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Starting a nonprofit requires commitment, hard work, and plenty of patience. While the idea for a nonprofit may come to you instantly, actually getting one up and running can take several months, and often much longer.

What follows are key things you need to know about starting a nonprofit, plus a step-by-step guide to help you get your new nonprofit off the ground.

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What Makes a Nonprofit a Nonprofit?

A nonprofit is a type of business that is organized with the intention of furthering a specific cause or mission rather than earning profits for its owners. All the money that is earned by or donated to a nonprofit must go towards the organization’s programs and operating costs.

How Do Nonprofits Work?

Unlike other types of businesses, the funds a nonprofit organization brings in can’t be distributed to the group’s directors or members. Instead, the money must be used to help the organization meet its objectives. This includes funding programs and events, paying salaries, and covering day-to-day operating costs.

Also unlike other types of businesses, nonprofits are generally exempt from paying taxes — what’s known as 501(c) status. In order to be recognized as a 501(c) organization, your nonprofit will need to apply for a Recognition of Exemption through the Internal Revenue Service (IRS).

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Types of Nonprofits

There are many types of 501(c) designations for nonprofits. Here’s a look at three
common types of nonprofits.

501(c)(3)

•   The most common type of 501(c)

•   May not participate in political campaigns

•   Unrelated business activities (like selling merchandise or renting the organization’s space) are subject to limitations

•   Exempt from paying federal income tax

501(c)(4)

•   Used by civic leagues and social welfare organizations

•   May participate in political campaigns and political lobbying

•   Donations to the organization are not tax-deductible

•   Exempt from paying federal income tax

501(c)(7)

•   Used by social and recreation clubs

•   Primarily funded by membership fees and dues

•   May receive up to 35% of funding from nonmembers

•   Exempt from paying federal income tax

Others

There are dozens of other types of 501(c) designations, including 501(c)(5) for labor unions and 501(k) for childcare-related organizations. If your plan is to create your own nonprofit, you may want to consult the IRS’s complete list of tax-exempt groups to make sure you pick the right designation for your organization.

Recommended: Foundation vs Charity vs Nonprofit: Key Differences

11 Steps to Starting a Nonprofit

If you’re committed to starting a nonprofit, here are 11 steps that help you get from concept to creation.

1. Research Need

Before you start a nonprofit, you’ll want to make sure one doesn’t already exist near your area that is doing what you want to do. If there is, consider joining or donating to it. Or, you might consider creating a new chapter. This allows you to receive some financial help from the existing nonprofit, which means you won’t have to start from scratch. You’ll also likely be able to access professional guidance and advice when needed.

2. Choose a Name

To come up with a great name for your nonprofit, think of descriptive words that represent your purpose, mission, and/or values. Ideally, you’ll want something that is easy to remember.

Once you’ve chosen a name, check to make sure it’s not already taken. It’s illegal to use a name that’s been trademarked or is already being used by another nonprofit in your state. Many state government sites offer a free online search tool to make sure there isn’t another nonprofit with the same name in your state. You’ll also want to make sure the name isn’t trademarked, and find out if it’s available as a website URL (domain name).

3. Create a Detailed Business Plan

Like a for-profit business, you’ll need to create a well-thought-out business plan for your nonprofit. Before you start, you may want to do some additional market research to fully understand the need your organization will service and to gather as much relevant data as possible.

The purpose of a nonprofit business plan is to clearly lay out your organization’s objectives and provide details about how you will go about achieving them. Consider including these sections:

•   Executive Summary: This succinctly explains the change you hope to make.

•   Products, Programs, and Services: This section sets out the need you are addressing and all of the different ways you will address it.

•   Operations: This is where you detail what type of nonprofit you are, who will be on your team, and where you will operate.

•   Marketing: This explains how you’ll get the word out about your organization and its work.

•   Finances: This outlines exactly where your funding will come from, as well as how your organization will spend those funds.

Recommended: 5 Essential Nonprofit Financial Documents

4. Recruit Your Board of Directors

Your board will be responsible for regulatory compliance, strategic decision-making, supporting everyday operations, and making hires. So who you choose is key.

