary depending on the taxpayer’s income and filing status as provided by the employee when they fill out form W-4.
State and Local Taxes
Each state has its own tax laws that impact tax withholdings from an employee’s paycheck. Some states charge a fixed tax rate, some have unique tax brackets, and others do not charge any state income tax. Employers are responsible for complying with local tax regulations and requirements when navigating payroll taxes.
Wage Garnishments
Collection agencies like the IRS may issue a wage garnishment that orders an employer to withhold wages from an employee’s post-tax paycheck to be applied toward their outstanding debt, such as for unpaid taxes, alimony, child support, or defaulted student loans.
Multiple types of income can be withheld during a garnishment, including hourly wages, salaries, bonuses, commissions, pensions, and retirement plan payments. The withholding amount or percentage of withholding, and the location to send the payment, will be outlined in the garnishment order.
Voluntary Payroll Deductions
Employees can request to have extra money withheld from their paychecks to achieve benefits through voluntary payroll deductions. Employees must provide written consent before a payroll deduction is subtracted from their earnings.
Health Insurance Coverage
Both employees and employers can achieve savings when they purchase health insurance on a pre-tax basis, including medical insurance, dental insurance, and vision insurance. Health plan payroll deductions also include flexible spending accounts (FSAs) and health savings accounts (HSAs). These health savings deductions should be set up as a dollar amount rather than a percentage of the employee’s earnings.
Group-Term Life Insurance
Employers often offer life insurance premiums as an option for payroll deductions. These funds are usually deducted from an employee’s pay on a post-tax basis.
Retirement Plans
Employees can contribute to their retirement savings by choosing payroll deductions that contribute to their retirement plan. One common employer-provided retirement plan is the Roth 401 k in which employee contributions are subject to FICA taxes, but are deferred for federal income tax and most state income tax. 401k retirement accounts are usually pre-tax, and many times, the employer will match employee contributions to this type of account. Another common type of retirement plan is the Roth Individual Retirement Account (IRA), which is withheld on a post-tax basis.
Job-Related Expenses
Job-related expenses that are charged to employees can also be deducted from a tax return. This can include union dues, uniforms, meals, travel, parking fees, public transportation fees, and gym membership fees. Some states prohibit job-related expenses, so it is important to check the laws in the state your company or small business operates in.
How Are Payroll Deductions Calculated?
- Withhold pre-tax contributions from the gross pay and apply them to 401(k) retirement plans, health insurance, and other voluntary benefits.
- Calculate and deduct federal income tax using the employee’s Form W-4 and the latest IRS tax tables.
- Subtract 7.65% of the adjusted gross pay for FICA taxes, including 1.45% for Medicare tax and 6.2% for Social Security tax, up to the wage limit.
- Deduct 0.9% of the pay for Additional Medicare Tax if the year-to-date income reaches or exceeds $200,000.
- Withhold state income tax, if applicable, utilizing the state’s employer’s tax code.
- Deduct costs for garnishments, post-tax retirement plan contributions, and other post-tax dues to find the final net pay.
How Payroll Deductions Are Reported
Three IRS forms are usually used when filing the required employer tax payments and reporting employee tax withholdings to the IRS:
- Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return
- Form 941, Employer’s QUARTERLY Federal Tax Return
- Form 944, Employer’s Annual Federal Tax Return
If you are responsible for managing the payroll deductions for a business and have questions about the types of payroll deductions, how much money should be deducted from each paycheck, or how to report taxes, speak with an expert at Ideal Tax for guidance.
