What is direct deposit?

Direct deposit is the electronic form of a paycheck. It’s an electronic transfer of funds from an employer’s business bank account to an employee’s account at a bank or credit union. It’s also known as an automated clearinghouse (ACH) transaction. This process requires the employee’s bank account number, routing number, type of account, bank name and address, and the names of the account holders.

Direct deposit isn’t just for paying wages. “It is also used for tax refunds, retirement benefits, expense reimbursements, investment distributions and insurance claim payments,” said Heather McElrath, senior director of communications at the National Automated Clearing House Association (Nacha).

What is Nacha?

Nacha is the National Automated Clearing House Association, also known as the Electronic Payments Association. This nonprofit manages the ACH Network, which processes and moves trillions of dollars every year. For example, the ACH Network moved 26.8 billion payments, valued at $61.9 trillion, in 2020. These transactions included direct deposit, Social Security, government benefits, electronic bill payments, and person-to-person and business-to-business payments.

The ACH Network creates the grid for all American financial institutions to safely transfer money from one bank account to another. Nacha is not a government agency, but it works directly with the Federal Reserve, state banking authorities and the Treasury Department. Nacha has its own rules and code of ethics that ensure business is conducted fairly and with as little risk as possible.

How to set up direct deposit

A small business owner can set up direct deposit in five basic steps. Ultimately, the process will run through a payroll provider or bank, which brings us to the first step.

1. Choose a direct deposit payroll provider.

You will need to set up payroll services. When shopping around for the best online payroll solution, pay close attention to the services offered, the fees and several other components of direct deposit management. You can always start by inquiring with your existing bank. They likely manage direct deposit, and their terms and fees can give you a baseline when you compare your options.

2. Review federal and state laws on direct deposit.

Before implementing direct deposit for your business, take into account federal and state laws regarding the process. The complete rules regarding electronic funds transfer payroll payments can be found in the Electronic Fund Transfer Act (part of the Comptroller’s Handbook). These are a few of the federal law highlights:

• An employer has the responsibility to provide each employee with consent and direct deposit authorization forms.
• An employer must collect the employee’s bank information, including bank name, account type, and routing and account numbers. The employee’s signature must be completed on the above forms.
• Although the employer may require the employee to accept direct deposit (depending on the case and state), the employee can choose the financial institution to receive said payments.

States are allowed to impose additional requirements for direct deposit. While some states require employers to follow federal laws only, most states have supplementary stipulations.

Eight states have no requirements other than abiding by federal laws:

• Alabama
• Georgia
• Hawaii
• Louisiana
• Massachusetts
• Mississippi
• Nebraska
• Ohio

Nine states give employers the right to require employees to use direct deposit (according to federal law):

• Indiana
• Kansas
• Minnesota
• Missouri
• South Carolina
• Texas
• Virginia
• Washington
• West Virginia

Twenty-one states require an authorization form to be completed by employees before the employer can pay them via direct deposit:

• Alaska
• California
• Connecticut
• Colorado
• Delaware
• Florida
• Idaho
• Illinois
• Iowa
• Maryland
• Montana
• New Hampshire
• New Jersey
• New York
• North Carolina
• North Dakota
• Oklahoma
• Pennsylvania
• Rhode Island
• Vermont
• Wyoming

3. Collect information from your employees.

Once you have a direct deposit provider, you will need information from your employees to process the payments. Each service will provide you with their direct deposit forms, but some information will prove universal. Make sure that every employee can safely and reliably provide the following information.

• Bank information: The employee should providethe name and address of their bank, as well as list the account holder’s name for the account they want to use for direct deposit.
• Key numbers: Three numbers are necessary to set up direct deposit. These are the employee’s bank account number (checking or savings), routing number (also known as an ABA number) and Social Security number. The account number is obvious; it tells the provider where to deposit funds. The routing number is necessary for a digital transfer, and the Social Security number provides an additional identity check to make sure the money goes to the right person.
• Personal information: The employee’s name and address are standard requests; other providers may require more details. This is all for verification to avoid mix-ups and problems with deposit delivery.
• Consent and authorization: The provider will need to cover the legal basis and assure that the employee understands the agreement and is entering into it willingly.

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4. Add employees to the payroll system.

Before you were using direct deposit, you still had a payroll system. The new method requires a system update. You will be running your payroll through the new provider, which will require an exchange of information. It may take a little time to set up, but it should prove easier to manage once you have everyone in the new system. Automation can help you stay ahead of payroll and have everything processed quickly, easily and consistently.

For many small businesses, the transition to direct deposit does not happen all at once. Some employees may opt out for any number of reasons. You may find yourself using a hybrid payroll system – at least for a while. The good news is that the automation available with direct deposit can make a hybrid system ultimately easier to use than writing out checks for every employee.

5. Select your deposit schedule.

Once your provider has all of the necessary information and reviews your orders, they will handle the actual process of depositing the checks, so you will need to pick a deposit schedule. There are a couple of things to consider when selecting the schedule.

The first is your own financial schedule. Funds need to be liquid and available for transfer in your business account before paychecks can be distributed. Make sure you pick a payment schedule that works with your expected cash flow.

The second consideration is payment time. Employees depend on those checks, and they need to be received in a timely fashion. When the ACH distributes funds to employees’ banks, the process is not instantaneous, despite being digital. On average, it takes two business days for the money to go from your business account to your employees’ accounts. Depending on the banks involved, downtime will be expanded in the case of holidays.

Direct deposit services for small business

In the years after World War II, 28 million checks were written daily, according to a study in James McKenney’s Waves of Change: Business Evolution Through Information Technology. Today, nearly 93% of American workers are paid by direct deposit, which includes both small and large businesses, according to a 2018 American Payroll Association survey. Like many technological advancements, direct deposit has pushed out its paper predecessor.

