Pre-tax Deduction

What Are Pre-tax Deductions?

A pre-tax deduction is any money taken from an employee’s gross pay before taxes are withheld from their paycheck. These deductions reduce the employee’s taxable income, meaning they'll owe less income tax. They may also owe less Federal Insurance Contributions Act (FICA) tax, which includes Social Security and Medicare.

Pre-tax deductions might also lower employer-paid taxes like Federal Unemployment Tax Act (FUTA), FICA, and state unemployment insurance (SUI).

Pre-tax Deductions vs. Payroll Deductions

Pre-tax deductions and other payroll deductions both allocate a portion of an employee’s paycheck for specific purposes. This reduces their net pay (take-home pay). All pre-tax deductions are payroll deductions, but not all payroll deductions are withheld on a pre-tax basis.

The term "payroll deductions" describes the wages withheld from an employee’s paycheck that go toward federal income tax (FIT) and other levies, benefits contributions, and garnishments like delinquent child support payments. An employee's pay stub should reflect mandatory and voluntary payroll deductions.

Pre-tax deductions only refer to the contributions that come out of an employee's paycheck before taxes are withheld.

Pre-tax Deduction List

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 paycheck deductions before modifying payroll. Here’s a list of items that typically qualify as pre-tax deductions (as of 2023):

• Healthcare insurance
• Health savings accounts (HSA)
• Supplemental insurance coverage
• Short-term disability
• Long-term disability
• Dental insurance
• Dependent care benefits
• Medical expenses and flexible spending accounts (FSA)
• Life insurance
• Commuter benefits
• Retirement contributions
• Tax-deferred investments
• Vision benefits
• Parking permits

Benefits of Pre-tax Deductions

Pre-tax deductions are beneficial to most employees and employers. Using a pre-tax deduction plan allows employees to get coverages and perks like medical care and life insurance before their gross income is taxed. This reduces the employee’s tax burden and usually saves them money over time. For instance, an employee will often pay less for health coverage than they would if they bought a private plan with after-tax dollars.

Pre-tax deductions are advantageous, but most plans have a limit to the amount of contributions that can be made in a year. This means employees don't get infinite savings from their pre-tax contribution program.

Some pre-tax deductions may also be subject to Social Security and Medicare tax. So, 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 help the employee, increasing the credits and benefits they'll receive from these programs in the future.

Do Pre-tax Deductions Reduce Taxable Income?

Yes, pre-tax deductions almost always reduce taxable income for an employee. This is because the money is taken out of the employee’s gross pay, which leaves a lesser amount subject to tax withholding. 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're 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, after-tax deductions don't reduce an employee’s taxable income—the employee’s pay is taxed before the money is taken from the paycheck. Post-tax deductions may include several items, such as union dues, charitable donations, certain retirement contributions, and benefits that exceed the pre-tax deduction limits.

Examples of Pre-tax Deductions

A variety of deductions and contributions can be considered pre-tax. Here's an example of how to calculate 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.
• This makes the employee’s taxable income $950 ($1,000 - $50).

At this point, you can withhold taxes from the employee’s pay. Taxes should not be withheld before subtracting the employee's HSA (and other qualified contributions, if applicable).

Other examples of pre-tax deductions include:

Retirement Funds

Retirement plans like 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 Insurance

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 voluntarily pay for health coverage.

Commuter Benefits

Commuter benefits are a type of qualified fringe benefit that goes into an employer-funded account, which is considered a pre-tax deduction. For example, an employer may put $100 a month into a commuter account for bus passes or train tickets.