Pre-tax deductions play a major role in the way employers handle employee paycheck tax obligations (especially regarding employee benefits) – to the ultimate benefit of the employer and the individual taxpayer.
What Is a Pre-Tax Deduction?
A pre-tax deduction is the amount an employer deducts from a staffer’s paycheck each time that payment is issued. The money is deducted from the gross amount of the payment prior to any taxes withheld from that payment.
The pre-tax pay deduction is a benefit to the employee, as the deduction lowers their tax liability not just on general income taxes, but also on key individual taxes like the FICA (Social Security and Medicare) tax (but not in every instance), while also curbing employer-based taxes such as the Federal Unemployment Tax and the employer’s end of the FICA tax.
Employees benefit further with pre-tax deductions.
For instance, the deductions enable staffers to participate in various health care insurance and life insurance plans, prior to having their gross income taxed. Having the money available for such programs before gross income is taxed lowers that employee’s taxable income, giving them access to important financial, work-related and health care-related opportunities, thus saving them a significant amount of household income in the process.
It’s important to note that a worker may benefit from a pre-tax deduction in the short-term and have to pay some taxes on the money withheld over the long term.
A great example of that scenario is an employee’s 401(k) retirement plan, which is taxed on a deferred basis – tax-free when that employee is working and participating in a 401(k) plan but taxed-owed (the amount depends on the payer’s tax bracket) once the worker is retired and starts withdrawing from his or her 401(k) plan.
Understanding Payroll Deductions a Big Help With Pre-Tax Deductions
Since all pre-tax deductions come attached to a worker’s paycheck, it helps to understand the role pre-tax deductions have in employer payroll deductions.
In a word, paycheck deductions represents cash taken from a worker’s payment, on a regular basis, that is steered toward taxes, employee benefits, and other financial obligations.
There are three primary payroll deduction models that employers adhere to, as follows:
- Federal, state and local taxes (when applicable).
- Pre-tax deductions
- Post-tax deductions (more on those below)
As explained above, pre-tax deductions is cash removed from a worker’s paycheck before taxes are withheld from that same paycheck.
Examples of pre-tax deductions include:
- Retirement funds, like a 401(k) plan
- A health insurance plan (like a health savings account or flexible spending account) that helps workers put money away for health care needs, at a tax advantaged basis. Employee health care plan funds can also be deemed as a pre-tax deduction.)
- Commuter assistance plans. A less traditional example of a pre-tax deduction allowance is a commuter cash benefit, which helps staffers pay for transportation to and from work. In most situation, commuter benefits are considered as a pre-tax deduction.
Any of the above can involve a pre-tax deduction, and lower an employee’s overall tax burden for that tax year.
A Word on the FICA Tax
It’s worth taking a look at why pre-tax deductions are generally favorable for both the employer and the employee, both of whom see their tax liability reduced on FICA taxes.
FICA taxes are a breed apart on income taxes, in that they are taxable to both the employer and the worker. Thus, the employer is taxed on a portion of the income it pays the employee, and that employee is taxed on the amount of wages he or she earns, with the taxes earmarked for the employee’s Social Security and Medicaid fund accounts, usually paid out when that employee is of retirement age.
Here’s how the FICA tax is broken down for the employee and the employer, according to the Internal Revenue Service.
Each pay period, the employee pays . . .
- A 6.2% Social Security tax
- A 1.45% Medicare tax (the “regular” Medicare tax)
- A 0.9% Medicare surtax when the employee earns over $200,000
Each payment period, the employer pays . . .
- A 6.2% Social Security tax
- A 1.45% Medicare tax (the “regular” Medicare tax).
Pre-Tax Deductions Are Not the Same as Post-Tax Deductions
It’s a fairly clear distinction between pre-tax deductions and post-tax deductions. In fact, the difference comes down to a single word.
Here’s the deal.
With a pre-tax deduction, a company withholds the deduction from a worker’s paycheck before withholding that worker’s taxes on the money.
With a post-tax deduction, that same company withholds the deduction after it withholds taxes. Unlike pre-tax deductions, post-tax deductions don’t effect a worker’s taxable income at all.
That said, pre-tax withholding and post-tax withholding rules aren’t set in stone. There are instances (and often employers and employees can agree on them or make a choice independently) where a tax deduction can be either “pre or pro” based on the company’s own rules for a particular benefit, like when weighting a health insurance plan or company retirement plan.
Granted, the area of what counts as a 100% pre-tax deduction and what doesn’t can be fuzzy (example: adoption assistance from an employer can be included as a pre-tax deduction for federal income taxes, but not for FICA taxes, which considers that taxable income.)
To get a better grip on the issue, IRS Publication 15 offers constructive advice on pre-tax deduction options and breaks down what is and is not allowable under federal tax law. Both employers and employees can benefit from giving Publication 15 a thorough review.
A candid discussion on the topic with your tax professional can be invaluable, as well.
Example of a Pre-Tax Deduction
Let’s take a look at how a pre-tax deduction would actually work, using a standard health care savings account as a model:
Here, the employer has an HSA plan deductible (straight from her paycheck) of $100 for every pay period.
That same employee grosses $1,500 every pay period (assuming a twice-a-month pay period for the purposes of this example.)
With the $100 pre-tax deduction per paycheck, the staffer’s taxable income is $1,500 minus $100 – or $1,400.
That lowers the employee’s tax burden by $100 a pay period thus enabling the worker to get a good tax break on her employer-sponsored health care savings account.
The Takeaway on Pre-Tax Deductions
Pre-tax deductions are a solid way for employers and employees to save on current taxes, while giving the employee access to some highly useful employee benefit plans.
The tax breaks may not last forever, and the recipient may owe some taxes down the line (as they would with a 401(k) plan), but there’s little doubt the financial edge the employee is getting on the front end makes pre-tax deductions a tax break worth celebrating.