Table of Contents
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Table of Contents
What Are Pre-Tax Deductions?
Pre-tax deductions are deductions for benefits that are taken out of an employee’s gross wages prior to tax calculation and deduction. Pre-tax deductions are identified as part of the employer’s cafeteria plan, which must be compliant with Section 125 of the Internal Revenue Code. A cafeteria plan is the benefit plan that is pre-tax and subject to Section 125. Plans eligible for pre-tax deductions tend to be related to health and/or retirement.
What Are the Pros and Cons of Pre-Tax Deductions?
There are both pros and cons of pre-tax deductions. Let’s look at a couple together.
Pro: Save Money
A benefit of pre-tax deductions is that they reduce taxable wages. When the tax percentage is calculated from gross earnings after pre-tax deductions have been removed, the taxable amount is less than if the calculation included pre-tax benefits. The amount saved varies based on tax rates, but a common estimate is around 25%.
A con of pre-tax deductions are the limits that may apply to the different benefits eligible for a cafeteria plan. The Internal Revenue Service (IRS) puts parameters on the usage of Section 125 and compliance is crucial, as non-compliance can bring liability to your plan. These limits include when an employee is eligible to start, stop or make changes to their plans. Some eligible plans limit the amount of pre-tax dollars the employee can contribute. More on this further down.
Examples of Pre-Tax Deductions
We now have an understanding of some pros and cons, so let’s see what that looks like through an actual benefit. Here are examples of pre-tax deductions:
Group Insurance Plans
Employers who provide group insurance coverage to their employees typically offer benefits as pre-tax deductions. These insurance plans usually include coverage for medical, dental, vision, life and disability insurance (although not all insurance coverage is offered pre-tax). Once an employee has elected their benefits, they should remain on the plan through the rest of the plan year. There is an open enrollment period prior to the end of the plan year that allows employees to start/stop coverage, change their benefit levels or change who is covered under the plan. This open enrollment period is when employees make the necessary changes for the next plan year. Outside of this window, the only time employees are able to make changes to pre-tax insurance deductions is during what the IRS defines as a qualifying event. A qualifying event is a life event such as marriage, divorce, birth of child, loss of coverage due to termination. etc.
Spending and Savings Accounts
Flexible Spending Accounts (FSA) and Health Savings Accounts (HSA) are also benefits eligible for pre-tax deductions. FSA accounts are limited to the ability to make changes to your plan, similar to the group insurance plans above. However, HSA contributions are allowed to be changed mid-year according to your plan’s designs. Both the FSA and HSA are limited by the IRS on how much an employee can contribute to the plan. Each plan’s contribution limits are set at different maximums based on plan type and are subject to changing each calendar year per the IRS guidelines.
A retirement savings plan such as a 401(k) allows you to contribute pre-tax dollars to your retirement account. The retirement savings plans are subject to the annual IRS funding limits put in place each year, but are not subject to having a qualifying event to make any changes. Changes would just be defined by your plan’s plan design. What is different about retirement plans is that there is a catch-up option for individuals over the age of 50 who participate in the plan to save an additional amount per year because they are closer to retirement age. The catch up limit is announced by the IRS at the same time as the standard annual limit is released. Employers typically offer a matching calculation to also fund the employee’s retirement account, but the employer’s portion does not apply to the annual limits.
One other caveat that applies to retirement savings plans is the fact that while you get to contribute your money tax-free, there will still be taxes paid when you take distributions from your account. So while you’re saving tax money going into the plan, the government still wants taxes paid to them.
How Do Pre-Tax Deductions Affect Taxes?
Let’s walk through a quick example to see the process and effects:
Step 1: Gross Wages Are Earned
An employee works during a pay period and earns gross wages. These wages could be from hourly or salary rates, PTO, holiday, paid leave, or any other type of earning where wages apply. In this example, let’s say the employee’s gross wages during the pay period was $1,000.00
Step 2: Pre-Tax Deductions Are Removed
Of the employee’s $1,000 gross wages, we need to remove the employee’s pre-tax deductions. They’ve signed up for a medical and dental bundled insurance plan that is $50 per pay period, and they also have an FSA contribution of $50, along with a 5% contribution savings rate for their retirement plan. Their total pre-tax deductions equals $150.00. That means their $1,000.00 becomes $850.00.
Step 3: Taxes Are Calculated
To make this calculation easy, we will say that the employee’s Federal Income Tax Withholding, State Income Tax Withholding, Social Security Tax and Medicare Tax all combined are 25%. So we will take $850.00 x 0.25 = $212.50 and then remove that from the $850, which gives us a net earnings amount of $637.50 for the employee to take home.
Now let’s look at how the calculation would work if these were not pre-tax deductions. We’d take the $1,000.00 gross earnings and figure out the taxes. $1,000.00 x 0.25 = $250.00 So removing the $250.00 taxes takes our earnings down to $750.00, but we still have to remove our deductions. After removing those $150.00 deductions, the employee’s net portion is $600.00.
Using pre-tax deductions saves the employee $37.50 each pay period. If we say this is a bi-weekly pay period, then there are 26 pay periods in a year— that’s an annual savings of $975 per year!
As you can see, the calculations show a glimpse of how much someone could save just by taking advantage of the pre-tax deductions. When they file their taxes at the end of the year, their W-2 will show a lower earnings amount than what they actually earned in gross earnings because the pre-tax deductions decrease that amount.
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Samantha is the HR Manager at an oil and gas midstream company. Her niche is the smaller mid-size company where you’re in that in-between of having formal structured policies and procedures and where HR is just a thought of a concept. Samantha is a serial hobbyist – name it and she’s probably dabbled in it.