An advisor asked, “I’ve run across the client situation where an individual’s paycheck is too small to handle all the mandatory deductions or withholdings (e.g., payroll taxes, health insurance premiums, FSA contributions, life insurance, garnishments for child support and taxes, repayment of qualified loans, union dues, elective deferrals to a 401(k) plan, etc.) Is there a hierarchy of deductions that a payroll department should follow?
ERISA consultants at the Retirement Learning Center (RLC) Resource Desk 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, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from California is representative of a common inquiry related to withholding on payroll.
Highlights of the Discussion
First, check to see if the employer or payroll processor have a written policy. With respect to 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. ERISA does not prescribe a hierarchy of withholding, neither is one specified in federal tax law. For guidance, it would be prudent to discuss the issue with a tax attorney. For reference, here’s one example  of withholding order that applies to Federal civilian employees issued by the United States Office of Personnel Management.
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. Notice that 401(k) salary deferrals are akin to Thrift Savings Plan deferrals and, therefore, are considered “optional.”
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.