Ideally, you’ll want to choose board members who not only have business management experience, but also share your passion for the mission. It can also be smart to choose people who bring a mix of skills and knowledge to the table, including financial, marketing, and legal expertise. Once you have a short list, you can reach out to each candidate to discuss potential involvement with your nonprofit. Keep in mind that board members typically aren’t paid.

5. Secure Startup Funding

The most common way to secure startup funding for a nonprofit is by applying for grants, which are typically awarded to a nonprofit organization for a distinct program or purpose. Competition for grants can be stiff, however, so you’ll need to invest time and resources into writing a great grant proposal. Other common sources of nonprofit funding include: membership dues, event fees, fundraising, sales of merchandise, and donation-based crowdfunding campaigns.

You may also be able to qualify for different startup loans, even as a nonprofit business.

Recommended: Guide to Business Loans for Nonprofit Organizations

6. Incorporate Your Nonprofit

To make things official, you’ll need to determine your nonprofit’s legal structure (you can choose between an association, corporation, or trust). Next, you’ll need to file articles of incorporation, which is essentially a request for business recognition by your state. The process varies depending on the state, so check with the National Association of State Charity Officials (NASCO) for your state.

Also, your nonprofit will need to get an Employer Identification Number (EIN). An EIN functions like a Social Security number for your nonprofit. You will need it to perform a number of different tasks, including hiring staff, opening a business bank account, applying for permits, and filing tax forms. You can apply for an EIN online by visiting the IRS website.

7. File for Tax-Exempt Status

To apply for tax-exempt status, you will need to fill out IRS Form 1023. This form is complex and can be time-consuming to complete. If your nonprofit earns less than $50,000 annually and has under $250,000 in total assets, you may be able to fill out a shorter version of the form called Form 1023-EZ.

8. Hire Employees

Nonprofits need a variety of skilled employees to run smoothly. You may want to include the following positions on your staff:

•   Events manager: If you plan on having frequent events or large scale conferences to further your cause, then you may need to have a dedicated events manager.

•   Membership manager: This is someone who will keep track of membership information and actively recruit and maintain current membership numbers.

•   Fundraising manager: Organizing fundraising activities and applying for government grants can be a full-time job. If your nonprofit is going to receive income through fundraising activities, then a fundraising manager is a must.

•   Communications manager: Whether you plan to communicate through social media, newsletters, or speaking events, a communications specialist can ensure the tone and message is appropriate for your nonprofit’s mission.

9. Automate with Software

Not long ago, someone had to manually enter a supporter’s information whenever a nonprofit received a donation. These days, software can do most of the work for you. Whether it’s taking payments online, updating email lists, or registering members for events, the right software can do it all automatically.

Depending on your budget, you might want to pick and choose different programs for different needs. Or, you might want to go with an all-in-one nonprofit fundraising platform that offers all the features your nonprofit needs (and possibly more).

10. Get the Word Out

Before you broadcast your launch, you’ll want to set up a website and a social media presence. Often, these are the first places people will go to learn more about you.

Next, you can start promoting your organization and its mission. Some strategies to consider:

•   Emailing all of your contacts (and asking them to spread the word with their contacts)

•   Hosting an open house event

•   Connecting with similar organizations in other cities

•   Posting industry-related blog posts

•   Joining online and offline communities where your target market is

11. Maintain Your Tax-exempt Status

Once you get your tax-exempt status, you’ll need to put some time and effort into maintaining it. That means operating your nonprofit within the parameters you stated in your application, and following the rules of your 501(c) designation (such as not supporting any political parties, etc). It also means maintaining careful financial records that show you are following all of the rules.

In addition, you’ll need to file a Form 990 or 990-N (which one will depend on your gross receipts) electronically each year. This is an informational return that asks for details about your revenue and expenses, along with other information about your nonprofit. Generally, you need to file this form within five months and 15 days after the end of your fiscal year.

How Long Does It Take to Create a Nonprofit?

Creating a nonprofit can take several months to a year. Where you’ll fall on that timeline will depend on how quickly you can get organized, assemble a board, and prepare all of your paperwork.

Depending on the state that you’re in, having articles of incorporation approved by your state government may take up to a few weeks. Once that’s done, you can apply for tax-exempt status by submitting Form 1023 to the IRS. It can take the IRS three to 12 months to get back to you with their decision. If you think your nonprofit will make less than $50,000 in annual revenue, however, you can file the expedited version called Form 1023-EZ, which will take two to four weeks to process.