“Whether you are a 10-person operation or smaller, or a business of more than 100 employees, you can gain from direct deposit’s advantages,” McElrath said. Direct deposit gives you more control over your finances and provides you with up-to-date electronic records of your payments. This electronic record helps clear up any confusion about your payroll deposit and provides a point of reference.

Pros of direct deposit

Direct deposit has a lot to offer in terms of speed and efficiency, proving to be a win-win for both you and your employees. Here are some of the benefits of using direct deposit.

It saves your business money.

Direct deposit, like most online innovations, has a lot to offer. It helps businesses save a lot of money by eliminating manual check preparation. Since there is no need for postage and mailing supplies, it saves business owners about $3 per paper check.

Direct deposit can also be used to pay Social Security benefits. In 2013, the Social Security Administration mandated beneficiaries collect their payments electronically. Child support payments and tax refunds can also be sent using this method. To receive your tax refund this way, inform your tax preparer. If you want to save some of your tax refund, you can disburse funds into several different accounts – you only need to provide your bank account information.  

It saves your business time.

Saving money is always a bonus, but saving time is also a welcome win. With direct deposit, you no longer spend time printing and mailing paper paychecks, and you no longer need to wait for all of your employees to cash their checks. It also saves employees time since they no longer need to wait in line at the bank to cash or deposit their paychecks.

It’s more secure than paper.

Direct deposit has a significant security advantage over paper checks, which can be lost, stolen or counterfeited. According to a Nacha survey, 83% of employees perceive direct deposit as more secure. In a survey on payment fraud by the Association for Financial Professionals, researchers found that checks are the most vulnerable method to fraud.

It supports employees’ financial health.

Direct deposit allows you to help your employees automatically direct part of their paychecks into their savings accounts. 

“With split deposit, employees can direct a fixed amount or percentage of their pay into a savings or investment account to help build savings,” McElrath said. “As the single biggest influence on employees’ use of direct deposit, businesses can play a key role in supporting employee financial health.”

Most financial institutions offer free checking when employees use direct deposit, which saves on banking fees, according to Kristin Walle, senior vice president of global payments and compliance at ADP.

It’s good for the environment.

Our environment is precious, and when we say direct deposit is greener, we mean it. A 10-person small business that pays employees twice a month uses 10.7 pounds of greenhouse gases each year – the equivalent of driving almost 40 miles in your car.

If the same small business switched to direct deposit instead of printing paper checks, it would save 3.7 pounds of paper, 35.7 gallons of wastewater from being drained into natural bodies of water, 1.4 gallons of gas, and 4.3 pounds of solid waste, according to Wagepoint.

Can you imagine the impact on the environment if big corporations like Amazon or Microsoft used only paper checks?

Cons of direct deposit

There are some drawbacks of using direct deposit that you’ll want to consider, both for employers and employees.

It’s time-sensitive.

Direct deposit is a time-sensitive process, and it’s easy to overlook deadlines when you’re particularly busy. If you don’t collect all of your employees’ time and attendance sheets and process payroll by a certain time, the money won’t transfer into your employees’ accounts on time. Late checks can lead to disgruntled employees, and if you want to speed up the process, it will cost you extra.

There are potential security risks.

Because you need your employees’ bank routing and account information to set up direct deposit, you need strong security measures in place to protect this sensitive information.

Changing banks means starting over.

Changing banks can also be an inconvenience because it means changing direct deposit information, so all of your employees will need to submit new authorization forms.

There’s no ‘stop payment’ option.

Although it’s convenient to use direct deposit for payments, you can’t stop the payment like you can with a paper check, which might be an issue if you make a mistake.

You could incur overdraft fees.

If you don’t have enough money in your account when funds for payroll are withdrawn, it will put you in the negative and you’ll incur overdraft fees, which can be both inconvenient and expensive.

How much does it cost to set up direct deposit for my employees?

Direct deposit may seem to be all about saving time and money, but you can be hit with service fees that range from $50 to $149. Banks may also charge employers each time money is transferred from their account to an employee’s. Individual deposit fees can range from $1.50 to $1.90 per transfer.

Contact your financial institution or payroll services provider to find out exactly how much it costs to set up and maintain direct deposit. The financial institution or payment processor pays a fee to use the ACH Network, but Nacha does not track fees that a business may incur, according to McElrath.

“Generally, [the] cost to use direct deposit [is] low,” she said. “Most companies would save money using direct deposit compared to other payment methods, and any startup costs would be recouped in savings and increased productivity.”

What time do payroll direct deposits post?

According to Walle, direct deposit fund posting is governed by Nacha’s rules, which all financial institutions abide by. “As a result, the funds are available by 9 a.m. local time at the receiving depository institution on the settlement day. Many financial institutions ‘memo-post’ incoming transactions, so employees may see a pending transaction prior to funds being available.”

Most American employees who use direct deposit are paid at the opening of business on the Friday of payday. If your business doesn’t have set paydays, you can use direct deposit to pay employees promptly using same-day ACH. The payment would post by 5 p.m. on the day the payments are made, McElrath said.

Can you pay contractors using direct deposit?

Businesses can pay independent contractors using direct deposit the same way they pay traditional employees – contractors need to fill out the direct deposit form. “While there may be differences in the specifics of how a contractor is administered in a payroll system, the money-movement mechanics are the same,” Walle said.

The difference is that contracted workers are not required to fill out a W-2 form during their payroll process like traditional employees. Instead, they fill out W-9 forms, and you provide a 1099 form if you pay them $600 or more per year.

Julie Thompson contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.