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15.1 Payroll 585withhold according to the information each employee provides on his W-4 form and a
withholding schedule published by the IRS and state or local tax agencies. This money is
then forwarded to the appropriate tax collection agencies. In this section, we will simply
state the amount of withholding without discussing the details of its calculation.^1
In addition to income tax withholding, employers are required to deduct payroll taxes
for Social Security and Medicare, collectively referred to as FICA. These taxes are cur-
rently 6.2% for Social Security and 1.45% for Medicare, applied to income after pretax
benefits are subtracted. The Social Security tax applies only up to a certain maximum
income (the maximum increases each year—in 2006 the amount was $94,200), but this
maximum is large enough that this is an issue for only very highly paid employees.
Insurance Benefit Deductions: Many employers offer their workers the opportunity
to obtain health insurance and other insurance benefits such as dental, life, or disability
insurance through their work. While a few employers bear the entire cost of these benefits,
in today’s world this has become quite rare. Usually, employees are required to pay at least
a portion of the cost of these benefits, and deductions are made from gross pay to cover
the employee’s share of the costs. In most cases the amount the employee pays for these
benefits is tax free; the costs are subtracted from income before income tax is calculated.
For this reason, these are often called pretax deductions.
Companies use a wide variety of formulas to determine the employee’s share of these
benefits. Some commonly used formulas are discussed in Chapter 13, Section 13.2.
Flexible spending accounts (FSAs) are another common pretax deduction. An FSA is a
special account that is funded by a pretax payroll deduction, which can be used to pay for
medical expenses or child care expenses. By avoiding paying taxes on the money deposited
to these accounts, an employee may be able to save quite a bit versus paying these expenses
with after-tax money.
Other benefits: Some companies also offer their employees the opportunity to obtain
other benefits through payroll deduction. Employees may be able to purchase auto or
homeowner’s or long-term-care insurance, or purchase prepaid legal services plans or
real-estate service discounts or other similar programs. Some employers may even offer
veterinary insurance—health insurance for your pets! The deductions for these types of
programs, though, are generally not tax-deductible; these costs are subtracted after taxes
are calculated. For this reason these are often called after-tax benefits. The entire cost of
these sorts of benefits is usually paid by the employees who choose to take advantage of
them. Even though the costs may not be reduced by any employer subsidy, the group rates
for these plans may be more favorable than the rates that you would have to pay for similar
benefits if you bought them as an individual.
Retirement Programs: Many employers offer retirement plans as part of their benefits
offerings. The costs for some retirement plans may be borne entirely by the employer, while
others may be funded primarily by the employee. 401(k) plans are a type of retirement
savings plan to which a worker can make pretax contributions through payroll deductions.
The company may, or may not, offer to match employees’ 401(k) contributions; even if the
company does not, these programs are attractive because they both allow workers to avoid
current income taxes on their contributions and also allow the money invested in them to
grow tax-deferred until retirement.
Usually an employee is free to decide how much, if at all, to contribute to a 401(k) plan,
though recent legislation appears to be moving in the direction of making some level of
401(k) participation mandatory. Employees may specify that they want to contribute a cer-
tain percent of their gross pay, or may contribute a fixed dollar amount each pay period.^2
As a result of technical distinctions in the tax code, some employers offer plans that are
similar to 401(k)’s (such as 403(b) plans offered by nonprofit employers) but are called by
different names. Some employers also offer the opportunity to put money into other types
of investment programs through payroll deduction, though these programs may not offer
the same tax advantages as 401(k)’s.(^1) The calculation of income tax withholding amounts is covered in detail in Chapter 9, Section 9.2.
(^2) Retirement plans are discussed in more detail in Chapter 7.