Payroll mistakes can expose your business to more than just upset employees, it can also incur fines and penalties from the IRS associated with delinquency, failure to pay taxes and payroll accuracy.
Processing payroll is complex because payroll impacts tax compliance, retirement plan funding, and benefits. Let’s discuss some of the most common payroll mistakes and how to avoid them. Consider if these risks apply to your firm’s payroll system.
Worker Classifications
Your business must determine if each worker is an employee or an independent contractor. As more people work remotely, this has become a bigger issue.
According to the IRS: “Generally, you must withhold and deposit income taxes, Social Security taxes, and Medicare taxes from the wages paid to an employee. Additionally, you must also pay the matching employer portion of Social Security and Medicare taxes, as well as pay unemployment tax on wages paid to an employee.
Generally, you do not have to withhold or pay any taxes on payments to independent contractors.”
If you categorize a worker as an independent contractor when the IRS rules classify the worker as an employee, you will not make the required withholdings from pay.
Employers have a degree of control over workers. Facts that provide evidence of the degree of control and independence fall into three categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of relationship: Are there written contracts or employee-type benefits (that is, pension plan, insurance, vacation pay, etc.)? Will the relationship continue, and is the work performed a key aspect of the business?
Use Form SS-8 to determine the status of each worker and how the worker’s pay will be treated for payroll purposes.
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Tax Withholdings
Businesses must withhold taxes based on each employee’s completed W-4 form. The company may pay a Failure to Deposit Penalty when the rules are not followed.
If you underwithhold, you are not sending in the correct amount of tax deposits. The late deposit penalties are based on the number of days the payment is late. The business will also invest time to file Form 941-X to correct the payroll tax return.
This situation also creates problems for the employee.
Assume, for example, that a worker expects $25,000 in withholdings and makes $3,000 in quarterly payments for estimated taxes. If the employer withholds only $20,000, the worker must pay $5,000 out of pocket when the return is filed. This may create a financial hardship and damage the relationship with the employee.
Overtime and Minimum Wage Calculations
Companies must comply with the overtime rules in the Fair Labor Standards Act (FLSA).
Covered nonexempt employees must receive overtime pay for hours worked over 40 per work week at a rate not less than one and one-half times the regular rate of pay.
Your firm will pay penalties if overtime pay is not paid, or is incorrect. Employers must pay any overtime hours that were missed, and businesses can be subject to civil and criminal penalties.
FLSA also dictates rules for paying the federal minimum wage. A business is subject to other penalties if the minimum wage is not paid.
Late Payroll Processing
Your staff relies on timely payments to pay their bills and manage personal finances. If a payroll run is late, the business creates financial hardships for employees. Even worse, the staff may lose confidence in management’s ability to operate the business.
Recordkeeping Errors
Your business must comply with FLSA payroll recordkeeping rules. Here are some of the records that a business should keep on file:
- Employee data: Name, address, birthdate, occupation
- Type of pay: Annual salary or hourly rate paid (including overtime pay)
- Totals: Gross wages paid, all deduction amounts
- Payments: Date of payment and the pay period covered by the payment
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Records used to compute wages should be retained for at least two years.
Employers must send each employee’s W-2 to the Social Security Administration each year and provide a copy to the employee.
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Companies face penalties if records are not retained, and if W-2s are not submitted on time.
Retirement Plan Mistakes
Retirement plans are a valuable benefit for your workers, and the IRS and the Employee Retirement Security Act (ERISA) determine rules for retirement plans. Many businesses offer retirement and 401k plans to employees. Here are some errors to avoid.
Determining when a worker is eligible
Eligibility for a 401(k) is based on the worker’s age, years of service, and other factors. Participating in the 401(k) is a valuable benefit, and you need a reliable system to determine who is eligible. Track the employee’s start date so you can inform them when they can contribute.
You want employees to be able to participate in a 401(k) as soon as they are eligible. If you make a mistake and don’t give the worker the choice to start investing, the employee may be frustrated.
Contributions above the 2025 limit
One key benefit of using a 401(k) is that both worker and employer contributions are not taxed until funds are withdrawn from the plan. All of the dollars are invested before taxes are deducted, and the earnings are tax deferred.
The 2025 employee contribution limit is $23,500. You need controls in place so that the worker does not contribute more than the allowed maximum. There are some exceptions, based on the worker’s age and contribution history.
Investing Contributions
Each 401(k) plan has a trust that is responsible for holding the plan’s assets. It’s your firm’s responsibility to send employer and employee contributions to the plan trust for investment.
ERISA rules require that contributions be sent to the trust as soon as the employer can; however, in no event can the deposit be later than the 15th business day of the following month.
If contributions are not invested quickly, the employee may miss out on interest and dividend income, as well as possible capital gains.
Investment Options
When you send employee contributions, you must communicate how the employee wants the dollars invested. A 2025 Investment Company Institute study found that the average large 401(k) plan offers 29 investment options.
Your company must report the investment option dollar amounts (or percentages) chosen by the employee.
Assume that the employee near retirement age chooses to invest 70% of contributions into a fixed income fund, based on an investment advisor’s recommendation. If 70% is invested in an aggressive growth stock fund by mistake, the investor is exposed to far more market risk than intended.
Recordkeeping Requirements
If your business provides a retirement plan, you are required to complete and submit Form 5500, Annual Return/Report of Employee Benefit Plan, each year. Form 5500 documents each plan participant, the dollars invested, and the investment options chosen by the employee.
The IRS penalty for late filing of a 5500 return is $25 per day, up to a maximum of $15,000. The Department of Labor (ERISA) penalty for late filing can run up to $2,529 per day, with no maximum.
Planning to Avoid Payment Mistakes
Payroll mistakes generally fall into these categories:
→ Regulations not reviewed frequently
Many regulations, such as income tax brackets and retirement plan contribution limits, are subject to annual changes. You need systems in place to update changes into your payroll process. This applies to federal laws, as well as state and local regulations.
→ Calculations errors
Businesses make hundreds or even thousands of calculations to manage payroll. Manual processing increases the risk of errors.
→ Reviewing and approving data
You need a system to alert approvers to review and sign off on payroll data. Without a system in place, approvals are delayed or never completed.
→ Flagging errors for correction
When an error is found, the payroll department needs a system that alerts the staff. This ensures that errors are fixed quickly.
→ Systems not integrated
Payroll, HR, and tax systems must be able to share data. Mistakes occur when data is siloed and not easily shared between systems.
A Better Way to Manage Payroll
Automation is the key to improving payroll processing and eliminating errors. You can process more transactions in less time and with fewer errors. Businesses have many payroll automation choices, and you need a reliable partner.
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Payroll Integrations is the only payroll API built exclusively for benefits. You can transform benefits management and elevate employee financial wellness with the Payroll Integrations API platform.
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Payroll Integrations is the leader in payroll and retirement integrations with institutional partnerships across hundreds of leading payroll companies, 401(k) providers, recordkeepers, and third-party administrators.
Help your staff save time and focus on tasks that add value to the organization. Contact Payroll Integrations to create a seamless payroll processing system.
