Mandatory vs. Voluntary Payroll Deductions: 9 Deductions You Need To Consider

How sure are you about your payroll process? While paying your employees might seem straightforward, anyone who has managed it in full compliance knows it can get complicated very quickly. But what makes it so complicated? Payroll deductions.

Most people are familiar with federal and state taxes which require employers to withhold certain amounts from every paycheck. These universally deducted funds contribute to wider societal benefits such as Medicare and unemployment, but other mandatory deductions (wage garnishments, debt repayments, etc.) may be less common.

Then there are several other voluntary deductions you may allow for your employees, like contributions to retirement accounts like 401(k)s and payments towards health insurance premiums. Although the employee initiates these deductions, they require careful handling by employers to ensure proper tax withholding adjustments.

If this sounds daunting, you’re not alone. Many employers get tangled in the complexities of payroll deductions, risking errors that can lead to disgruntled employees and even legal penalties.

To demystify payroll compliance, let’s look at some examples of mandatory and voluntary deductions, some key regulations for making deductions, and strategies to make your processes more efficient.

What Are Payroll Deductions?

Payroll deductions are specific sums taken out of a paycheck by the employer before it is issued to the employee. Deductions will typically appear on the employee’s pay stub, showing the amount subtracted from their gross pay. These deductions are classified in two main categories: mandatory and voluntary.

• Mandatory Deductions: Employers are legally required to make these from every paycheck, regardless of employee consent. Examples include federal and state taxes, Social Security contributions, and in some cases, wage garnishments and union dues.
• Voluntary Deductions: These are made from an employee's paycheck at their request and typically include contributions to retirement accounts, health insurance premiums, and possibly charitable donations. Employers must obtain written consent from the employee before making voluntary deductions.

Minimums, Maximums, and Exceptions

The Consumer Credit Protection Act (CCPA) limits the amount that can be garnished from an employee’s earnings in any given week. For ordinary garnishments, the amount cannot exceed the lesser of:

• 25% of the employee’s disposable earnings
• The amount by which an employee’s disposable earnings are greater than 30 times the federal minimum wage ($7.25)

For example, if the federal minimum wage is $7.25, and an employee's weekly earnings are $290 or more, up to 25% can be garnished. However, if the same employee’s wages are $217.50 ($7.25 × 30) or less, they cannot be garnished at all (Department of Labor).

These limits are designed to prevent excessive financial hardship for employees. But what happens when there are several mandatory deductions, but the employee’s gross pay isn’t enough to cover all of them?

In this case, employers should generally make deductions in the following order of precedence (in accordance with the Department of Labor):

1. Taxes (federal, state, and local)
2. Mandatory deductions (child support, garnishments)
3. Benefits (401(k), health insurance)
4. Other voluntary deductions

NOTE: The CCPA also states that an employer cannot terminate an employee whose earnings are subject to garnishment for one single debt. However, it does not restrict termination after multiple garnishments.

Mandatory Payroll Deductions

Mandatory payroll deductions are required by law, regardless of employee consent. Some examples include:

Federal Income Tax

Federal income tax withholding is more nuanced than many realize. The amount withheld from each paycheck is a function of the W-4 form that employees fill out when first hired.

The W-4 form now focuses on dependents and other income rather than just allowances, considering not just an employee’s family situation but also other potential income and tax credits. This can make each individual's tax obligations unique. However, regardless of how an employee fills out the W-4 form, every working individual is required to pay the following in some amount:

FICA Tax

The Federal Insurance Contributions Act (FICA) tax consists of Social Security and Medicare taxes. Each employee will pay a fixed rate: 6.2% for Social Security and 1.45% for Medicare deducted from taxable wages. Employers match these contributions in their own tax payments.

This is usually straightforward. But there are complexities with this deduction which usually require software to implement effectively. For example, many employers overlook the Social Security wage base limit that caps the amount of income subject to Social Security taxes annually. However, there is no wage cap for Medicare taxes, and in fact, high earners are subject to an additional Medicare tax, which payroll systems must account for.

What Is Taxable Income?

An employee’s taxable income is the amount which can be calculated when figuring federal and state taxes each paycheck. In some cases, this may be simply an employee’s gross pay (the full amount of pay calculated for the period without any deductions). However, some benefits (mostly voluntary) are taken out pre-tax, meaning they are calculated before an employee’s taxes, thus lowering an employee’s taxable income.

For instance, if an employee’s gross pay is $2,000, and they pay $200 in health insurance premiums, this lowers their taxable income to $1,800. Therefore, when you calculate FICA taxes, you take 6.2% of ($111.60) for Social Security and 1.45% for Medicare ($26.10). Likewise, the employer’s matched tax contributions are also reduced in this case.