Starting Nonprofits vs Small Businesses

Starting and running a nonprofit is similar to starting and running a for-profit business. However, there are some notable differences. Here’s a side-by-side comparison.

Recommended: 10 Steps for Starting a Small Business

The Takeaway

Launching a nonprofit doesn’t happen overnight. It takes research, planning, and plenty of legwork. But the rewards — being able to attract donors and use those donations to make a positive impact on your community (or the world at large) — can be well worth the time and effort you invest.

Whether you choose to start a not-for-profit or for-profit business, keep in mind that you may be able to access funding by applying for a small business loan. While banks and credit unions often have strict qualification requirements regarding time in business and annual revenue, online lenders tend to be more flexible and faster to fund (though rates can be higher).

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

How do you start a nonprofit with no money?

To start a nonprofit with no money, you’ll need to:

•   Write a business plan

•   Build a board of directors

•   Find an online fundraising tool that’s free to start

•   Gather donations (from friends, family, and board members)

•   Find an attorney willing donate their services to help you register your nonprofit

•   Plan free and low-cost fundraising events

•   Apply for grants

How do nonprofit owners make money?

If you own a nonprofit, you can generally earn a salary as long as you serve as the organization’s executive director and do not sit on the board of directors.

Can you run a nonprofit by yourself?

Running a nonprofit by yourself is possible during its early stages, but it’s challenging due to legal requirements and operational demands. Most nonprofits require a board of directors, and managing tasks like fundraising, compliance, and program delivery typically involves collaboration to meet the organization’s mission effectively and sustainably.

Photo credit: iStock/SDI Productions

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOSMB-Q424-063

Small business owners are never guaranteed success. It’s those that take the time to learn business fundamentals and apply them early on who are generally most likely to succeed.

Whether you’re in the early stages of launching a startup, or already own a young small business, understanding these five business fundamental principles of business can go a long way toward helping you and your business thrive.

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What Are Business Fundamentals?

How the “fundamentals of business” is defined can vary widely. Typically, however, this phrase refers to the basic skills and concepts needed to run a business that hold true no matter what the industry or size of the organization. Getting these business basics right from the start can help lay the groundwork for a solid future.

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Why Are Business Fundamentals Important?

It often matters less what type of products or services a business sells and more how the company is run. Applying time-tested business fundamentals when starting or growing your small business can help you avoid costly mistakes, weather economic downturns, and stay one step ahead of your competitors.

However, these skills and concepts aren’t a one-and-done proposition. Rather, they are elements that generally require constant effort to nurture. You won’t, for example, become an excellent leader overnight and then never have to worry about it again. Knowing when to grow your enterprise via a small business loan vs. other sources of capital requires gathering insights at every crossroad. Each of these business fundamentals requires time and effort over the long haul to master, and the target is always moving.

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The 5 Business Fundamentals

If you want to equip yourself with the skills necessary to effectively start a small business and successfully run it, consider focusing on these five key business principles.

1. Leadership

There is a difference between a manager and a leader. A manager makes sure employees are doing their jobs day-to-day, while a leader inspires and motivates them to give the job their all.

Positive leadership is one of the most important business basics. However, many, if not most, business owners don’t start out as excellent leaders. This is a skill that can take time to master.

There are many different types of leaders, from the autocratic leader who prescribes how staff should achieve a goal, to the laissez-faire leader who lets employees find their own creative solutions.

As a rule, however, a strong leader has great communication skills and truly listens to what employees have to say. They are open to suggestions and feedback and are constantly seeking ways to improve not only the company but also morale.

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2. Goals

One of the big business fundamentals you need to succeed is setting specific and achievable goals. A company without goals is like a boat adrift in the sea. Even if you’re mired in your daily responsibilities, it’s important to have both short-term and long-term goals for the company.

A short-term goal might be to expand your sales territory and increase sales by 10%. A long-term goal might be to open a second location for your business.

Understand that sometimes goals change, and that’s okay. It’s a good idea to review company goals every quarter and adjust them as needed. Even if you have a three-year business plan that you think is perfect, economic and other forces are constantly changing and must be accounted for.

