Payroll Deductions: Ultimate Guide 2025

Welcome to the world of payroll deductions, where numbers, acronyms and regulations collide in a flurry of financial wizardry.

Use this guide to help you understand the what, why and how and get the best deal for your org and workers.

What Are Payroll Deductions?

Payroll deductions are amounts taken out of an employee’s gross pay to cover taxes and other withholdings.

There are two types of deductions:

• Mandatory deductions like federal and state income tax, Social Security, Medicare, and wage garnishments,
• Voluntary deductions such as health insurance premiums, retirement contributions, and commuter benefits.

Further, some deductions are pre-tax, lowering taxable income, while others are post-tax, taken out after taxes are calculated.

Accurate payroll deduction management is essential for compliance, employee satisfaction, and financial transparency.

It’s the employers’ job to clearly communicate these deductions and ensure they’re accurately processed each pay period.

How Do Payroll Deductions Work?

Payroll deductions work by the employer withholding specific amounts from an employee’s gross wages each pay period to cover taxes and other obligations.

While many companies use payroll software or external payroll companies to handle deductions, some small businesses may process deductions manually.

The process begins with calculating gross pay, then subtracting mandatory deductions like taxes and Social Security, followed by any voluntary deductions such as benefits or retirement contributions (usually in that order).

The remaining amount is the employee’s net pay. It’s the employer’s responsibility to ensure accurate calculations, submit payments to the correct agencies or vendors, and maintain proper payroll records.

Pro Tip

Payroll is a critical business operation that should remain “unseen” by the majority of staff because it should be consistently submitted on time and without errors. Having two people review the full details is one of the most effective ways to avoid errors. — Katrina Magdol, Founder, Amalou Consulting

Pre-Tax Deductions

So I mentioned pretax deductions, what should you be aware of regarding these? Remember, they reduce an employee’s taxable income, which can lower both their tax bill and your payroll tax liability:

• Health insurance premiums (medical, dental, vision)
• Health Savings Account (HSA) contributions
• Flexible Spending Account (FSA) contributions (for healthcare or dependent care)
• 401(k) or traditional retirement plan contributions
• Commuter benefits (e.g., transit passes, parking)
• Group term life insurance (up to $50,000 in coverage)
• Short- and long-term disability insurance (if set up as pretax).

It’s worth noting that pretax deductions do come with limits and a few important rules you should keep in mind:

Contribution limits:

The IRS sets annual caps on pretax contributions. For example:

• 401(k): $23,000 for 2025 (plus $7,500 catch-up for 50+)
• HSA: $4,150 for individuals / $8,300 for families in 2025
• FSA: $3,200 per year for healthcare FSA

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Use-it-or-lose-it rules

FSAs often follow this rule—unused funds may be forfeited unless your plan allows a rollover or grace period.

Eligibility and compliance

Employees can only make pretax elections during open enrollment or after qualifying life events. And to legally offer pretax benefits, you’ll need to set up a Section 125 Cafeteria Plan.

Impact on future benefits

Pretax deductions lower taxable wages, which could slightly reduce benefits tied to gross income (like Social Security later on).

Author's Tip

Make sure any pretax benefits are offered through a Section 125 (Cafeteria) Plan to stay compliant with IRS rules.

Post-Tax Deductions

These are taken out after taxes and don’t reduce taxable income:

• Roth 401(k) contributions
• Wage garnishments (e.g., child support, court orders)
• Charitable donations (if withheld through payroll)
• Union dues
• Additional life insurance coverage (beyond $50,000)
• Some disability or supplemental insurance plans.

Unlike pretax deductions, post-tax items like union dues or supplemental insurance don’t have strict annual caps—but there may still be plan-specific rules or contribution limits (e.g., Roth 401(k)).

Some important points to know about post-tax deductions:

• More flexible participation: Post-tax deductions typically don’t require a formal Section 125 Plan, and employees may have more flexibility in opting in or out.
• Voluntary vs. mandatory: Some post-tax deductions (like Roth IRA contributions or gym memberships) are voluntary, while others (like wage garnishments) are legally required and must be handled with care.
• Roth contributions grow tax-free: While you pay taxes upfront, Roth 401(k) or Roth IRA contributions grow tax-free and can be withdrawn tax-free in retirement (great for long-term planning).
• Can affect net pay significantly: Since they don’t reduce tax liability, large post-tax deductions can noticeably lower take-home pay—something employees should be aware of.

Statutory Deductions

Statutory deductions are withholdings that are required by law, and employers must deduct and remit them correctly to stay compliant. 

These aren’t optional and apply to nearly all employees, regardless of whether they opt into any benefits.

