Payroll Deduction Plan: Meaning & Definition

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.

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:

• Pre-tax deductions
• Post-tax 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. 

Examples of Payroll Deduction Plans

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

• Health insurance plans such as medical, vision, or dental.
• 401(k) plans.
• IRA plans or other retirement saving plan contributions.
• Union dues.
• U.S. Savings Bond purchases.
• Short-term disability insurance plans.
• Life insurance premiums. These are often sponsored by the employer.
• Charitable giving plans.
• Payment for job-specific items. This can include things such as uniforms, clothing, or tools.
• Tuition or professional certification fee deductions.
• Pre-tax health savings account contributions.
• Flexible spending account contributions.
• Payments for purchases of company merchandise. This includes computers and any other retired equipment.

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

• State income tax withholding. This is mandated by certain states that impose taxes on income. 
• Wage garnishments
• Local taxes. These are imposed by towns, counties, and cities for unemployment or disability insurance. 
• Child support payments. These are only when it has been ordered by a court of law. 
• Federal Insurance Contributions Act (FICA) taxes. This is for Medicare and Social Security premiums and contributions. 
• Federal income tax withholding that is federally mandated. 

Pre-tax Deductions for Payroll

Common pre-tax deductions include:

• Health insurance
• Health savings accounts
• Life insurance
• Retirement plan contributions
• It is possible to be eligible to deduct up to $260 for commuting expenses

Summary

Payroll deduction plans can be a useful tool for employers and employees. They can help an employee contribute a portion of their paycheck to helpful benefits such as Medicare, retirement plans, and union dues. This minimizes the chance that payments will be missed, and saves the hassle of doing it manually. 

The calculations for the deductions can be slightly confusing. However, they also go some way to simplifying the process. All while ensuring that retirement, insurance, and healthcare payments are made promptly and with no chance of delay. 

It’s also important to remember that some of the deductions are made with pre-tax income. This can have a decent impact on employees’ various tax burdens.