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3. Strategy

Goals state what you want to accomplish; strategy is your plan for achieving them.

If you want to expand your business with a second location, for example, you would need the cash to do so. That might start with applying for a business loan that gets you the capital you need for the investment, looking for retail space, and hiring staff for the second location.

It can be a good idea to make a timeline for each goal, as well as a deadline for each action item required to meet the objective.

Many of your overarching business goals may already be outlined in your business plan. However, it’s a good idea to periodically review and update your plan to make sure it reflects where your company currently is, and where you want it to go.

4. Finances and Accounting

Even if you aren’t actively managing the company’s finances, it’s wise to have a good understanding of small business accounting. Regularly reviewing financial statements like the balance sheet and profit & loss statement can help you understand how your money is flowing in and out of the business. You can assess expenses and cut where you can to increase profits.

Keeping an eye on your finances also allows you to forecast when you might need an injection of capital. There are a variety of business loans available, but you don’t want to wait until your cash has run dry to apply for one. It can also be a good idea to keep an eye on credit score (personal and business) and small business loan interest rates to ensure you get financing with favorable rates and terms.

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5. Systems and Processes

For a business to run smoothly and efficiently, it needs the right systems and processes in place.

•  Systems refer to the tools and software programs your business uses to stay organized. That might include your accounting software, customer relationship management software, and email marketing program. Each of these has a specific purpose and can help drive sales, keep your finances organized, or help you better serve customers.

•  Processes are the tasks or actions taken to achieve an objective. You and your staff likely already have processes in place. It’s a good idea to document each one. That way, any time you hire someone new, all they have to do is learn how to follow the process. There’s no need to reinvent the wheel.

For example, your marketing director may have a step-by-step process for scheduling two weeks’ worth of social media content. If they document this process, including what to post and where to find images, they can delegate this task to an assistant who can follow the process document. This reduces the risk of errors and streamlines the training process.

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Applying the Business Fundamentals

Feeling daunted by all these business fundamentals? The good news is that you don’t have to master them all at once. In fact, it’s often better to focus on excelling at one business fundamental at a time. Just keep in mind: You’ll never be done working on these business fundamentals. Consider yourself a lifelong student of entrepreneurship!

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The Takeaway

The fundamentals of business can mean different things to different business leaders. However, the basic tenet is that every business requires a strong foundation. By understanding and applying basic business principles — like good leadership, goal-setting, strategy, and systems and processes — early on, you can build and grow your company with confidence.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What are the fundamentals of business?

Fundamentals of business are key skills and concepts a business needs to be successful over the long-term. They often include leadership, goals, strategy, finances, and systems and processes.

What is considered the first business fundamental?

Leadership is often considered the first business fundamental because it impacts everyone in a company and can guide the enterprise’s vision from startup through expansion.

What is a core business principle?

Many people think of core business principles as having five key components. Core business principles include leadership, goals, strategy, finances, and systems and processes.

Photo credit: iStock/Weekend Images Inc.

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

SOSMB-Q424-062

Whether you’re starting a beauty salon or you’re in expansion mode, taking out a beauty salon business loan can help turn your business dreams into a reality. Though you may not be able to find financing specifically designed for beauty salon owners, there are a number of small business loans — including Small Business Administration-backed term loans and equipment financing programs — that can give you the funding you need to start or grow your business.

Which type of small business loan will work best for your salon will depend on how much money you want to borrow, how you want to spend the funds, and how soon you need it. Here’s what you need to know to find, and apply for, a beauty salon business loan.

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What Are Business Loans and How Do They Work?

Whatever type of business you own, a small business loan gives you access to capital so you can invest it into your company. The funding can typically be used for an array of different purposes, including working capital, renovations, buying equipment, staffing, real estate, and marketing.

When a lender is assessing if you are eligible for a loan and how much debt your business can afford, they will typically look at several different factors, including the condition of your business, available collateral, your cash flow, and the credit profile of the business, as well as your (the owner’s) credit profile.

Small business loans are available through banks, credit unions, and online lenders. Depending on the type of financing, you can find unsecured business loans that don’t require collateral or secured loans backed by your business assets or the item you’re purchasing. Interest rates can be fixed or variable, with repayment terms lasting anywhere from six months to 25 years.