Statutory deductions include:

• Federal income tax
• State and local income taxes (if applicable)
• Social Security tax (FICA – 6.2%)
• Medicare tax (FICA – 1.45%)
• Additional Medicare tax (0.9% on high earners)
• Court-ordered wage garnishments (also considered post-tax, but legally required)

Key things to know about statutory deductions:

• Always required: These deductions must be taken out of employee paychecks—there’s no opting out.
• No contribution limits (for income taxes): Unlike pretax benefits, income taxes (federal, state, local) don’t have contribution caps. The amount withheld depends on earnings and the employee’s tax filing status.
• Fixed rates for some items:
  • Social Security tax: 6.2% from the employee, up to the annual wage base limit ($168,600 in 2025)
  • Medicare tax: 1.45% from the employee, with an additional 0.9% for high earners (income over $200,000)
  • Employers must match Social Security and Medicare taxes.
• Applies to most workers: Even if an employee doesn’t qualify for certain benefits (like health insurance), statutory deductions still apply unless they’re classified as an independent contractor (in which case, you don’t withhold taxes).
• Must be remitted on time: Employers are legally responsible for sending these withheld amounts to federal and state agencies by strict deadlines. Late payments can result in penalties.

FICA Taxes

FICA taxes are federal payroll taxes that fund two key U.S. programs: Social Security and Medicare. 

They’re automatically withheld from employees’ paychecks and matched by the employer, making them a major part of every payroll run.

FICA taxes come in two parts

• Social Security: 6.2% on wages up to $168,600 (2025 limit)
• Medicare: 1.45% on all wages (no income cap)

Important things to know about FICA Taxes:

• You, as the employer, must match both, bringing the total to 15.3% per employee
• Employees earning over $200,000 pay an extra 0.9%—this part is not matched by employers.
• Applies broadly: FICA taxes apply to most employees and most types of compensation, including wages, bonuses, and some taxable benefits. Even if someone contributes to a 401(k), FICA still applies.
• Not optional: Unless a worker qualifies for a rare exemption (like certain student jobs or specific visa types), FICA must be withheld.
• Strict deposit and filing rules: FICA taxes must be paid to the IRS regularly and reported on Form 941. Late or missed payments can lead to steep penalties.

Federal Income Tax

Federal income tax is a mandatory payroll deduction used to fund U.S. government operations and services, including defense, education, infrastructure, and more. 

It’s withheld from each employee’s paycheck based on their earnings and tax filing details.

What you should know about federal income tax:

• Amount varies by employee: Withholding depends on income level, filing status, number of dependents, and other info provided on Form W-4.
• No fixed rate: Unlike FICA, federal income tax is progressive—higher income levels are taxed at higher rates. Employers use IRS tax tables or payroll software to calculate the correct amount.
• No wage cap: There’s no limit on how much federal income tax can be withheld—higher earnings can mean higher tax amounts.
• W-4 is key: The accuracy of withholding hinges on the employee’s W-4 form. Updates to marital status, dependents, or other income sources should be reflected in a new W-4.
• Not employer-matched:  Unlike FICA, employers do not contribute to federal income tax—your role is to withhold, report, and remit it accurately (no pressure).
• Must be deposited on time: Payments to the IRS are typically due monthly or semiweekly, and reported quarterly on Form 941.

State And Local Taxes

State and local income taxes are payroll deductions required by individual states, cities, or municipalities to fund things like public schools, roads, safety services, and local government operations.

Not all states or cities impose them, but when they do, it’s your job as the employer to handle withholding and remittance.

Some useful sources to check state and local taxes:

• State Department of Revenue Websites: Each state has its own official tax or revenue department. Example: California Franchise Tax Board
• The Federation of Tax Administrators (FTA): A helpful directory of all state tax agencies
• Payroll Software and providers: Payroll software tools or payroll companies stay up-to-date with tax changes automatically and have handy state-by-state tax guides built in.
• SBA (Small Business Administration): Offers employer tax guidance, including by state.
• Local government websites: For city or county taxes, check the city’s official website or local tax collection agency (e.g., NYC Department of Finance or Philly’s Revenue Department).

This can all get a bit much so, if you’re unsure, you can always seek advice from a HR consultancy in your area.

Voluntary Deductions

Voluntary deductions are amounts an employee chooses to have withheld from their paycheck, often to pay for benefits, retirement plans, or other programs.

Unlike mandatory deductions, these are optional and require written authorization from the employee.

Types include:

• Health & Wellness Benefits (usually pre-tax, reducing taxable income)
• Retirement Contributions (can be pre-tax or post-tax depending on the plan)

• Insurance premiums (tax depends on the policy and plan setup)
• Work-related programs (often pre-tax, if part of a qualified plan)
• Other voluntary withholdings (usually post-tax and based on employee opt-in)

Important things to know about voluntary deductions:

• Require employee consent: You must have clear, documented permission (usually via a signed form or benefits enrollment) before withholding anything voluntarily.
• Can be pre-tax or post-tax: Some lower taxable income (e.g., 401(k), health insurance), while others do not (e.g., Roth 401(k), union dues). This affects payroll tax calculations.
• Impact on net pay: Voluntary deductions reduce an employee’s take-home pay, so it’s important they understand how their choices affect their paycheck.
• Limits may apply: The IRS sets annual limits for certain pre-tax deductions (e.g., $23,000 for 401(k) in 2025), and plan rules may set caps or enrollment restrictions.
• You’re responsible for remitting funds: It’s the employer’s job to collect these deductions and send them to the correct provider or account on time (e.g., health insurer, retirement plan administrator).

