Payroll Deductions: The Complete Guide for Small Business Owners

Every two weeks, your employees eagerly check their bank accounts for their paychecks. But here's the thing: what they receive is significantly less than what they actually earned. The difference? Payroll deductions—the often-misunderstood bridge between gross pay and take-home pay that every business owner needs to master.

Getting payroll deductions wrong can cost you more than just employee trust. The IRS imposes penalties ranging from 2% to 15% of your total payroll for late or incorrect tax deposits, and that's just the beginning. For small businesses without dedicated accounting departments, navigating the maze of mandatory withholdings, voluntary benefits, and ever-changing tax rates can feel overwhelming.

This guide breaks down everything you need to know about payroll deductions in 2026—from the taxes you're legally required to withhold to the benefits your employees might choose—so you can pay your team accurately and stay on the right side of the law.

What Are Payroll Deductions?

Payroll deductions are amounts withheld from an employee's gross pay before they receive their paycheck. These deductions cover everything from federal taxes to retirement contributions, and they determine the difference between what an employee earns and what actually lands in their bank account.

Here's a simple way to think about it:

Gross Pay (total earnings) - Payroll Deductions = Net Pay (take-home pay)

For example, if an employee earns $5,000 per month in gross pay but takes home $3,750, the $1,250 difference represents their total payroll deductions for taxes, insurance, retirement, and other withholdings.

Two Categories of Payroll Deductions

All payroll deductions fall into one of two categories: mandatory and voluntary. Understanding this distinction is critical because it affects how you calculate withholdings, when you can start deducting, and what documentation you need.

Mandatory Deductions

These deductions are required by law. You don't need employee permission—you're legally obligated to withhold them regardless of what your employees might prefer.

Voluntary Deductions

These deductions require explicit employee consent. Even if you offer health insurance or a 401(k) plan, employees must opt in before you can deduct anything from their paychecks. Always get written authorization before withholding voluntary deductions.

Mandatory Payroll Deductions Explained

FICA Taxes: Social Security and Medicare

FICA (Federal Insurance Contributions Act) taxes fund Social Security and Medicare programs. Both employers and employees contribute equally.

2026 FICA Rates:

Tax Type	Employee Rate	Employer Rate	Wage Base Limit
Social Security	6.2%	6.2%	$184,500
Medicare	1.45%	1.45%	No limit
Total FICA	7.65%	7.65%	—

The Social Security wage base increased from $176,100 in 2025 to $184,500 in 2026. This means the maximum Social Security tax for both employees and employers is $11,439 each.

Additional Medicare Tax: Employees earning more than $200,000 per year owe an additional 0.9% Medicare tax on wages above that threshold. This additional tax applies only to employees—there's no employer match.

Federal Income Tax

Federal income tax withholding depends on information from your employee's W-4 form, including their filing status (single, married filing jointly, or head of household) and any additional withholding they request.

The 2026 federal tax system uses seven brackets, ranging from 10% to 37%. To calculate the correct withholding amount, use the IRS withholding tables in Publication 15-T, available at IRS.gov.

State and Local Income Taxes

Most states impose their own income taxes with varying rates and rules. Some states have flat tax rates, while others use progressive brackets similar to the federal system.

States with No Income Tax:

• Alaska
• Florida
• Nevada
• New Hampshire (dividends and interest only)
• South Dakota
• Tennessee
• Texas
• Washington
• Wyoming

Even in states without income tax, you may still need to withhold local taxes depending on where your employees work or live. Always verify state and local requirements for each employee's location.

State-Specific Mandatory Deductions

Depending on your state, you may also be required to withhold for:

• State Disability Insurance (SDI): Required in California, Hawaii, New Jersey, New York, and Rhode Island
• Paid Family and Medical Leave (PFML): Mandatory employee contributions in states like Massachusetts, Connecticut, Washington, and Oregon
• State Unemployment Insurance (SUI): Some states require employee contributions in addition to employer payments

Wage Garnishments

When courts order an employee to pay child support, unpaid taxes, or other debts, you're legally required to withhold the specified amount from their paycheck. Garnishment orders take priority over most other deductions, and failing to comply can make you liable for the unpaid amount.

