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How to Apply Deductions and Tax to your Payroll in best 8 Methods

In Finance
January 10, 2022
payroll

Pay stubs are a necessary tool for building any kind of payroll system and are best known for summarising everything that an employee has earned and has had deducted over the previous month. This starts with the gross income and calculates the total net income, with deductions applied.

But these deductions are not always as straightforward as the rest of the accounting work might be. While only some come directly from your business operations, finance details like this can quickly make it harder than expected for an unprepared HR team to fill out a payroll in a small business.

How do these deductions apply, and what influences the overall pay of each employee?

What are Deductions?

If you are a higher-up owner in a business, then you might not be aware of exactly how deductions work. Most people are not aware and simply know that deductions take money from the original paycheck for various purposes. But what are they, really?

In the context of a pay stub, deductions are anything that removes money from the gross pay – the amount that an employee gets to begin with. This could be things like medical care, tax, or even court-ordered amounts that have to be removed for other purposes in that employee’s personal life.

Payroll

Either way, these deductions reduce the overall pay that the employee earns. Once these deductions are all applied, the employee is left with the net income – the amount that they actually ‘take home’ at the end of the month. In an official payroll, at least one or two deductions will always apply, often more.

Common Deductions

While every single employee might end up with their own specific deductions and taxes depending on how their personal life intertwines with their income, some are common among most employees. Understanding these deductions is important to building a good payroll for your business operations.

Federal Income Tax

Income tax is calculated based on an employee’s total pay, either as a salary or through wage-based income. This means that it will increase based on the employee’s total earnings but should still generally use the same sets of formulas to calculate properly.

This makes it an easy thing to add to pay stubs since most tax will just use the same formula regardless of who it applies to.

State Income Tax

Not all states have a state income tax, but those that do will have specific taxes levied in particular places. This varies from state to state, so it is important to find the one that is relevant to your business location. If your company operates across multiple states, it can get even more complex.

It is important to keep this in mind when you employ remote workers or other long-distance help since there may be specific laws in their states that apply to the money that you give them. Make sure you understand every relevant law and regulation before making that first payment to them.

Social Security

Social Security tax and Medicare tax are handled by the employer, who submits them directly to the government. Since these taxes use set percentages (6.2% Social Security, 1.45% Medicare), they can easily be applied to an existing pay stub, but you should keep an eye out for any changes.

Remember that these are submitted by the employer, so your business operations will also involve making sure that the tax is correct and sent over when it is available. Failing to do this will get you in serious trouble, so do not treat the tax like a ‘fire and forget’ process.

Voluntary Deductions

Sometimes, employees will have the option to opt into a certain deduction (or, more commonly, opt-out of one that applies automatically). These are things that benefit the employee in the long term but are essentially voluntary for each employee and are not for the government’s use.

This includes long-term plans like retirement or employee benefit spending accounts, as well as more immediate safety nets like health insurance and life insurance. These vary from business to business and are rarely ever the same rates between two companies.

Remember that employees might have the option to opt-out of these plans or sometimes even alter the amount that they are contributing. This can mean that you have more information to keep track of, so be sure to log this information in an employee’s record where it can be kept track of.

Court-Ordered Deductions

In rare cases, an employer can get a court order that directly tells them to deduct money from an employee’s income. These are generally to satisfy debts, ranging from child support or serious personal debt to cases where they have not paid federal or state tax altogether.

In this case, the employer has to begin the garnishment (slow repayment of the debt) by a certain date and will face a penalty if they fail to do so. This means that each specific employee’s debt will have its own requirements and specifics that the employer has to follow independently.

Applying Deductions

The hardest part of making deductions work is figuring out how to apply them, especially since an incorrect calculation can lead to you taking deductions out of other deductions. Thankfully, it only takes some practice to get the hang of the accounting work involved.

If you need more time to practice, then you can learn how to make fake pay stubs using online generators. These will give you plenty of ways to try out new methods of making the calculations work without putting real employee data at risk.

These same generators can also help you create real pay stubs quickly, allowing you to easily apply the various deductions and taxes to existing data without having to manually rework the calculations every time. If the payment deadlines are getting close, then this technique can save you a lot of time.

Remember that deductions are not actually that complex once you get the hang of them – it just takes a little while to put it all together and practice combining them. Once you have the basic idea figured out, you can easily apply it to any employee’s paycheck without issue.