What banking activity allows an employer to deposit an employees paycheck electronically?

Paying your employees and contractors accurately and on time is a painless way to keep morale high and retain the talent that makes your company successful. Many businesses find direct deposit a reliable means to automate payroll functions, stay in compliance with tax laws and ensure workers can promptly access their funds on payday.

But there are gotchas to watch for, like more difficulty switching financial institutions or updating payment errors. So is direct deposit right for your business? Here’s a guide to how the process works, a checklist to set up direct deposit, and a rundown of benefits and drawbacks.

What Is Direct Deposit?

Direct deposit replaces older payment methods, such as issuing paper checks and envelopes of cash. By electronically transferring funds from your company’s bank account to your employees’ accounts, you minimize risk and set your payroll team up for success.

You may also hear direct deposit referred to as direct pay, electronic funds transfer (EFT) or electronic checks. Whatever the term, most businesses choose to pay their employees using this option, with 94% of workers receiving their pay through direct deposit .

Key Takeaways

• Direct deposits are widely used as a convenient, time-saving and cost-effective way to pay employees.
• Direct deposit is also generally safer for both employers and workers than paying by check or cash.
• There are a few drawbacks: It’s more difficult to change banks and to stop or adjust erroneous payments than when issuing a check.
• Direct deposits can also be used for payments to contractors and for bonuses, annuities and travel expenses.

Direct Deposits Explained

Direct deposits move funds between banks over a centralized electronic payment network called the Automated Clearing House (ACH) network. A bank-funded nonprofit organization called Nacha—which was established as the National Automated Clearing House Association—manages the administration, development and governance of the ACH network.

Nacha facilitates information-sharing among regulatory bodies and financial institutions. It also focuses on reducing risk and fraud with the goal of keeping banks, employers and workers confident in the direct deposit system.

How Does Direct Deposit Work?

As an employer, you’ll get started by setting up direct deposit with your bank or a payroll service provider and connecting your accounting system.

You’ll need information about the account that will be used to pay employees and the checking or savings account numbers for the accounts into which each worker or contractor wants pay to be deposited.

Then, for each payroll run, you provide your bank or payroll service with direct deposit instructions listing the amount to be transferred to each employee’s account. Your bank or provider sends the direct deposits to the ACH network, which directs them to your employees’ banks. The receiving banks then credit your employees’ accounts. Funds are immediately available to your employees once payment posts.

ACH payments generally take one to two business days to close. The ACH network also supports same-day payments, which usually involve an additional fee.

Can Small Businesses Use Direct Deposit?

Businesses of any size can use direct deposit—the payroll process is essentially the same whether you have 10 employees or 10,000. And in fact, payroll often emerges as a pain point as small companies add workers. Direct deposit helps remove that barrier to growth and puts your firm on an equal footing with larger companies come hiring time.

Advantages of Direct Deposit

Direct deposit is easy, safe and cost-effective. It also makes cash flow more predictable compared with paying employees with paper checks.

Many of the benefits of direct deposit apply both to your company and to your employees. Let’s look at it from both angles.

Benefits of direct deposit for your business

Save time: Because direct deposit is automatic, it takes less time to process payroll. You’ll reduce bookkeeping hours because you don’t need to write, mail and reconcile checks—or reissue lost checks. And, you’ll minimize payroll-related accounting issues like delays updating the general ledger and time spent on manual reconciliations.

Save money: Besides finance team time savings, you’ll eliminate the costs of checks, postage and other mailing supplies required for a paper-check-based process. Reissuing lost checks may incur fees from banks or payroll services. And, payroll services can ensure your company accurately retains tax and other deductions, and thus avoids penalties.

Improve cash flow projections: Minimizing cash flow problems is paramount for any business. With direct deposit, you know exactly when payments to employees will be withdrawn from your bank account, and the exact amount. This means you can accurately predict cash requirements. In contrast, when paying by check, your cash flow will depend on when employees choose to cash their paychecks.

More secure than paper checks: Direct deposits are generally considered safer than issuing checks, which can be lost, stolen or forged. Nacha reports that payroll impersonation fraud, where a criminal targets an employee by sending a phishing email that impersonates the employer’s human resources or payroll department, is a real concern.