Using a Loan to Open a Beauty Salon: Pros and Cons

A loan can help you improve or expand your beauty salon and increase your profits. But borrowing money always comes with risks. Here’s a look at the benefits and drawbacks of taking out a beauty salon business loan.

Pros of Beauty Salon Business Loans

A small business loan will allow you to invest in and grow your business. Financing can also solve cash flow issues that beauty salons can experience during growth, as you may need to increase staff and buy more equipment and supplies before getting paid by customers.

In addition, a business loan allows you to gain access to funding without diluting ownership of your company, as you would if you were to sell equity in your business.

Cons of Beauty Salon Business Loans

Loans aren’t free money. There is a cost, including both interest and fees. You’ll have to decide whether that cost is worth having access to capital. And, if you don’t have good credit, those costs could be fairly high, as you may not qualify for the lowest rates available.

Another potential hitch is that if you need the money right away, you may find the application and approval process frustrating. It can take months to get a business loan, especially one backed by the Small Business Administration (SBA).

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Finding Beauty Salon Financing

The process of getting a loan for your beauty salon requires looking closely at your business finances, figuring out what you want the loan for, and determining how much you will need. You’ll also need to gather some information and documents about your salon. The more work you do up front, generally, the easier it will be to apply once you find the right loan and lender.

Understanding Your Business

Before you start applying for a loan, it can be a good idea to take a close look at the current financial state of your business. That means delving into things like your fixed costs, cash flow, operating margin, credit score, and annual revenue. If you’re looking to grow, you may want to build out or update your business plan to see, on paper, what that growth looks like.

Doing all this can help you figure out the type of business financing that will help you most, as well as what size and type of loan you may qualify for. It will also help you prepare for the application process.

How Much Do You Need?

The next step is to determine how much of a loan you need to accomplish your goals. As you run the numbers, you may want to add some extra padding to your budget. If your goal is to open a second location and become profitable within three months, what happens if you aren’t profitable by then? Will you be able to still afford to repay the loan? A little extra money can help cover unanticipated setbacks or expenses.

When considering loan size, you’ll also want to make sure you can afford to make the monthly loan payments. Borrowing a million dollars to overhaul your business may sound fabulous, but what happens when that large payment is due? Not being able to make your payments puts you at risk of defaulting on the loan and could jeopardize your business.

Necessary Documentation

When you apply for your loan, the lender will want some documents about your business. These may include:

•  Tax returns

•  Financial statements (such as profit and loss statements and bank account statements for business and business owners)

•  Corporation or LLC paperwork

•  Business plan or proposal for how you plan to use the loan

•  Owner’s photo ID

It can be a good idea to gather these documents now so that you’re ready to go when you start applying for a small business loan.

Recommended: Guide to Typical Small Business Loan Requirements

Loan Options for Beauty Salons

There are many different types of loans you can use to invest in your beauty salon. Below are some options to consider. It can be a good idea to compare business loan rates from multiple lenders to make sure you’re getting the best deal.

SBA Loans

If you have strong credit, you may want to look into an SBA loan, such as the popular SBA 7(a) program, for your beauty salon. SBA loans, which are backed by the U.S. Small Business Administration, stand out among small business loans due to their favorable terms — low rates, high amounts, and long payback periods. They are also highly competitive, which is why you need a high credit score to be considered a candidate.

SBA Microloans

Through the SBA Microloan Program, the SBA loans money to intermediary nonprofit lenders. These lenders then provide business loans of up to $50,000 to startups and small businesses, many of them run by women, minorities, or veterans. This can be a good option if you need a smaller amount of capital to purchase equipment or hire help and your business doesn’t have a long (or any) track record.

Term Loans

Small business term loans let you borrow a set amount of money that’s paid back with interest on a predetermined schedule. The SBA loans mentioned above fall into this category, but you can also find term loans not backed by the SBA that may be easier to qualify for. The lenders who offer these loans determine rates and terms based on your creditworthiness.

Both long-term and short-term small business loans are available. Which type will work best for you will depend on your beauty salon’s needs.

0% APR Credit Card

If you’re intimidated by the idea of borrowing a large amount of money, you might consider applying for a business credit card.

There are many 0% APR credit cards that offer no interest for a fixed period (often longer than a year). During this period, you can make a purchase for your salon without interest. You can then create a plan to pay off your balance before the introductory period ends and the standard APR sets in.

