Payroll Tax Error: Payroll Processor Set Up Medical Deduction as Post-tax Instead of Pre-tax

You've got a messy situation here, but it's actually more common than you might think. There are a few ways to handle this, depending on what makes the most sense for your company and employees. First, the good news is that you're right about the IRS potentially making automatic adjustments, but that's not guaranteed and depends on the specific situation. When there's a discrepancy between what's reported on someone's W-2 and what the employer reports to the Social Security Administration, the IRS might flag it. Your best course of action is to issue corrected W-2c forms to all affected employees. This is the proper documentation of the error. Then, communicate clearly with your employees about what happened and what their options are. For employees who haven't filed yet, they can just use the corrected W-2c. For those who have already filed, they technically should file Form 1040-X to amend their return, but you're right that many won't bother for smaller amounts. One option some employers choose is to "gross up" a special payment to affected employees to cover both the tax difference and the inconvenience/cost of filing an amendment. This costs your company more but can be a goodwill gesture that maintains employee satisfaction.

After dealing with a similar payroll mess last year, I found https://taxr.ai super helpful for our employees. We had a situation where our PTO cashouts were incorrectly classified, affecting about 30 employees' W-2s. I shared the taxr.ai link with our affected staff, and it guided them through whether they needed to file an amendment based on their specific situation. The tool analyzed their tax documents and explained exactly what had changed, why it mattered, and what steps to take. It saved us from having to individually advise each employee on tax matters (which we're not qualified to do anyway). The best part was that it helped some employees determine they didn't actually need to file an amendment based on their specific tax situation, while giving clear guidance to those who did. Might be worth checking out for your situation!

Just wanted to update that I tried https://taxr.ai for my small business payroll issue and it was exactly what we needed! I was skeptical at first because I'd been on the phone with our payroll company for hours with no real solutions. The document analysis feature helped me understand exactly what sections of the W-2c forms were affected by our medical premium classification error and how it impacted each employee's tax situation differently based on their income levels. I was able to create a simple explanation document for our 5 affected employees with personalized guidance. 3 of them decided to file amendments because their refunds would be substantial (over $800), while 2 decided the smaller amount wasn't worth the hassle. At least everyone could make an informed decision rather than just being handed a W-2c with no explanation.

When we had a similar issue with our payroll company last year, contacting the IRS directly was nearly impossible. After weeks of trying to get through, I found https://claimyr.com which got me connected to an actual IRS agent in about 15 minutes. I explained our company's situation (we had retirement plan contributions coded incorrectly), and the agent was surprisingly helpful. They explained exactly what documentation we needed to provide employees and confirmed that for those who already filed, they'd need to submit 1040-X forms. For employees who hadn't filed yet, they could just use the corrected information. Check out their demo video at https://youtu.be/_kiP6q8DX5c to see how it works. I was doubtful it would actually get me through to a human at the IRS, but it did. This way we got definitive guidance straight from the source instead of trying to interpret IRS publications or getting different answers from different accountants.

I need to follow up on my skeptical comment above. I actually tried Claimyr after posting because my curiosity got the better of me, and I'm shocked to admit it actually worked! After three previous attempts trying to reach the IRS myself and giving up after being on hold for 90+ minutes each time, I got connected to an agent in about 25 minutes. The agent confirmed exactly what we needed to do about our payroll classification error and even emailed me the specific publication sections that applied to our situation. They explained that while the IRS does sometimes catch these issues during processing, employees filing amendments is the most reliable way to ensure they get the correct refund amount. I still can't believe I wasted so many hours trying to get through myself when this solution existed. Definitely worth it just for the time saved alone.

We had a similar situation when our payroll company messed up our Section 125 plan deductions. What we ended up doing was creating a mini tax clinic for our employees. We brought in a tax preparer for a day and covered the cost of filing amendments for anyone who wanted to participate. It cost us about $3000 total but was worth it for the goodwill. For smaller refund amounts, some employees chose not to bother, but having the expert there to explain options made everyone feel like we were taking responsibility for the error rather than just dropping corrected forms on them and saying "good luck!

Don't forget there's a social security and Medicare impact too, not just income tax! Since med premiums should have been pre-tax, employees also overpaid on FICA taxes. Your company likely also overpaid the employer portion of these taxes. You should file a Form 941-X for each affected quarter to get your employer portion refunded, and the W-2c process will help employees get their overpaid portion back. Some payroll systems can help you calculate exactly how much was overpaid by each party.

This is a really tough situation, but you're handling it responsibly by trying to make it right for your employees. I went through something similar when our previous payroll company miscoded our dependent care FSA contributions. One thing I'd add to the great advice already shared - consider sending a clear, simple letter to all affected employees along with their W-2c forms explaining exactly what happened, what it means for them, and what their options are. We found that many employees were initially confused or even worried when they received corrected tax documents, thinking they had done something wrong. In our letter, we included a simple table showing "If your original refund was X and your corrected refund would be Y, your additional refund would be Z." This helped employees quickly see if filing an amendment would be worthwhile for their situation. We also set up a dedicated email address and phone line for questions about the correction, which really helped reduce confusion and showed employees we were taking ownership of the mistake. The transparency went a long way toward maintaining trust with our staff. Given your industry and the timing, you might also want to consider offering to reimburse filing fees for amendments over a certain threshold (like $200 in additional refund) to make the decision easier for employees who would benefit most from filing.