What Are Pre-Tax Deductions?

Pre-tax deductions are one of two types of benefits deductions: pre-tax deductions and post-tax deductions. They can be difficult to navigate; however, they play a major role in how employers handle employee paycheck tax obligations. Here’s what you need to know to make the most out of pre-tax deductions. 

What Are Pre-Tax Deductions?

A pre-tax deduction is an amount an employer deducts directly from the employee’s paycheck to cover the cost of benefits. This money is taken out of the employee’s gross amount before any taxes are withheld from that paycheck. When an employee pays for a benefit with pre-tax payments, like health insurance, the amount is deducted from their gross income before taxes.

Pre-tax deductions have the potential to reduce taxable income for both the employer and the employee. They can lower Federal Insurance Contributions Act (FICA) taxes, federal and state income taxes, and employer-paid payroll taxes such as the Federal Unemployment Tax Act (FUTA) taxes.

The IRS specifies what qualifies as a pre-tax deduction for each tax. For example, employee contributions to a traditional 401(k) are a pre-tax deduction for federal income taxes but not FICA taxes. 

Pre-Tax Deductions vs. Post-Tax Deductions

While pre-tax deductions are tax-advantaged and can potentially reduce taxable income, post-tax deductions are taken out of an employee's paycheck after taxes get withheld and have no effect on taxable wages and the amount of tax owed. Post-tax deductions don’t lower your overall tax burden but can provide future relief when it’s time to use those benefits and result in potential savings. 

Types of Pre-Tax Deductions

Pre-tax deductions can help reduce your tax liability, but there are restrictions. Here are different types of pre-tax deductions:

• Health insurance: Contributions to certain health plans, like health, vision, and dental insurance plans, Health Savings Accounts (HSAs), and Flexible Savings Accounts (FSAs), may qualify as pre-tax deductions. However, healthcare paid for by the employer is not a pre-tax deduction. The organization deducts this as a health plan cost on their business taxes.

• Retirement plan contributions: Contributions made toward certain retirement savings plans, like a 401(k) plan, are often pre-tax deductions. Not all retirement plans are pre-tax and an employer’s contribution to an employee’s pre-tax retirement account doesn’t qualify as a pre-tax deduction.

• Commuter benefits: Some commuter benefits help cover an employee’s transportation costs, including bus fares and parking fees, that qualify for pre-tax deductions. Not all areas have a commuter program that qualifies for a pre-tax deduction.
• Life insurance contributions: Contributions made to group-term life insurance are eligible for pre-tax deductions for federal income tax withholding, Federal Unemployment Tax Act taxes, and FICA. However, only the first $50,000 of coverage is a pre-tax deduction for FICA.

Final Thoughts

While pre-tax deductions can potentially lower an employee’s tax burden, employees could still owe taxes on pre-tax benefits down the road, like when they go to use the benefit. There are also limits on certain benefit deductions. This means that the employee is exempt from taxation until the IRS contribution or tax-exempt limit is reached. These limits can change annually.