This article is part of a larger series on How to Do Payroll.
The main difference between pre-tax and post-tax deductions is the time at which employees are required to pay taxes on them. Pre-tax deductions, like some retirement contributions and insurance premiums, are amounts you subtract from the employee’s earnings before computing taxes, driving the tax bill down for both you and your employees. Post-tax deductions are the opposite, meaning that they are deducted after an employee’s earnings are taxed.
How Pre-Tax and Post-Tax Deductions Work
When you’re ready to calculate payroll, you must know the total amount of deductions applicable to each employee and whether they’re pre-tax or post-tax.
For instance, Employee A may have health insurance (pre-tax) and child support (post-tax) deductions taken from their check while Employee B has a Roth 401(k) premium (post-tax) and a flexible spending account (FSA) contribution (pre-tax). To calculate the payroll and income taxes you should withhold, you would multiply the employee’s taxable income by the applicable percent (set by the IRS, state, or local agency).
The most common mistake employers make when reducing an employee’s income by payroll deductions is subtracting the deductions at the wrong time. Post-tax deductions are not factored into the payroll tax calculation. If you deduct money from an employee’s check for a post-tax deduction, like a Roth 401(k) premium, you do not need to reduce the employee’s taxable income amount to account for it. No matter how much money you withhold from an employee’s paycheck for post-tax deductions, employees should still be taxed on all of the income they earned.
Types of Pre-Tax and Post-Tax Deductions
When it comes to payroll deductions, there are many different types that may apply to your payroll. Some are either always pre-tax or post-tax, and others may be one or the other, depending on the situation and what your employee chooses. Some pre-tax deductions are also limited to certain benefit amounts. For instance, the pre-tax benefit for voluntary life insurance premiums is up to $50,000 in benefits; anything after that is taxable.
Some pre-tax employee deductions you may be familiar with are:
- Health insurance: This typically includes medical, dental, and vision insurance; some post-tax options are out there, though, so it’s important for you to check when adding them to your benefit offerings.
- HSAs (health savings accounts) and FSAs: These give employees an opportunity to pay for projected medical expenses before actually incurring them so they can avoid taxes; employers benefit too because they don’t have to pay Social Security or Medicare tax on income employees deposit into these accounts.
- Commuter benefits: Employers can deduct transportation costs for expenses like parking garage fees and public transit passes from employee paychecks on a pre-tax basis if they find a provider that offers a plan with commuter benefit options.
- Life insurance: Employer-paid life insurance premiums are tax exempt up to $50,000 of benefits in regards to FICA and unemployment taxes. There is no limit to the pre-tax amount when it comes to income taxes.
- Retirement contributions: Traditional IRA plans, 403(b) plans (for nonprofits), and many 401(k) plans are pre-tax. Employees, however, are limited on how much they can contribute to each plan on an annual basis, and they will have to pay taxes when they withdraw the funds during retirement. Also, these are still subject to FICA, just not income taxes.
If you’re interested in learning more about what you can offer your team, check out our guide to employee benefits for small business owners. Payroll providers like Gusto can broker benefit plans for your team directly through their software and will set up the pre-tax or post-tax deduction in the system for you.
Some post-tax employee deductions you may be familiar with are:
- Retirement contributions: Roth IRAs are paid for with after-tax dollars. The benefit is that employees won’t owe taxes on it when they withdraw the funds during retirement.
- Disability insurance: Disability insurance for which your employees pay the premium is typically available to purchase with either pre- or post-tax dollars. Employees have the option of deciding which to sign up for.
- Life insurance: Premiums for any life insurance benefits offered over $50,000 must be paid on a post-tax basis.
- Garnishments: Examples include student loans in default, child support, and old medical debt; these don’t receive any tax benefit and should be classified as post-tax deductions.
Which Is Better: Pre-Tax or Post-Tax Deductions?
As your employees start weighing their options for certain benefits, they may have questions about whether they should choose pre-tax or post-tax benefits. There is no true answer as to which is better.
Some pre-tax benefits, like retirement contributions, are subject to taxes later, so employees need to consider how much they expect their income to increase over time. Generally, higher income leads to higher tax rates. If an employee expects their income to rise significantly during their retirement years, it would be a good idea to make post-tax contributions. However, if they expect it to drop significantly, they should consider using pre-tax dollars; they’ll have to pay taxes later, but it might be at a much lower rate.
Keep in mind that we can’t forecast future tax rates. It’s important to know that there’s no way to know exactly what they will be or the impact they’ll have on your employees’ pre-tax benefits until the time comes.
It’s important to pay attention to the types of payroll deductions you are processing for your employees because they all have different tax rules. Being familiar with the different benefit plans as well as your state and local laws regarding certain pre-tax benefits will save you time when you’re running payroll. Many payroll deductions can be applied on either a pre-tax or post-tax basis, so be sure you know exactly which options your employees want to pursue.
If you’d rather not worry about what deductions need to be made pre-tax and which are meant to be taken post-tax, consider using a payroll provider like Gusto. You can choose the benefit or deduction needed, and Gusto’s system handles the rest. Once entered in the system, Gusto’s software will deduct all pre-tax and post-tax deductions automatically each period. Try it free for 30 days.