State/Local Taxes

State and local tax deductions vary widely depending on the employee's work location and residence. Some states, like Texas and Florida, do not levy state income taxes, whereas others, like California and New York, have complex tax structures with multiple brackets.

Local taxes (which can include city or county taxes) add another layer of complexity. This can be particularly challenging for businesses with multiple locations or a geographically dispersed workforce. To remain fully compliant in today’s hybrid working world, payroll systems need to be highly configurable and updated regularly.

Union Dues

While union dues may not be universally applicable, they are often considered a “mandatory” deduction. The status as “mandatory” is debatable only because it is technically the responsibility of the union member to pay these dues. However, if you are a business owner working with a union which has a stipulation in their collective bargaining agreement (CBA) about deducting union dues from paychecks, you are legally obligated to at least negotiate with that union about those terms.

In any case, deducting union dues from an employee’s paycheck is a good practice, even if the employee must voluntarily commit to doing so. These dues (which are a post-tax deduction) can vary not only by union but also by the local chapter, and it’s wise to make correct calculations with your own configured payroll software.

The frequency and amount in which these dues must be paid can even be affected by the employee's job site. This can be especially complex in industries like construction where workers may operate in multiple union jurisdictions throughout the year. For example, a union electrician may work at a job in Boston one week and Detroit the next. If those union locals have different structures for paying union dues, your payroll process must account for both in calculating deductions.

Child Support

Child support deductions are post-tax deductions mandated under specific circumstances. They require a court order and can vary in amount and duration based on the court’s judgment and state laws, which often stipulate a percentage of the non-custodial parent's income. Handling these garnishments properly is critical as errors can have significant legal repercussions for both the employer and employee.

Unpaid Student Loans and Other Garnishments

Garnishments for unpaid student loans or other debts such as credit card bills or medical expenses also require court orders. However, unlike child support, these garnishments are capped at certain percentages of the employee’s disposable income (income left over after taxes).

Managing these requires an understanding of both federal and state laws, as some states have garnishment laws that are more restrictive than federal guidelines. Calculating these deductions correctly is essential to remain compliant and protect the employee’s welfare.

Voluntary Payroll Deductions

Voluntary deductions are those the employee chooses to withhold from their paycheck. They may relate to benefits such as health or life insurance or willing repayments of debts. Let’s look at a few examples:

Health Insurance

Health insurance premiums are typically deducted from an employee's paycheck on a pre-tax basis under a Section 125 cafeteria plan. This arrangement lowers the employee's taxable income, reducing federal income and FICA taxes as well.

Of course, that means this adjustment also directly affects the employer's payroll tax liabilities, potentially saving the company significant money on matched Social Security and Medicare contributions.

Life Insurance / 401K Contributions

Contributions to life insurance and 401(k) retirement plans are usually made pre-tax, providing a similar tax benefit to insurance deductions. However, the IRS does impose a limit on annual contributions to an employee’s 401(k) plan, which is adjusted periodically.

These adjustments require payroll systems nimble enough to update contribution limits automatically across the employee roster. Additionally, employers must ensure their payroll systems can handle catch-up contributions for employees over 50, who are allowed to contribute additional amounts beyond the standard limit.

Short Term/Long Term Disability Insurance

Disability insurance can be deducted from an employee's wages on a pre-tax or post-tax basis. However, the payouts are still technically taxable in some way. Here’s the rule in basic terms:

If premiums are paid pre-tax, the employee will need to pay taxes on the benefits at the time when they are received. This can pose a substantial tax bill during a time of need, which usually isn’t ideal. If premiums are paid post-tax, the benefits can be received tax-free in the event of a disability.

As an employer, you can choose how you offer these benefits, but it’s best to leave the choice to the employee, if possible. While it may seem wiser to offset tax payments early so disability insurance payouts are received tax free, the employee might feel differently. The more granular control you can offer employees over their pay (without hindering your process or compliance standards), the better.

In either case, clearly communicating the implications of these deductions to employees is crucial to helping them make informed decisions.

Charitable Deductions

You can choose to allow employees to support causes they care about directly from their paycheck. Charitable contributions made through payroll are typically post-tax deductions, but may potentially qualify employees for tax deductions when filing personal income taxes. In other words, they don’t reduce taxes on each paycheck, but they may reduce an employee’s taxable income later on and potentially provide a bigger refund.

Offering a voluntary payroll deduction for charitable donations can also enhance corporate social responsibility efforts and employee engagement. However, these deductions will need to be properly recorded and reported on employee W-2 forms for accurate tax filing.

Payroll Deduction Example

Here, the employee doesn’t have all the deductions listed above, however, this example illustrates how pre-tax deductions influence taxable income and take-home pay.