5 Steps to Keep Payroll Safe

Process anytime/anywhere: Once you’ve set up direct deposit, you’ll be able to pay your employees with a few clicks. Whether you’re in the office, working from home or travelling, your employees will still be paid on time. Note that, for companies that have human resources teams, it’s good practice to unite HR and payroll systems from the get-go so that the payroll process can be run and data updated by more than one group.

Help the environment: If environmentally friendly practices are important to your business, then direct deposit is the way to go. You’ll save trees and reduce greenhouse gas emissions by eliminating the need to print and deliver checks.

Benefits of direct deposit for your employees

Save time: Most employees like getting their pay automatically deposited in their accounts. They don’t have to worry about picking up checks, running to the bank or waiting for checks to clear. They enjoy rapid access to their funds, since their money is always available on payday, even if they’re sick or on vacation.

Save money: Some banks offer free checking accounts if they know account holders will receive their pay via direct deposit and meet other conditions, such as maintaining a minimum monthly balance.

Simpler expense reimbursements: You can include expense reimbursements through direct deposit simplifies the process for employees and employers.

More secure than paper checks: Employees no longer need to worry about their checks being lost or stolen.

Choose where the money goes: Some banks and payroll providers enable employees to split their direct deposit among multiple accounts, so they can direct part of it into a savings account every month.

Disadvantages of Direct Deposit

Although direct deposit is more efficient than paying by check, there are some drawbacks for both employers and employees.

Disadvantages of direct deposit for your business

Time-sensitive: To ensure payments reach employees’ bank accounts on payday, you need to run payroll one to two days in advance—regardless of how many other priorities you’re juggling. If you fail to do so, you’ll have unhappy employees.

Potential security risks in housing employee bank data: To enable direct deposits to employees, you need to store their bank account and routing information. Ensure that you have adequate security measures and policies in place to protect their sensitive financial data—it’s not unheard of for finance employees to be targeted by scammers.

Fewer “stop payment” options than with paper checks: It can be more difficult to stop or reverse direct-deposit payments than when paying by check. If you accidentally overpay an employee, you can generally reverse the payment as long as you do so within five days, but some states apply additional restrictions once the money has reached employees’ bank accounts.

Potential bank and overdraft fees: Banks generally charge employers fees for direct deposit payments. And if you don’t ensure your account contains all the funds required for a payroll run before payday, you may incur expensive overdraft fees.

Disadvantages of direct deposit for employees

Bank account fees: If employees don’t already have a bank account for receiving direct deposits, they may need to open one and pay monthly account maintenance fees. As an employer, you may consider offering education and referrals to institutions that will offer free checking, or even provide membership in a credit union as a benefit.

Makes changing banks harder: If employees change banks, they’ll have to repeat the initial direct deposit setup process, which can take several days.

Potential security risks. Your employees are entrusting your company, or your payroll service provider, with sensitive financial information, potentially creating new risks including identity theft if the information isn’t well guarded.

Pros and Cons of Direct Deposit

How Much Does Direct Deposit Cost?

There are several costs to consider. Banks generally charge an initial setup fee of $50 to $149 plus transaction fees averaging from $1.50 to $1.90 for each individual deposit. Some banks may also charge monthly fees.

We say “generally” and offer a range because the fee structure depends on the size of your business, your bank, whether you process payments yourself or use a service and your specific direct deposit agreement. It’s worth comparing prices among different financial institutions and payroll service providers.

When Do Payroll Deposits Post for Employees?

With next-day ACH payments, payroll deposits are posted and available to your employees as early as 9:00 a.m. or as late as 5:00 p.m. local bank time on payday, depending on when the receiving bank receives funds. If the receiving bank receives funds by 5:00 p.m. local time, the money will be in employees’ accounts by the following morning.

Under same day ACH, employees are paid by 5:00 p.m. on the same day that you transfer funds, provided you meet specific deadlines set by your bank and the ACH network. Banks generally charge extra for same-day ACH payments.

How Does Paying Contractors Work?

If you work with many independent contractors, it’s worth keeping your options open in regard to direct deposit. If you’re using payroll software or an outsourced payroll service, check to make sure the system supports payments to contractors as well as employees—though independent contractors are usually paid through accounts payable, not payroll. ACH can also be used for direct deposit through accounts payable.