Along with giving yourself time to pay off your balances, you’re also building credit — which can help you access loans and credit cards with low interest rates in the future.

Recommended: Can You Get a Business Credit Card Before You Open Your Business?

Business Line of Credit

Another alternative to getting a loan is to apply for a line of credit. With a business line of credit, you don’t get a lump sum of cash like you do with a loan. Instead, a line of credit gives you access to cash up to a pre-approved maximum. You can take out however much you need up to the limit, repay it, and then borrow it again.

This can help relieve temporary cash flow issues or help you seize opportunities as they present themselves. You only pay interest on the amount you use.

Equipment Financing

If you’re looking to upgrade the equipment in your salon, you might consider equipment financing. With this type of small business loan, you typically get a quote for the equipment you’d like to buy, and a lender will front you a significant portion of the cost. The asset you purchase acts as collateral for the loan.

This can be helpful for businesses that don’t have strong credit. However, if you default on the loan, the lender can seize the asset. This type of financing can also be limiting, as you can only use the funds for business-related equipment.

The Takeaway

There are many types of loans available to you as a beauty salon owner. The best rates and terms will typically come from the SBA 7(a) program if you qualify. You can find those through banks, credit unions, and online lenders. And you can pursue other forms of financing to achieve your goal.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What credit score is needed for a salon business loan?

The credit score required for a salon business loan typically starts at 600. However, a higher credit score can give you access to more favorable terms, such as lower interest rates and better repayment conditions. Lenders also evaluate other factors like revenue, time in business, and financial documentation to determine loan eligibility.

How much does financing a beauty salon cost?

Financing a beauty salon can cost between $50,000 and $250,000 depending on factors like location, size, and services offered. This includes expenses for equipment, supplies, renovation, marketing, and permits. If you use a loan to start your beauty salon, you’ll pay interest and fees, which will add to the overall cost of starting your business.

Can you open a salon with no money?

Opening a beauty salon with no money is challenging but possible through strategies like securing grants, finding investors, or entering into partnerships. Additionally, you can reduce startup costs by starting small with mobile services or renting a booth in an existing salon to build clientele and revenue.

Photo credit: iStock/Dimensions

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOSMB-Q424-061

Payroll deductions are amounts of money that are taken out of your gross pay, leaving you with net (or take-home) pay. Common types of payroll deductions include taxes, retirement savings, and Social Security contributions, among others. However, it can be confusing (and sometimes a little discouraging) to see how much money comes out before you have cash in hand.

Here, take a closer look at the deductions that are required by law and are out of your control, as well as others that are part of your employee benefits package, which means that you may be able to adjust them. This paycheck breakdown can help you understand more about where your money goes so you can manage it better.

What is Net Pay?

Whether you’re paid hourly or by salary, your rate of pay is the compensation that you and your employer agreed upon when you accepted the job. That said, it’s typically expressed as your annual salary for full-time employees.

This number appears in official contracts and is referred to as your gross pay. However, it does not represent the actual amount that you will be paid.

Net pay, also referred to as take-home pay, is the compensation that is paid out via check or direct deposit to an employee. It is your gross pay with all the deductions taken out, which can make you think, “Wait, where’d my money go?” when it hits your checking account.

What Are Payroll Deductions?

So, to answer that question: Here’s where your money goes before it lands in your checking account:

•   Mandatory deductions: By law, an employer must subtract various mandatory federal and state tax withholdings.

•   Elective deductions: Employers will also subtract costs for employer-sponsored offerings that the employee takes part in, such as healthcare, life insurance, and retirement.

Whether required or optional, these are pulled out of your gross pay and applied where needed. While you may feel disappointed to see these funds siphoned off, they have an upside. They are saving you from owing major taxes come April 15, and they are potentially helping provide important elements of financial fitness, like saving for your future. This knowledge can be reassuring, especially if you are filing taxes for the first time, and are feeling a bit shocked about the difference between your gross and net pay on an annual basis.

How Do Payroll Deductions Work?

As mentioned above, payroll deductions may be required, such as federal or any state taxes, or they may be optional (say, a 401(k) plan or health insurance). The mandatory and elective deductions are subtracted from your paycheck’s gross pay amount.