Voluntary Payroll Deductions

Voluntary deductions only apply when employees specifically elect them. You need written consent before withholding any voluntary amounts.

Retirement Plan Contributions

401(k) Plans:

For 2026, employees can contribute up to $24,500 to a traditional or Roth 401(k) plan—up from $23,500 in 2025. Workers age 50 and older can make an additional catch-up contribution of $8,000, bringing their total possible contribution to $32,500 annually.

Traditional 401(k) contributions are pre-tax, reducing the employee's taxable income immediately. Roth 401(k) contributions are post-tax but grow tax-free and can be withdrawn tax-free in retirement.

IRA Contributions:

If you offer payroll deduction IRAs, employees can contribute up to $7,000 in 2026 ($8,000 if age 50 or older).

Trump Accounts (New for 2026):

Starting July 4, 2026, a new type of individual retirement account is available for children under 18. Employers may contribute up to $2,500 annually toward an employee's or their dependent's Trump account, and these contributions are excluded from the employee's gross income.

Health Insurance Premiums

Health insurance is the most sought-after employee benefit, even though small businesses with fewer than 50 full-time equivalent employees aren't required to offer it. When employees opt into your health plan, their premium contributions are typically deducted pre-tax, reducing their taxable income.

Health Savings Accounts (HSA) and Flexible Spending Accounts (FSA)

HSAs are available to employees enrolled in high-deductible health plans. Contributions are pre-tax, grow tax-free, and can be withdrawn tax-free for qualified medical expenses. Unlike FSAs, HSA funds roll over year after year.

FSAs let employees set aside pre-tax dollars for healthcare expenses, but most FSA funds must be used within the plan year or forfeit (though some plans offer a grace period or limited rollover).

Life and Disability Insurance

Employer-sponsored life insurance and disability coverage are voluntary benefits that employees can elect. Premium deductions may be pre-tax or post-tax depending on the plan structure and applicable tax rules.

Commuter Benefits

Commuter benefit programs allow employees to pay for qualified parking or public transit expenses with pre-tax dollars. In 2026, the IRS limit is $340 per month for transportation and $340 per month for qualified parking. These benefits don't cover fuel costs, bike commuting, or car insurance.

Union Dues

If any of your employees are union members, you're typically responsible for deducting union dues from their paychecks per the collective bargaining agreement.

Other Voluntary Deductions

Additional voluntary deductions might include:

• Charitable contributions through payroll giving programs
• Education assistance or student loan repayment programs
• Gym memberships or wellness program fees
• Company stock purchase plans

Pre-Tax vs. Post-Tax Deductions

Understanding the difference between pre-tax and post-tax deductions affects both your calculations and your employees' tax bills.

Pre-Tax Deductions

Pre-tax deductions reduce an employee's taxable income before federal, state, and FICA taxes are calculated. This means employees pay less in taxes overall.

Common pre-tax deductions include:

• Traditional 401(k) contributions
• Health insurance premiums
• HSA and FSA contributions
• Commuter benefits

Post-Tax Deductions

Post-tax deductions are taken after all taxes have been calculated and withheld. While employees don't get immediate tax savings, some post-tax options provide other benefits.

Common post-tax deductions include:

• Roth 401(k) and Roth IRA contributions (tax-free growth and withdrawals)
• Life insurance premiums above certain thresholds
• Some disability insurance premiums
• Wage garnishments
• Union dues (in some cases)
• After-tax charitable contributions

How to Calculate Payroll Deductions: Step-by-Step

Follow this order when calculating deductions from each paycheck:

Step 1: Start with gross pay

Calculate total earnings including regular wages, overtime, bonuses, and commissions.

Step 2: Subtract pre-tax deductions

Remove employee contributions for health insurance, traditional 401(k), HSA/FSA, and other qualified pre-tax benefits. This gives you the taxable income for Step 3.

