Glossary of Human Resources Management and Employee Benefit Terms
A pre-tax deduction is any money taken from an employee’s gross pay before taxes are withheld from the paycheck. These deductions reduce the employee’s taxable income, meaning they will owe less income tax. They may also owe less FICA tax, including Social Security and Medicare. Pre-tax deductions might lower employer-paid taxes like the Federal Unemployment Tax (FUTA), FICA, and SUI.
The federal government may change the rules regarding pre-tax deductions on an annual basis. Regulations and limits are also subject to change. Be sure to check for updated information regarding pre-tax deductions before making changes to payroll. Here’s a list of items that currently qualify as pre-tax deductions:
Health Savings Accounts
Supplemental Insurance Coverage
Child Care Expenses
Medical Expenses and Flexible Spending Accounts
Pre-tax deductions are beneficial to most employees and employers. Using a pre-tax deduction plan allows employees to get coverages and benefits like medical care and life insurance before gross income is taxed. This reduces the employee’s taxable income and usually saves them money over time. The employee will often pay less for health coverage than they would if they bought a private plan with after-tax dollars.
Because pre-tax deductions are considered so advantageous, most plans have a limit to the amount of contributions that can be made in a year. This means employees will not be able to get limitless savings from their pre-tax deduction plan.
Some pre-tax deductions may also be subject to Social Security and Medicare tax. Hence, the Social Security and Medicare taxes an employee pays may be based on a higher gross income than shown for computed income taxes. This can be a benefit to the employee, increasing Social Security credits and benefits in the future.
Yes, pre-tax deductions will almost always reduce taxable income for an employee. This occurs because the money is taken out of the employee’s gross pay before taxes are withheld. Pre-tax deductions may also reduce taxes for an employer who pays FUTA, FICA, and SUI.
Pre-tax deductions change from year to year. They are adjusted for inflation and costs of living by the federal government. This may affect how much taxable income is reduced from one year to the next.
In contrast, post-tax deductions do not reduce an employee’s taxable income. An employee’s income will be taxed before the deduction is taken from the paycheck. Post-tax deductions may include items such as union dues or other benefits that exceed the pre-tax deduction limits.
There are a variety of deductions and contributions that can be considered pre-tax deductions. Here is an example of how to go about calculating a pre-tax deduction:
An employee has a gross pay of $1,000 per pay period. They also have an HSA deduction of $50 per pay period. The pre-tax withholding needs to be subtracted from the gross pay first, making the employee’s taxable income $950. At this point, you can withhold taxes from the employee’s pay. Taxes should not be withheld before subtracting the HSA amounts or conducting any other pre-tax deductions.
Other examples of pre-tax deductions include:
A traditional 401(k) can be considered a pre-tax deduction. Both the employee and employer may make contributions before the income is taxed.
Health benefit plans like an HSA or FSA are considered pre-tax deductions. Company-sponsored health insurance may also allow pre-tax deductions for employees who pay for such health plans.
Commuter benefits are a type of qualified fringe benefit that goes into an employer-funded account. This account is considered a pre-tax deduction. For example, an employer may put $100 a month into a commuter account for a bus pass or train tickets.
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