Payroll Deduction Calculator

Wondering what a worker’s or your own paycheck will look like after the payroll deductions? We made a handy payroll deduction calculator to help.

Payroll Deduction Authorization Forms

A payroll deduction authorization form is a document where an employee formally consents to their employer deducting specific amounts from their paycheck for various purposes, such as taxes, benefits, or other authorized deductions. 

The form allows employees to authorize their employer to make deductions from their wages for taxes and benefits etc.

Authorization is generally necessary for both voluntary deductions (like for benefits or savings plans) and, in some cases, for mandatory deductions, as it provides written consent for the employer to make the deduction from an employee's paycheck.

You have two options here, depending on the purpose:

1. Create your own payroll deduction authorization form

• Use this for general payroll deductions (benefits, retirement plans, wage advances, etc.).
• Fully customizable
• Used internally by your company
• Needs to include employee authorization, deduction type, amount, and signature
• Ideal for everyday voluntary deductions.

2. Use IRS Form 2159 (for tax debt only)

Use the IRS Form 2159 only if the employee has an agreement with the IRS to pay off tax debt through payroll.

• Official government form
• Specific to IRS tax installment plans
• Requires IRS involvement and employer consent
• Not intended for regular benefits or employer-administered deductions.

How To Calculate Payroll Deductions

OK strap in, it’s time to get the calculator out and work out the payroll deductions (payroll software will do this for you automatically).

1. Start with gross pay
   1. Salary or hourly rate × hours worked
   2. Include overtime, bonuses, or commissions if applicable
2. Apply pre-tax deductions (This gives you taxable income for federal, state, and local taxes.)
   1. Subtract any eligible pre-tax items:
      1. Health insurance premiums
      2. 401(k) or traditional retirement contributions
      3. HSA/FSA contributions
3. Withhold statutory taxes
   1. Federal income tax: Use IRS tax tables or payroll software, based on the employee’s W-4
   2. State and local income tax: Based on local laws and the employee’s location
   3. FICA taxes:
      1. 6.2% Social Security (up to wage cap)
      2. 1.45% Medicare (no cap)
      3. +0.9% Medicare on income over $200,000 (employee only)
4. Apply post-tax deductions
   1. Subtract items like:
      1. Roth 401(k) contributions
      2. Union dues
      3. Charitable donations
      4. Wage garnishments or loan repayments
5. Calculate net pay
   1. What’s left after all deductions = take-home pay.

Payroll Deductions FAQs

What are the penalties for non-compliance?

The penalties for non-compliance with payroll deductions can vary depending on the specific violation and the governing laws. Common penalties for employees may include fines, interest on unpaid amounts, legal action from creditors or tax authorities. For employers, it could mean potential legal consequences and an audit.

What are some common mistakes in managing payroll deductions?

• Calculation Errors: Incorrectly calculating deduction amounts, which can lead to over or under-withholding.
• Failure to Stay Updated: Not keeping abreast of changing tax laws, deduction rates, or contribution limits.
• Lack of Communication: Failing to communicate effectively with employees about their deductions and how they impact their paychecks.
• Missed Deadlines: Missing deadlines for remitting deducted amounts to the appropriate entities, which can result in penalties.
• Incomplete Records: Poor record-keeping of payroll deductions, making it challenging to address discrepancies or audits.
• Ignoring Employee Changes: Not updating deductions when employees experience life changes that affect their tax status or benefits eligibility.
• Mishandling Garnishments: Mishandling wage garnishments such as child support, alimony, unpaid taxes or failing to prioritize multiple garnishments correctly.

How are payroll deductions reported?

Employers are legally required to report and remit payroll deductions to federal and (if applicable) state/local agencies on a regular schedule. Here’s how it breaks down:

1. Form 941 – Employer’s Quarterly Federal Tax Return: Used to report federal income tax withheld and employer and employee portions of Social Security and Medicare (FICA)
2. Form W-2 – Wage and Tax Statemen: This is given to employees and filed with the Social Security Administration (SSA). It shows total wages and all payroll deductions (income tax, Social Security, Medicare, etc.)
3. Form W-3 – Transmittal of Wage and Tax Statements: Summary form submitted to the SSA with all W-2s.
4. Form 940 – Employer’s Annual Federal Unemployment Tax Return (FUTA): Used to report and pay federal unemployment tax, which is employer-paid (not deducted from employees).
5. State and Local Reporting: Each state has its own forms for income tax, unemployment tax, and wage reporting. Visit your state’s Department of Revenue or Employment website for more info.

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