Pre-Tax Deduction

Understanding tax responsibilities, withholdings, benefits, and contributions are part and parcel of payroll processing. And while it is true that businesses hire payroll providers to do all the calculations, having a clear understanding of the different aspects of payroll is always an advantage. Today, we’ll be talking about pre-tax deductions. 

What is the meaning of a “pre-tax deduction”? 

A pre-tax deduction refers to an amount of money that is subtracted from the gross wages of an employee before withholding taxes. Note that it says “pre-tax” which strictly means before taxes. 

If you are an employer, it is best to be updated on regulations on pre-tax deductions set by the Internal Revenue Service (IRS). Here are some examples of pre-tax deductions: 

• Health Savings Account
• Healthcare Insurance
• Supplemental Insurance Coverage
• Short-Term and Long-Term Disability
• Dental Insurance
• Child Care Expenses
• Flexible Spending Accounts (FSA)
• Life Insurance
• Commuter Benefits
• Retirement Funds
• Tax-Deferred Investments
• Vision Benefits
•  Parking Permits

What is the significance of pre-tax deductions? 

There are many benefits that employees may be offered at work. These benefits may fall under pre-tax or post-tax deductions. If you are just beginning to know what deductions are, you might wonder why it matters if something is a pre-tax deduction or a post-tax deduction if both will be deducted from the gross pay anyway?

Whether a deduction is pre-tax or post-tax is significant because of its impact on taxes. Because pre-tax deductions are subtracted before taxes are taken from the gross wages, they reduce the reportable W-2 income. They lower the taxable income of the employee. As a result, the employee may have lesser Social Security, Medicare, and income taxes. Additionally, pre-tax deductions can also result in lower federal unemployment tax (FUTA) and state unemployment tax (SUTA) for employers. 

On the other hand, post-tax deductions are taken after taxes are withheld. They have no bearing on an employee’s taxable income. 

A note to employers, know that the rules on pre-tax deductions can vary. Be vigilant and check everything before running your payroll. 

What are other examples of pre-tax deductions? 

• 401(k) Contributions.  Not all retirement plans are considered pre-tax. A traditional 401(k) plan is the most common type of retirement plan that is considered pre-tax deduction. However, the contributions of employers to a 401(k) plan are not pre-tax but a business expense. To make things a little bit more complicated, employee contributions to a 401(k) are pre-tax for federal income tax purposes only but are not pre-tax for FICA taxes. Income taxes on 401(k) plans are paid once they are withdrawn. 
• Health plan Contributions. Employee contributions for health savings accounts (HSAs) and flexible savings accounts (FSAs) are considered pre-tax deductions. 

• Commuter benefits. These are qualified fringe benefits for employer-funded accounts which are considered pre-tax deductions. The funds are used for things such as train tickets or bus passes. 

Let us see an example of how a pre-tax deduction can be calculated. 

Anna is an employee who receives $1,200 each pay period. She has a health savings account (HSA) with a deduction of $50 per payroll period.

Remember that a pre-tax deduction is subtracted before withholding taxes from gross wages. This means that the $50 is taken out first. 

$1,200 -$50 = $1,150

Anna’s taxable income becomes $1,150 per pay period after taking out the pre-tax deduction. Withholding taxes are based on $1,150 and not on the original gross wages of $1,200.