Although the direct deposit payment process for contractors is generally the same as for employees, you will need to maintain different paperwork. When you hire an independent contractor or firm, they’ll complete a W-9 tax form instead of the W-2 that employees use. If you pay a contractor $600 or more per year, you’ll need to provide a 1099 form at the end of the year.

How to Set up Direct Deposit for Your Small Business

You’ll need to go through five initial steps to set up direct deposit. It’s important to note that the setup process can take seven to 10 business days, so plan accordingly to ensure there’s no disruption to your employees’ pay cycle.

1. Select a direct deposit provider: You have a number of options here. You can set up direct deposits directly with your financial institution, or you can use payroll software or a payroll service that will handle the direct deposits for you. Take the time to understand and compare the options, including costs, security features and payment processing times. Your chosen provider should walk you or your HR or finance team through the setup steps. Be sure to run test transactions to ensure the direct deposit process is running smoothly.

2. Obtain required employee information: After the setup and test phase is complete, it’s time to load employee data into your system. Employers generally need to obtain the following information from employees, although the requirements may vary by state:

   • Bank account number
   • Type of bank account (checking, savings)
   • Bank routing number
   • Bank name
   • Employee signature authorizing the deposit of funds in the account(s)

   Some providers also request a copy of a voided check to ensure the accuracy of the bank information.

3. Enter employee information into your system: If you’re using your bank to process direct deposit, you’ll either have to manually enter the information into your bank’s online portal, or you may be able to export the information from your payroll system.

   If you’re using payroll software or a service, employees can generally enter their own information, including the data on deductions and residency you need to calculate payroll taxes, and supply the necessary authorization.

4. Create a payroll direct deposit schedule: Create a schedule that includes a deadline for entering employees’ hours worked and provides enough time to review the data, process payroll and meet direct deposit transfer deadlines.
5. Run payroll: It’s time to send your first set of direct deposit instructions. Your upfront time investment in the initial setup will be rewarded by increased automation and convenience on each payroll run.

What Else can Direct Deposit be Used for?

Once you get direct deposit set up the system can be used for a variety of other payments, including:

• Bonuses and commissions
• Annuities
• Reimbursements for travel and other expenses
• Interest payments/dividends
• Pensions and 401(k) disbursements
• Tax and other refunds

Again, you’ll enjoy the cost savings, security and other benefits of direct deposit and have an easily accessible record of these outlays for general ledger and audit purposes.

Payroll Software and Direct Deposit for Small Businesses

Managing payroll can be an extremely time-consuming and complex process, and it’s critical to get it right. Payroll software can relieve companies of most of the burden by automatically calculating wages and tax withholding, filing taxes and paying employees by direct deposit or other methods.

Features that growing businesses should look for include links to other systems, like HR and ERP, as well as security roles and alerts that will help guard against data theft.

Paying employees and contractors with direct deposit does require an initial investment in resources, time and planning. But once established, you will enjoy the speed, accuracy and safety of automated payments while having one more touchpoint when competing for talent.

Direct Deposit FAQs for Small Businesses

Is direct deposit safe?

Direct deposit is one of the safest ways to pay employees because money is transferred directly into their bank accounts through the secure ACH Network.

How reliable is direct deposit?

Direct deposit is automated and highly reliable, as long as employers and banks meet the ACH payment transfer deadlines.

Can an employer require an employee to use direct deposit?

It depends on location. Federal law permits mandatory direct deposit as long as the employee can choose which bank should receive the deposit. However, some states require employee consent or impose other conditions.

What types of payment can be made by direct deposit?

Direct deposits can be used to pay employee’s salary, expenses, commissions, bonuses, tax refunds, investment redemptions, payments from retirement accounts, and government benefits such as Social Security.

Do I have other options besides direct deposit?

Yes, companies may pay employees with pay cards that are essentially debit cards onto which you deposit funds. But be aware of state laws governing these cards.

In addition, in 2015, the U.S. Federal Reserve created the Faster Payments Task Force to make recommendations about developing methods to support faster payments, including for payroll, by modernizing the ACH system.