Hierarchy of Pay Deductions
If an employer does not have a policy regarding the hierarchy of payroll withholdings, a best practice is to put one in place with the help of a tax advisor and apply it consistently. Guidelines apply for mandatory vs. optional withholdings.
Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in California is representative of a common question on payroll deductions.
"Does the IRS (or any other source) have a flow chart of the hierarchy of how payroll deductions should be handled?"
Highlights of the discussion
First, check if the employer or payroll processor has a written policy. Concerning 401(k) salary deferrals, you could check the governing plan documents to see if there is a written policy (although few plans contain such information). If no policy exists, it is best to put one in place.
The IRS has Publication 505, Tax Withholding and Estimated Tax, and Publication 15, Circular E, which provide some basic guidelines. For example, an employer must withhold Social Security, Medicare and federal income taxes first, up to the amount of available pay. If payroll cannot withhold all of these amounts, the employee may need to pay the remainder (IRC §§ 3402 and 3201).
Generally, payroll deductions are either mandatory or optional. Mandatory deductions would include those identified under federal, state, and local law. An employer is legally obligated to collect this money and remit it to the proper authority.
Optional deductions, on the other hand, are voluntary, and an employee must provide written authorization to have such amounts withheld from a paycheck. Note that 401(k) salary deferrals are considered “optional.”
For example, one deduction hierarchy that is based on IRS, DOL, and court guidance is as follows:
1. Legally required deductions
Federal income tax (FIT) – IRC §3402
FICA (Social Security & Medicare) – IRC §3102
State/local income tax (if applicable)
2. Court-ordered deductions
Child support, garnishments, tax levies – [e.g., IRC §6331 (levies)]
3. Voluntary (optional) deductions
401(k), health insurance, charitable contributions
As another reference, here’s one example of a withholding order that applies to Federal civilian employees issued by the United States Office of Personnel Management.
However, for specific guidance, it would be prudent to discuss the issue with a tax advisor.
Conclusion
If an employer does not have a policy regarding the hierarchy of payroll withholdings, a best practice is to put one in place with the help of a tax advisor and apply it consistently.