What Is a Pre-Tax Deduction?

Pre-tax deductions reduce your income tax.

Employers often offer employees the ability to deduct the cost of certain programs from their paychecks before being paid the remaining amount. