Payroll Deduction Plan: Definition, How It Works, and Reasons

What Is a Payroll Deduction Plan?

A payroll deduction plan refers to a plan where an employer withholds money from an employee's paycheck for a variety of purposes, but most commonly for benefits.

Payroll deduction plans may be voluntary or involuntary on the part of the employee. An involuntary payroll deduction plan involves an employer withholding money for Social Security and Medicare, as required by law.

A payroll deduction plan is voluntary when an employee authorizes an employer in writing to withhold money for certain benefits or services, such as a retirement savings plan, healthcare, or life insurance premiums, among others.

How a Payroll Deduction Plan Works

Payroll deduction plans offer employees a convenient way to automatically contribute income toward an ongoing expense or investment.

For example, it is common for employees to deduct a set percentage of their income and contribute it to their traditional Individual Retirement Account (IRA) or Roth IRA. An employee may also choose to have the premiums for an insurance policy deducted from their pay, ensuring that payment is never missed.

Some payroll deduction plans may also involve voluntary, systematic payroll deductions to purchase shares of common stock. In such cases, the employee opts into their employer's stock purchase plan, and a portion of each paycheck goes to buying shares of company stock, generally at a discounted price.

In an example provided by the Securities and Exchange Commission (SEC) of the Employee Stock Payroll Deduction Plan at Domino's Pizza, Inc., eligible employees could opt to allocate 1% to 15% of their paycheck for the purchase of company stock priced at 85% of the fair market value of the date the option was exercised.

Reasons for Payroll Deduction Plans

The purpose of payroll deduction plans is to ensure that the funds necessary for taxes, social programs, and various benefits are obtained from workers before they receive their paychecks.

This approach to funding services, whether voluntary or involuntary, not only supports an efficient and effective process of participation. It can also ensure the continuation of the services that the vast majority of individuals rely on at one time or another.

Payroll deduction plans can provide great help to employees by transferring money to financial accounts that can invest and build their savings for their future well-being.

If deductions from pay weren't made before paychecks were issued, and instead programs, savings plans, and other services relied on people taking active responsibility for sending checks or transferring money in a timely manner, those actions might never be taken (for any number of personal reasons).

Examples of Payroll Deduction Plans

Common voluntary payroll deduction plans and deductions include:

• 401(k) plan, IRA, or other retirement savings plan contributions
• Medical, dental, or vision health insurance plans
• Flexible spending account or pre-tax health savings account contributions
• Life insurance premiums (often sponsored by the employer)
• Charitable or employer-sponsored charitable giving plans
• Short-term disability insurance plans
• Payment for job-specific items, such as clothing, uniforms, or tools
• Union dues
• U.S. Savings Bond purchases
• Purchases of company merchandise (computers or other retired equipment)
• Tuition or professional certification fees

Common involuntary payroll deductions include:

• Federal income tax withholding (federally mandated)
• FICA taxes (for Social Security and Medicare contributions and premiums)
• State income tax withholding (mandated by states that impose a tax on income)
• Local taxes (imposed by cities, counties, and towns for disability or unemployment insurance)
• Wage garnishments
• Child support payments (when ordered by a court)

Pre-Tax Deductions

Pre-tax deductions are subtracted from an employee's gross salary before taxes and Social Security are calculated. The deductions, therefore, reduce the employee's taxable income and overall tax burden and, thus, provide an incentive to participate.

These deductions are commonly used to pay for health insurance, life insurance, health savings accounts, or retirement plan contributions. You may also be eligible to deduct a portion of commuting expenses.

Take-Home Pay After Deductions

As mentioned, there are two types of payroll deductions: pre-tax and after-tax. To calculate your take-home pay, follow these steps:

1. First, subtract any pre-tax deductions from gross income, such as insurance deductions and certain retirement contributions. The difference is taxable income.

2. Next, calculate the tax withholding based on the amount of taxable income. Use the appropriate tax rates for federal, state, and local taxes, as well as Social Security and Medicare.

3. Finally, subtract after-tax deductions, such as union dues, certain employee expenses, and any wage garnishments. Roth IRA contributions are also after-tax.

After accounting for all of these deductions, the result is your net income, or take-home pay, which should align with the amount of your paycheck.

Special Considerations

Payroll deductions are a little more complicated when it comes to tipped income. Tips must be recorded on a daily basis on IRS Form 4070A. If you earn more than $20 in tips in a month, that sum must be reported to your employer. See Publication 1244, "Employee's Daily Record of Tips and Report of Tips to Employer" for more information.

Just as with any other salary, the combined tips and wages are subject to payroll taxes and deductions.

In addition, employers in tipped industries are also responsible for ensuring that employee tips are equal to at least 8% of the business's total revenue for the same period. If tips do not equal 8% of total revenue, the employer is responsible for paying the difference to their employees. Employers can also request a lower percentage, but no lower than 2%.

The Bottom Line

Payroll deduction plans are used to support employee benefits. They subtract payments directly from an employee's pay.

Payroll deductions ensure that healthcare, retirement, and insurance payments are made promptly and without delay. In addition, some deductions are made with pre-tax income, which can have a sizable impact on employee tax burdens by reducing taxable income.