Employee Details:

• Name: John Doe
• Pay Period: Bi-weekly
• Gross Pay: $2,000

Voluntary Deductions (Pre-Tax):

• Health Insurance Premium: $150
• 401(k) Retirement Plan (5% of Gross Pay): $100

Mandatory Deductions (Taxes):

• Social Security: (6.2% of $1,750) = $108.50
• Medicare: (1.45% of $1,750) = $25.38
• State Income Tax (5% of Taxable Income): $87.50

Total Employee-paid Taxes: $221.38

Other Deductions:

• (Mandatory) Child Support: $300
• (Voluntary) Charitable Donation: $50

SUMMARY

• Gross Pay: $2,000
• Total Pre-tax Deductions: -$250
• Taxable Income: $1,750
• Employee-Paid Taxes: -$221.38
• Other Deductions: -$350
• Net Pay: $1,178.62

How To Manage Payroll Deductions

Managing payroll deductions efficiently is crucial for ensuring compliance, accuracy, and employee satisfaction. Here are a few tips for streamlining this process within your organization.

Get Written Consent for Voluntary Deductions

Before implementing any voluntary deductions from an employee's paycheck (for retirement plans, health insurance, charitable contributions, etc.), you’ll need to obtain written consent. This consent should detail the deduction amount, frequency, and purpose in the most explicit terms possible.

This written consent protects both the employer and employee, ensuring there are no misunderstandings about the amount deducted from the employee's wages. If the employee later contests the deduction, this signed consent serves as a legal safeguard.

Revise Your Pay Stub Format

Transparency in payroll processing builds trust and prevents disputes. It is essential that each pay stub clearly outlines all deductions: both mandatory and voluntary. This breakdown should include how much is taken out for taxes, health benefits, retirement plans, and any other deductions. The more transparently you can display the math to your employees, the better.

To facilitate this, ensure your payroll system can generate detailed and clear pay stubs (in a standardized format). Help employees to access these pay stubs electronically through a secure portal. Providing support for questions or concerns about the deductions, possibly through a dedicated HR helpdesk, can benefit employees as well.

Use Software That Automates Deductions

Automation plays a pivotal role in modern payroll management by significantly reducing the effort required to process deductions and minimizing errors. But not every payroll system can handle the complexity required of some industries. Even if many calculations are built in, most systems still need to be configured to a company’s unique needs.

Key features of an effective payroll automation system include:

• Custom Rule Settings: Ability to configure deductions according to specific needs, such as union dues, garnishments, or tax withholdings, tailored to different local, state, or federal requirements.
• Granular Control: Detailed control over how deductions are applied, ensuring accuracy across different types of pay and deductions.
• Error Reduction: Reduce the risk of human error (which can lead to fines and employee dissatisfaction) with automated payroll processing tailored to your needs.

Criterion’s payroll system can do all of this and more. We automate your payroll calculations based on preset rules and employee-specific settings, so you can leave behind manual workflows, saving time and money.

Integrate Your Payroll Software With an ERP

Integrating your payroll software with an Enterprise Resource Planning (ERP) system can significantly enhance your financial and operational efficiency. Combining HR, payroll, and financial data into a single system, you effectively simply accounting and financial reporting.

This integration allows you to seamlessly transfer payroll data into your financial systems, helping you manage budgets and forecasts with greater accuracy. It also provides comprehensive insights into how payroll deductions and labor costs impact your overall financial health.

With Criterion, you can integrate your payroll, HR, and talent engagement tools with any third-party tool. In fact, we’ve already developed integrations with popular ERP platforms such as:

• Acumatica
• Sage Intacct
• Microsoft Dynamics
• Unanet
• SAP

Final Thoughts

Managing payroll deductions may not be the most exhilarating part of running a business, but it is undeniably important. Without a robust system, the complex task of ensuring accurate and compliant payroll processing can be daunting.

Criterion is designed to alleviate the burdens of modern payroll complexities. Our HCM helps HR and payroll teams perform their roles more effectively and in full compliance with local, state, and federal laws. Whether you're operating across multiple countries, dealing with several states' regulations, or handling specific requirements of different local unions, Criterion manages it all seamlessly.

With Criterion, both mandatory and voluntary calculations can be automated with ultimate granularity. Create tailored pay and benefits packages to be deployed specifically to employees based on their needs, automating deductions for essential benefits like health coverage, 401(k) plans, disability insurance, and more. From there, you can generate detailed reports that help you analyze how your benefits structure impacts your company culture.

Don't let the complexities of payroll deductions hold your business back. Book a demo today to discover how Criterion can transform your payroll processes, simplify compliance, and enhance HR management.