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Learn the common pre-tax deductions, including health benefits.

What Are Pre-tax Deductions?

Payroll can involve a lot of deductions. You have to withhold taxes and money for employee benefits.

When it comes to benefits, there are two types of deductions, pre-tax and post-tax deductions. You will calculate the deductions differently. Let’s take a closer look at pre-tax deductions.

What is a pre-tax deduction?

A pre-tax deduction is money you remove from an employee’s wages before you withhold money for taxes. Pre-tax deductions are used to pay employee premiums of certain benefits. Not all benefits can be pre-tax deductions.

Pre-tax deductions reduce an employee’s taxable wages, meaning they will likely owe less federal income tax and FICA tax (Social Security and Medicare taxes). If your business is in an area with state or local taxes, pre-tax deductions might also reduce an employee’s liability for these taxes. Pre-tax deductions often give employees more spending money.

Pre-tax payroll deductions also lower federal unemployment tax (FUTA tax), which only employers pay.

Even though there is no tax now, employees might owe taxes on pre-tax benefits later. For example, an employee has a pre-tax retirement account. You withhold the money before taxes and deposit it into the account. When the employee retires and uses the saved funds, they will owe taxes on the amount.

Not all pre-tax deductions are completely tax free. Some deductions are exempt from federal income tax, but not exempt from FICA and FUTA taxes. For example, adoption assistance is exempt from federal income tax, but not FICA and FUTA. Also, some benefit deductions are only pre-tax up to a certain amount. For example, educational assistance up to $5,250 per year is exempt from taxes. Anything beyond that amount is subject to taxes.

Pre-tax deduction example

Let’s pretend you have an employee who has a pre-tax deduction for a flexible spending account (FSA). The deduction is $50 per payroll, and you pay the employee a gross pay of $1,000 per biweekly pay period.

You first need to subtract the $50 pre-tax withholding.

$1,000 – $50 = $950

The employee’s taxable income is $950 for the pay period. You can now withhold taxes.

What deductions are pre-tax?

Many fringe benefits might allow pre-tax deductions.

For information about the taxation of fringe benefits, check out Publication 15-B, Employer’s Tax Guide to Fringe Benefits. Make sure you also check your written plan documentation because each benefit has different rules.

Pre-tax deductions list

Below is a pre-tax deductions list of common employee benefits.

Common Pre-tax Deductions

Health benefits

You might be able to withhold health benefits before taxes, especially if the health benefits are part of a Section 125 cafeteria plan.

Common pre-tax health benefits include health insurance, accident insurance, dental and vision insurance, flexible spending accounts, and health savings accounts (HSA).

For the most part, health benefits are pre-tax. Some health benefits have contribution limits or special tax withholding rules.

Life insurance

Group-term life insurance is exempt from all employment taxes. However, it is only exempt from FICA taxes up to the cost of $50,000 of coverage.

Retirement accounts

Some retirement plans are eligible for pre-tax deductions, such as a SIMPLE IRA or some types of 401(k). Pre-tax retirement accounts are typically exempt from all employment taxes. Make sure you check the specific plan you offer for more details.

Transportation programs

Transportation benefits can help employees pay for public transportation and parking fees, among other things. Depending on the types of transportation benefits you offer, there might be limits. Once the benefit reaches that limit, it is no longer exempt from taxes.

Don’t calculate pre-tax deductions yourself. Patriot Software’s online payroll software will do all the calculations for you with guaranteed accuracy. Start your free trial now.

This article is updated from its original publication date of 4/25/2012.

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