A Payroll Advance vs On-demand Payroll: Which Should You Offer Your Employees?

You’re probably familiar with the term payroll advance, but on-demand payroll is still pretty new. Giving employees an advance simply means you’re giving them access to their paychecks early (due to an unforeseen event). It’s considered a loan because they haven’t yet earned all of it—they have to pay it back. On-demand payroll means giving employees early access to funds they’ve earned. For instance, if they’re only a week into a two-week pay period but want to cash out on the funds they’ve earned so far before payday arrives.

A Closer Look at On-demand Payroll

On-demand payroll is a benefit that more employers are starting to offer to help make their workplace more attractive. With on-demand payroll, employees aren’t limited to the pay period you set.

Managing and Funding On-demand Payroll

When it comes to funding on-demand payroll, you have a couple of options. Either you can handle it, administration and all, or you can work with a third-party provider like DailyPay, FlexWage, or your payroll provider (if it’s a feature that’s offered).

When Employers Manage On-demand Payroll

Managing the process yourself means you’ll have more control—you can decide how soon employees can withdraw funds (within a day of earning, or a week). But you’ll also need to ensure you always have enough funds in the bank to pay those who want to cash out early. If you choose to implement this system yourself, we recommend you spend sufficient time reviewing all aspects, like employee payment options, issuance of a related company policy, potential administrative fees you may want to charge, the ways in which it will affect how you do payroll, and limitations on how much they can request.

Using a Third-party to Manage On-demand Payroll

Working with a third-party to manage your on-demand payroll system will remove some responsibility from your plate but also control. If you use an on-demand pay app or work with a provider that does, it can deduct fees from your employees’ paychecks (if they use the on-demand pay option). These fees can vary, so you’ll need to do your research. Many of them charge each time an employee uses the system to access their money early—usually $1.50 to $3.50, and sometimes more. If you want to be generous, you can cover the fees yourself.

The good part about using a third-party system is that many of them will fund any early paycheck access requests for you, meaning you don’t have to check your bank account every five minutes, and employees can transfer funds instantly, if you allow it. The provider will square up the bill with you on your regularly scheduled payday, which will work smoothly for you since any funds distributed early would be deducted from the total payroll amount you process on payday.

Laws Affecting On-demand Payroll

Because on-demand payroll is just starting to become more popular, there are some outdated state laws that haven’t yet caught up. If you opt to offer this benefit to your employees, we encourage you to research your state laws and if possible, speak with a legal expert. By definition, some states (Florida, Alaska) consider any paychecks received in advance, regardless of whether they’re earned or not, a loan, and thus subject them to applicable laws, like those governing what you can and cannot deduct from employee paychecks.

Here are an additional few rules that states have on the books that affect on-demand payroll:

• Ohio limits all early payroll payments even though they’re earned, to paying court-ordered spousal or child support.
• In New York, an early payment that assesses interest or charges a fee does not qualify as on-demand pay and may not be reclaimed through payroll deduction. And remember, although you may not charge a fee, most on-demand apps do.
• Some states prohibit employers from linking pay cards to any form of credit; if you want to load the funds to an employee pay card and your state looks at on-demand pay like a loan, this will be problematic.
• Some states won’t allow you to load funds to a payroll card if there are fees involved.

A Closer Look at Payroll Advances

You’re probably more familiar with payroll advances than you are on-demand payroll. They’ve been around longer. They’re similar to on-demand payroll in that employees are paid before payday. However, the amounts are usually larger, and employees haven’t yet earned the funds.

Payroll advances are best for serious emergency situations that can’t be fixed with a single paycheck. We’re not saying issue a $10,000 advance to an employee who earns $10 an hour, but $1,000 could be reasonable.

Laws Affecting Payroll Advances

There are several laws affecting payroll advances, and they are subject to change so check them at least a couple of times a year.

Keep the following in mind:

• Payroll advances can’t reduce employee paychecks below minimum wage.
• You aren’t allowed to charge outrageous interest rates. In fact, many states have their own limits.
• If you’re issuing an advance that exceeds $10,000 AND apply an interest rate below the federal rate, you will have to recognize the difference as the employee’s income.

Regardless of the advance amount you approve, you’ll need to set guidelines on how it will be repaid. Large amounts that would eliminate an employee’s paycheck or bring it below minimum wage (calculated based on the number of hours they work) will need to be collected over multiple paychecks, or you will violate federal labor laws.

You should also note that you aren’t allowed to profit off issuing payroll advances. This means you don’t need to apply outrageous interest rates (20% would be excessive).

If you’re advancing more than $10,000, you’ll need to check the federal prevailing rate on personal loans, and consider charging the same rate. The IRS updates applicable federal rates monthly. Charging 3% when the federal rate is 6% will require you to recognize the difference as taxable income to the employee (more calculations, paperwork). The IRS will consider any fees you charge as interest, even administrative fees, so be sure to include that in your calculation.

And lastly, be sure to check your state’s employment laws. California won’t allow you to deduct money from an employee’s paycheck to repay a payroll advance unless the employee agrees to it—and we encourage you to get that agreement in writing.

Managing Payroll Advances

Since implementing a payroll advance is your responsibility, you’ll need to create and manage the process. If you’re using a payroll provider, you should loop a representative in to make sure all transactions are captured accordingly. Some providers even have tools that can help you manage this more efficiently—you can label an off-cycle payment as an advance and set the amount to be deducted as a repayment from the employee’s next paycheck (or next several paychecks, depending on how much you pay out).

Note, you will have to fund all payroll advances, so you will essentially absorb all of the risk. If the employee’s performance starts to slip or they do a no-call no-show one day, you’ll need to weigh the costs of terminating them—the chances of you receiving repayment decrease—with giving them a chance to improve, at least until you recoup the funds.

Should You Withhold Payroll Taxes From a Payroll Advance?

Since a payroll advance is essentially a short-term loan, you won’t need to withhold payroll taxes from it. Your employee should pay you back in full. You’ll continue to process payroll as usual, withholding taxes and the agreed upon amount from each paycheck until the debt is fully paid.

Payroll Advances Are Not the Same as Traditional Payday Loans

Now let’s briefly discuss the issue of predatory payday loans. They’re not the same as payroll advances, although they are short-term loans that lenders offer to target employees who need cash to help them out until their next payday. The problem with this payroll loan option is that the interest and fees are astronomical—15% to 30%, and sometimes more—and employees who are often short on cash usually go further into debt using them.

Our point in mentioning this is that even if you don’t want to make payroll advances an option for your employees, we urge you not to recommend they seek a payday lender. You would make more of a difference by trying out a free on-demand payroll app.

Which Is Better, On-Demand Payroll or a Payroll Advance?

In comparing the two, on-demand payroll is better overall for both employees and employers. The risks are lower; you don’t have to worry about whether you will be able to recoup the money, and employees don’t have to deal with having smaller paychecks for the next several pay periods.

On-demand payroll is also much easier to track, especially if you’re primarily offering electronic pay options. This will ensure you have an automatic paper trail so you (and auditors) can always see how your payroll payments flow.

Now, we’re not saying payroll advances are bad, but due to the risks involved, you should regulate them more—consider only giving employees the option to exercise them once a year, if that.

Bottom Line

On-demand payroll and payroll advances both help your employees deal with financial shortages. However, on-demand payroll is a more innovative way to routinely offer your employees early wage access, without all of the risks of payroll advances. Payroll advances are better reserved for one-off events since they’re short-term, no-interest loans employers issue solely to help employees.