What remains after these payroll deductions is your net pay. This is the amount that is paid to you. You can typically see a breakdown of exactly what has been subtracted from your compensation by looking at your paystub. If you are paid via direct deposit, you will likely find this information online at your employer’s portal. If you receive a paper paycheck, the paystub is often attached.

Types of Payroll Deductions

As you look at your paystub and see all the deductions that are being taken out of your gross pay, you may want a bit of help understanding what’s what. Below are explanations of some of the most common paycheck deductions:

Federal Taxes

Federal taxes include all the taxes you are required by law to pay to the federal government. These taxes (which are often referred to as being withheld vs. paid) help fund the federal government, allowing them to invest in things such as infrastructure, education, and national defense, and provide services to the American people.

It’s common to wonder what tax withholding is and how much must you allocate towards it. When you were first hired, you likely filled out an Employee’s Withholding Certificate or W-4 form form and claimed the number of tax exemptions you have. This amount tells the federal government how much money to take out of each paycheck to cover your taxes. The more allowances you take, the less federal income tax the government will take out of your paycheck.

One way to ensure that you have the right amount of tax withheld for each pay period is to use the Internal Revenue Service’s IRS Tax Withholding Estimator or speak with someone in your company’s HR department. You can tell them if you’re single or married, how many dependents you have, and if you have any other sources of income, and they should be able to help you fill out your form accurately.

It’s also a good practice to revisit your IRS Form W-4 selections annually as significant life events may change your withholding and also because the W-4 form is periodically updated. It can be wise to think about your exemptions regularly

During tax season of each year, individuals who have overpaid in federal taxes receive a refund from the government. Those who’ve underpaid, however, are required to pay additional funds and possibly a penalty.

State and Local Income Taxes

There are other types of taxes that will possibly be withheld from your gross pay. Many states require a state tax to help fund government projects and services. To learn more about your state’s taxation policy, you can look at this map for details.

Just as with federal taxes, your state income tax will get deducted from your paycheck to cover taxes you may owe at the end of the year.

Social Security and Medicare

Another common paycheck deduction you’ll see: Social Security and Medicare taxes that are part of the Federal Insurance Contributions Act (FICA) tax, a group of payroll taxes collected from both the employer and the employee. As the name implies, these taxes fund our nation’s Social Security and Medicare programs, helping with income and insurance needs once you reach retirement age.

The tax rate for social security is currently 6.2%, and Medicare receives an additional 1.45% (employers match these tax rates, bringing the total of FICA tax contributions to 15.3%).

Wage Garnishments

Another possible payroll deduction to know about: wage garnishments. These are legal procedures designed to repay delinquent, outstanding debts, such as unpaid child support, overdue credit card payments, or even unpaid taxes.

Most wage garnishments are initiated by court order. However, the IRS and other tax collection agencies also levy for unpaid taxes in the form of wage garnishment.

Garnishments are made on earnings leftover after all legally required deductions are made. The actual amount of any garnishment will depend on the amount of debt owed and income earned.

Employee Benefits

Depending on where you work, you may be able to opt into a variety of benefits. Typically, these costs are automatically deducted from your paycheck.

If you sign up for your employer-provided health insurance, at least some of the cost is likely to be a type of paycheck deduction.

Under the Affordable Care Act, employers with 50 employees or more must offer affordable health insurance. As part of an employee’s compensation package, many companies will pay half, or another percentage, of the insurance premiums. The employee’s portion of those premiums is represented on a pay stub as a deduction.

Other benefits, like flexible spending plans, commuter plans, and life insurance, may also be deducted from your pay, depending on whether or not you opt into them and if your employer picks up the bill fully or partially.

Health insurance and other benefits typically come out before your taxes, and you may be able to reduce your taxable income by signing up for them.

Retirement Contributions

Employee 401(k) savings plans are a common benefit offered in the workforce.

If you opt into this benefit, your employer will deduct funds from your wage earnings and deposit them into a retirement account. (How much of your paycheck should you save? Experts often recommend 20% should go towards saving for retirement and other short- and long-term goals.)

Employees are typically able to choose the amount they would like deducted from their earnings for retirement savings. In some cases, employers may contribute an additional percentage of your salary into your retirement account.