Step 3: Calculate and withhold federal income tax

Using the employee's W-4 information and IRS Publication 15-T tables, determine the federal income tax to withhold based on their adjusted gross income.

Step 4: Calculate and withhold FICA taxes

Withhold 6.2% for Social Security (on wages up to $184,500) and 1.45% for Medicare (no wage limit). Add the 0.9% Additional Medicare Tax for wages exceeding $200,000.

Step 5: Calculate and withhold state and local taxes

Apply your state's withholding rules based on the employee's W-4 or state-specific withholding form.

Step 6: Subtract post-tax deductions

Deduct Roth contributions, wage garnishments, after-tax benefits, and any other post-tax items.

Step 7: Calculate net pay

What remains is the employee's take-home pay.

Common Payroll Deduction Mistakes (and How to Avoid Them)

Misclassifying Workers

One of the costliest payroll errors is misclassifying employees as independent contractors. If the IRS determines you misclassified workers, you could owe back taxes, penalties, and be liable for unpaid benefits. Use the IRS guidelines to determine proper classification based on behavioral control, financial control, and the type of relationship.

Using Outdated Tax Rates

Tax rates, wage bases, and contribution limits change annually. Using last year's numbers leads to incorrect withholdings and potential penalties. Update your payroll system before processing your first payroll of each new year.

Missing Deposit Deadlines

The IRS imposes penalties for late payroll tax deposits:

• 1-5 days late: 2% penalty
• 6-15 days late: 5% penalty
• More than 15 days late: 10% penalty
• More than 10 days after first IRS notice: 15% penalty

Set up electronic deposits through EFTPS (Electronic Federal Tax Payment System) and automate the process whenever possible.

Incorrect W-2 or 1099 Information

Filing incorrect information returns can result in penalties up to $310 per form if not corrected by August 1. Verify employee information at hire and during annual reviews.

Forgetting to Tax Supplemental Pay

Bonuses, overtime, commissions, and vacation payouts are all taxable. Many business owners forget to withhold properly on these payments. The IRS allows a flat 22% supplemental wage rate for federal withholding, or you can use the aggregate method based on the employee's regular wages.

Neglecting State-Specific Requirements

Each state has its own rules for income tax withholding, disability insurance, and paid leave programs. Multi-state employers must track requirements for every state where they have employees working.

Employer Payroll Tax Responsibilities

Beyond what you withhold from employees, you have additional payroll tax obligations as an employer:

Employer's Share of FICA

You must match employee FICA contributions dollar for dollar—6.2% for Social Security and 1.45% for Medicare. This 7.65% comes from your business funds, not employee wages.

Federal Unemployment Tax (FUTA)

FUTA is 6% on the first $7,000 of each employee's wages, but most employers receive a 5.4% credit for paying state unemployment taxes, reducing the effective rate to 0.6%. FUTA is an employer-only tax—it's not deducted from employee wages.

State Unemployment Tax (SUTA)

SUTA rates vary by state and are based on your industry and claims history. Like FUTA, this is generally an employer cost, though a few states require small employee contributions.

Workers' Compensation Insurance

Most states require employers to carry workers' compensation insurance. This isn't a payroll deduction but is calculated based on your payroll amounts and job classifications.

Record-Keeping Requirements

The IRS requires you to keep payroll records for at least four years, including:

• Employee W-4 forms and state withholding certificates
• Dates and amounts of all wage payments
• Amounts and dates of tax deposits
• Copies of filed returns (Forms 941, 940, W-2, W-3)
• Documentation of adjustments or corrections

Good record-keeping protects you during audits and helps resolve discrepancies with employees or tax agencies.

Simplify Your Financial Management

Payroll deductions represent just one piece of your business's financial puzzle, but they're a critical one that demands precision and consistent tracking. Every deduction you process—from FICA taxes to 401(k) contributions—needs accurate documentation and timely reporting.

Beancount.io offers plain-text accounting that gives you complete transparency and control over your financial records. With version-controlled ledgers and AI-ready data formats, you can maintain the meticulous records that payroll compliance demands without being locked into proprietary software. Get started for free and bring clarity to your business finances.