As a small business owner or payroll professional, you need to be aware of payroll tax deductions, including both pre- and post-tax deductions. As the names suggest:
- Pre-tax deductions are those deductions subtracted from an employee’s pay before taxes are withheld (including health plan and life insurance contributions).
- Post-tax deductions refer to deductions taken from an employee’s pay after taxes have been withheld (including wage garnishments and union dues).
Tax deductions are set by the government, so you can’t choose whether a benefit is pre- or post-tax. You simply choose the benefit you want to offer and then follow the rules for taxation.
In this guide, we walk you through both types of deductions. By learning more about these concepts, you can better understand how to do payroll correctly.
Types of Pre-tax Deductions
Pre-tax deductions reduce an employee’s tax liability since money is taken out of an employee’s gross pay before taxes are calculated. Pre-tax deductions may also reduce your employer-paid taxes like federal unemployment tax (FUTA), Federal Insurance Contributions Act (FICA), and state unemployment insurance (SUI). Keep in mind, however, that pre-tax deductions are not limitless. Some annual limits apply to certain deductions, like 401(k) contributions.
While many pre-tax deductions have been approved for years, the federal government may change the rules for what qualifies as a pre-tax deduction. So, make sure you stay up to date on the requirements. You can find a full list of pre-tax deductions directly from the Internal Revenue Service (IRS).
Common pre-tax deductions include:
Certain employee contributions to health, vision, and dental insurance plans are pre-tax, including Health Savings Accounts (HSA) and Flexible Savings Accounts (FSA). Employer-paid healthcare is not income to the employee, so it’s not a pre-tax deduction. However, you can deduct employer-paid health plan costs, including administration fees, from your business taxes.
Employees’ 401(k) contributions are pre-tax, reducing their taxable income. However, if your company offers a Roth version and employees contribute, this is not a pre-tax deduction—Roth retirement contributions are post-tax. Many employers match 401(k) contributions up to a certain amount. These contributions don’t qualify as a pre-tax deduction for the employee, but your business can write off the contributions on your business taxes.
401(k) contributions get tricky because, even though they’re pre-tax for your employees, the amount still counts toward you and your employees’ FICA taxes. Also, the annual contribution amount is limited to $20,500 per year. Except for self-employed individuals, employees cannot contribute more than this amount, limiting the amount of tax liability reduction they can achieve each year.
Especially in large metropolitan areas, commuter benefits are a great benefit that employers can offer to their employees. An added bonus is that they’re a pre-tax deduction. However, there’s currently no tax benefit to employers, except if you offer bicycle commuting benefits.
Regular commuting is not tax deductible. However, these commuter benefits may qualify as pre-tax for your employees:
- A public transportation pass
- Parking garage or lot fees
- A commuter vehicle provided by the company to transport employees
There are limits on these deductions. You can only provide pre-tax commuter benefits of up to $280 per month. These contributions must also be recorded under an employer reimbursement plan, requiring you to verify the expense before you provide employees with a pre-tax reimbursement.
Employee contributions to life insurance are pre-tax. The contributions don’t count toward an employee or employer’s FICA or FUTA. However, only the first $50,000 of coverage is counted for FICA. Anything beyond that is taxable.
Pre-tax deductions offer benefits to employers and employees alike. Employers may see a reduction in taxes owed because an employee’s taxable income is reduced. Employees receive less income in their bank account when they utilize pre-tax deductions. This reduces their overall tax liability and the amount they may owe come tax season.
Types of Post-tax Deductions
Since they are taken after you’ve calculated an employee’s payroll taxes, post-tax deductions, also called after-tax deductions, reduce the employee’s net pay and don’t reduce the overall tax burden. Most post-tax deductions don’t show up on an employee’s W-2 because they are simply part of their income that was redirected.
Except for wage garnishments, which are court-ordered, employees can decline to participate in post-tax deductions. Common post-tax deductions include:
The biggest benefit to companies comes with post-tax retirement plans. While there’s no direct economic benefit, offering these plans will help you attract and retain top talent. For employees specifically contributing to post-tax retirement plans like a Roth 401(k), their biggest benefit is that the money they contribute grows tax-free. It’s also not taxable when they take the money out as a retirement contribution.
Pre-tax vs Post-tax Deduction Calculation Example
Let’s look at how pre-tax and post-tax deductions work in practice.
Say Anna earns $1,000 per pay period in gross wages. She contributes $150 per pay period toward health insurance (pre-tax deduction), reducing the taxable income to $850. This saves her taxes on the $150 per pay period because the tax burden is calculated on $850, not $1,000—meaning she will only be taxed $192.53, resulting in a net pay of $657.47.
On the other hand, say Anna instead has a wage garnishment of $150 for an unpaid bill. Because this is a post-tax deduction, it doesn’t affect the payroll tax calculation or reduce Anna’s income tax burden—meaning her $1,000 pay would be taxed by $226.50, and then deducted the $150, resulting in a net pay of $623.50.
The most common mistake employers make when calculating payroll is subtracting deductions at the wrong time. Pre-tax deductions must be removed from the payroll tax calculation before determining tax liability. Post-tax deductions aren’t factored into the payroll tax calculation.
Pre-tax deductions are just one of many parts of running payroll. While they don’t affect taxes directly, post-tax deductions must also be considered. Following this guide is a great start to ensuring you pay your employees correctly and on time. To help you eliminate mistakes, consider partnering with a trusted payroll software that can do these calculations for you automatically.