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Breaking Down Payroll Deductions: What Business Owners Need to Know
Payroll deductions can be complex, but understanding them is essential for business owners to remain compliant and ensure employees are paid accurately. In this guide, we’ll break down each type of payroll deduction, including federal and state-specific deductions, using Illinois as an example, to help you navigate payroll processing with confidence.
1. Federal Payroll Deductions
Federal payroll deductions apply to all U.S. businesses and employees. These include:
A. Federal Income Tax Withholding
- This is withheld based on the employee’s income, filing status, and W-4 elections.
- The IRS updates tax brackets annually; refer to IRS Publication 15-T for specific percentage breakdowns.
- Employers must use either the percentage method or the wage-bracket method to calculate withholding.
B. Social Security Tax
- Rate: 6.2% from the employee and 6.2% from the employer, for a total of 12.4%.
- Applies to earnings up to the Social Security wage base, which is $168,600 in 2025.
C. Medicare Tax
- Rate: 1.45% from the employee and 1.45% from the employer, for a total of 2.9%.
- No income cap, but an additional 0.9% applies to wages over $200,000 (single filers) or $250,000 (married filing jointly).
D. Federal Unemployment Tax (FUTA)
- Employers pay 6.0% on the first $7,000 of each employee’s wages.
- A credit of up to 5.4% may be available if the employer pays state unemployment taxes on time, reducing the effective rate to 0.6%.
E. Supplemental Wage Withholding
- Bonuses, overtime, and commissions are subject to a flat withholding rate of 22%.
- For supplemental wages exceeding $1 million, the withholding rate increases to 37%.
2. State Payroll Deductions
This section uses Illinois as an example, but state-specific payroll taxes vary.
A. State Income Tax
- A flat rate of 4.95% applies to all taxable wages in Illinois.
B. State Unemployment Insurance (SUTA)
- Paid by employers only; the 2025 rates range from 0.85% to 8.65%, depending on the employer’s experience rating.
- The taxable wage base is $13,271 per employee in Illinois.
C. Workers’ Compensation
- Employers must provide workers’ compensation insurance, with rates varying by industry classification.
D. Local Payroll Taxes
Some municipalities impose additional payroll taxes. For example:
- Chicago Employers’ Expense Tax: Employers with 50+ employees must pay $4 per employee per month.
- Paid Leave Ordinances: Certain cities require paid leave contributions.
3. Voluntary Deductions
Employers may also withhold voluntary deductions as authorized by employees, including:
- Retirement Contributions: 401(k) or IRA contributions (pre-tax or post-tax).
- Health Insurance Premiums: Employee-paid portions of medical, dental, and vision plans.
- Flexible Spending Accounts (FSAs) & Health Savings Accounts (HSAs): Pre-tax deductions for healthcare expenses.
- Union Dues: If applicable, based on collective bargaining agreements.
4. How Payroll Deductions Impact Tax Returns
Payroll deductions directly affect the employer’s and employee’s tax obligations:
- Employer Reporting: Businesses must report withholdings via IRS Forms 941 (quarterly) and W-2 (annually).
- Employee Tax Liability: Pre-tax deductions lower taxable income, reducing income tax owed.
- Business Tax Benefits: Employer-paid taxes (e.g., FUTA, SUTA) are deductible business expenses.
Final Thoughts
Understanding payroll deductions is crucial for compliance and financial planning. By staying updated on tax rates and regulations, business owners can simplify payroll processing and avoid penalties. If you’re unsure about payroll tax obligations, consulting with a payroll expert or accountant is always recommended.
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