What Is a Payroll Advance? Everything Employers Need to Know

Dana Miranda

It’s been recently reported that 63 percent of Americans are living paycheck-to-paycheck, according to recent data from LendingClub. That means one unexpected expense can derail a family’s financial plan for any given pay period.

This can be frustrating for workers who earn wages and have to wait up to two weeks to access them on payday. If you operate a business that runs payroll it is important for you to understand that employee access to a payroll advance can be a lifesaver in these unexpected situations.

If your employees are caught in this paycheck-to-paycheck cycle (and statistically, they might be, regardless of their income level!), a payroll advance is a benefit you might want to consider offering.

What is a payroll advance?

A payroll advance is a short-term loan an employer may offer employees based on wages they’ve already earned, usually only a few days ahead of the scheduled payday. The employees then repay the advance out of their next paycheck or in installments over several paychecks. (A payroll advance is sometimes known as a salary advance—although it is not necessarily limited to only those who earn salaries.)

You and the employee will agree to terms (including the amount of the loan, when repayment is due, and the amount of installments) and sign a formal agreement before you issue the advance.

A payroll advance or paycheck advance is different from an employee loan; while an employee loan is also a loan borrowed from an employer, it isn’t tied to earned wages, so it’s a little riskier for the employer. In the case of an employee loan, you just make an agreement with the employee to repay the loan in installments.

An employer-led payroll advance is also different from a cash advance from a payday lender. Those third-party lenders don’t have direct access to your payroll for repayment, though they also usually base loan amounts on an employee’s expected paycheck. However, they tend to charge exorbitant interest rates on short-term loans designed to prey on workers’ financial circumstances.

Is a payroll advance a loan?

A payroll advance is technically a short-term loan you make to employees. As such, you should only issue an advance with a formal financial agreement that details the employee’s request to be paid early and their commitment to repay the advance through future paychecks.

Payroll advance policies and regulations

Employers aren’t required to allow payroll advances, so you can choose whether this benefit makes sense for your business and employees. If you do, create a clear company policy to guide payroll advances.

Labor laws

If you allow the option for a payroll advance, you have to follow some basic federal and state policies that govern repayment.

  • Under federal law, you’re allowed to deduct an advance from an employee’s paycheck. But you can’t deduct so much from any single paycheck that it brings the employee’s take-home pay below the federal minimum wage ($7.25 per hour as of this writing). If recouping the full advance would bring pay below that threshold, you have to spread repayment across multiple paychecks.
  • Some states require you to have a written, signed agreement in place to issue a payroll advance and take repayment through paychecks. This is good practice whether your state requires it or not, but check with your state’s regulations to make sure your agreements are compliant.
  • Your state might impose a threshold for the employee’s pay based on the state or local minimum hourly wage, so be aware of that regulation if you operate in an area with a minimum wage that’s higher than the federal minimum.
  • As wage advance services become more popular, government regulatory agencies are weighing in on whether this activity should be subject to state or federal lending laws. Consult an attorney when creating your policies to stay up to date on the latest policies.

How to create a payroll advance policy

Consult an attorney to create a payroll advance policy for your business that’s compliant with federal and local laws.

The policy should include:

  • A description of the process, including how an employee can request an advance and the steps required to receive and repay the advance.
  • Which types of employees are eligible. You could limit eligibility based on seniority or full-time versus part-time status, for example. Like other employee benefits, these guidelines can’t be discriminatory against protected classes.
  • A minimum and maximum amount or portion for advances.
  • A limit on the frequency of payroll advances per employee.
  • Lending terms and repayment plan, including how repayment periods are determined and an interest rate if you’ll charge one.

No laws explicitly require you to put a payroll advance policy in writing, but it’ll help you avoid confusion and legal challenges down the line.

How to offer employees a payroll advance

Once an employee is interested in getting an advance on their paycheck, make sure your process includes these steps:

  1. Request in writing. The employee should submit a payroll advance request in writing, so you have a record of their request to initiate the lending process.
  2. Make a fair decision on eligibility. With a payroll advance policy in place, it should be easy to determine whether an employee is eligible for an advance and for how much.
  3. Sign a payroll advance agreement. You and the employee should both sign a standard agreement that states the amount of the advance and the repayment terms through payroll deductions. This is a clear record of the employee authorizing you to deduct funds from their wages.
  4. Issue the advance through your payroll software. If you use payroll software that facilitates payroll advances, follow the process to issue the advance properly on your employee’s next paycheck. This’ll ensure the advance is recorded correctly for purposes of taxes and employee wage statements, and it creates an accurate paper trail of the transaction.
  5. Record the advance. If you handle payroll manually, you’ll have to issue a cash or check to the employee and record the advance properly.

Is a payroll advance taxed?

The amount of a payroll advance is ultimately taxable as part of an employee’s earned wages — but you won’t deduct taxes from the advance payment itself. Instead, deduct taxes on the full amount of their future paychecks before deducting the amount of the advance repayment.

If you use payroll software to issue advance payments and regular paychecks, taxes should be calculated automatically based on how you classify payments. Just make sure you classify the advance payment as such (or as a reimbursement, depending on what your payroll software requires) and not as a regular payroll payment.

You may need to manually enter the amount to be repaid as a deduction on a future payroll run if your payroll software doesn’t explicitly facilitate payroll advances. Make sure this is entered as a post-tax deduction, so income and payroll taxes are calculated on the full paycheck amount.

For tax purposes, you don’t need to record the amount of a payroll advance separate from an employee’s normal wages. The total compensation gets recorded as wages and reported all together on the employee’s W-2 at the end of the tax year.

Alternatives to a payroll advance

A payroll advance might not be the right fit for your business or employees. Here are some other ways to help employees access cash when they need it if you don’t want to offer this option.

  • Gusto Wallet: If you use Gusto to process payroll, your employees can open a full-service bank account through the Gusto Wallet app. With the app, employees can access their funds as soon as you run payroll, up to two days ahead of payday.
  • On-demand pay: Other payroll providers offer a variety of options for on-demand pay that lets employees access their earned wages before payday. Look for these options when selecting a payroll provider to offer advance pay without the administrative hassle of a payroll advance.
  • Health care financing: Companies including Nibble Health and HealthBridge let employers offer health care financing as an employee benefit, which could reduce the need for payroll advances. For a per-employee fee, the service covers employee health care costs and auto-deducts installment payments from their bank account.
  • 401(k) loans: You can elect to allow employees to borrow low- or no-interest loans from their retirement accounts as part of your company’s retirement plan.
  • Wage advance services: Apps that offer earned wage access, like Earnin and Brigit, help workers access cash when they need it and repay automatically after future paychecks.
  • Employee loans: A more complex option than a payroll advance, an employee loan is a short-term loan you make to an employee that isn’t tied to wages they’ve already earned. You might deduct repayment from future paychecks or simply set up an installment plan and let the employee make manual payments.
  • Personal loans: If they have good or excellent credit, an employee could take out a personal loan from a lender and repay it over several months or years. This will likely come with higher interest and fees than an employee loan or payroll advance, but it may be the only option if they need to borrow a large amount (several thousand dollars).
  • Payday loans: As a last resort, a worker can borrow a cash advance from a third-party payday lender. These loans tend to come with high-interest rates and can prey on people in need by extending repayment deadlines and issuing subsequent loans that trap borrowers in a cycle of debt.
Dana Miranda Dana Miranda is a Certified Educator in Personal Finance® (CEPF®), author, and personal finance journalist. She is the founder of Healthy Rich, a platform for inclusive, budget-free financial education, where she works with organizations, schools, and companies dedicated to making money better for folks who are often left out of the conversation about money.
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