Contributions to your 401(k) can not only help you save for the future but also lower your taxable income, since they come out of your paycheck before taxes get assessed.

You’ll want to keep in mind, however, that there are yearly retirement plan contribution limits set by the federal government through the IRS.

Other Common Payroll Deductions

Depending on your workplace and career, other payroll deductions are possible. Among the ones you may find are:

•   Charitable giving plans

•   Payment for job-required items, such as tools or uniforms

•   Union dues

•   Professional certification or tuition fee deductions

Examples of Payroll Deductions

You’ve learned details about many types of payroll deductions above. In list form, examples of payroll deductions include:

•   Federal income tax

•   State and local income taxes

•   Social Security and Medicare taxes

•   Wage garnishments

•   Employee benefits

•   Retirement contributions

Steps to Calculate Payroll Deductions

Calculating payroll deductions is typically something done by employers, not employees. Here’s a quick overview of how the process typically works:

1.    Obtain a W-4 from employees indicating their withholding.

2.    Determine employees’ gross earnings, whether salary pay or hourly.

3.    Calculate any overtime for those employees who are not exempt and worked over 40 hours a week.

4.    Take any pre-tax deductions.

5.    Calculate and deduct federal income tax based on pay, withholding status, what tax bracket an employee is in, and other factors.

6.    Determine and deduct Social Security and Medicare payments.

7.    Calculate and deduct any state and local taxes.

8.    Take any other deductions, and move funds to the appropriate entity.

Tips to Manage Payroll Deductions

If you are an employee seeking to tweak your deductions, you will have a few options. You might update your W-4 to reflect more or fewer exemptions, depending on whether you want to reduce or increase the taxes withheld.

In addition, if you could use some breathing room in your budget during a financial crunch, you might decrease retirement contributions a notch to free up a little more money for bills.

If you are in a position to be managing payroll deductions, consider these tips for making the process run smoothly:

•   Develop organizational systems to manage forms, deadlines, and other aspects of the process. There are many digital and online tools you can use for this.

•   Keep up to date with federal, state, and local tax laws to make sure you are deducting the proper amounts; know the guidelines about, say, equal pay provisions; and more.

•   Automate the entire process with payroll software. This can save time and boost accuracy versus doing things by hand. Or consider outsourcing the responsibilities to an external agency.

•   Regularly update training for payroll and HR teams, if you employ them.

•   Don’t touch payroll taxes that are only paid quarterly. It may be tempting to dip into those funds before they are due and use them for other business expenses, but this is a very risky path to pursue. If you wind up being short when the taxes must be paid, you could face penalties.

Recommended: 50/30/20 Budget Calculator

The Takeaway

While you may be surprised to see all the deductions coming out of your paycheck, once you know what number to expect to see landing in your bank account each pay period, you’ll be able to plan your spending and budget accordingly. Deductions can include those you can’t change, such as taxes, and those that you may be able to alter, such as retirement contributions.

It’s a good idea to check your pay stubs periodically to ensure that the deductions being taken out are accurate and align with your financial goals.

Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with eligible direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.

FAQ

What are some common incorrect payroll deductions?

Examples of incorrect employee payroll deductions are expenses that have to do with running the business, workers’ compensation premiums, and some personal protective gear costs. In addition, payroll deductions should not bring an employee’s income below minimum wage.

How do I report payroll deductions?

If you are an employee, your payroll deductions will be reflected in the end-of-year W-2 form that you receive. If you are an employer, you are likely filing IRS Form 941, Employer’s Quarterly Federal Tax Return, or Form 944, Employer’s Annual Federal Tax Return, which shows the wages you’ve paid and various taxes withheld.

Recommended: IRS Form 941 Explained

What are the pros and cons of payroll deductions?

Payroll deductions are a fact of life. On the plus side, they whisk away taxes regularly so you don’t face a huge tax bill come April 15, and the money paid in taxes can help quality of life in America. Also, deductions like health insurance and retirement savings go towards achieving financial security. The main con, of course, is that you take home less pay than your gross earnings and may need to budget wisely to balance your spending and saving.

What are the categories of payroll deductions?

The main categories of payroll deductions are federal, state, and local taxes; Social Security and Medicare; employee benefits; and retirement contributions.

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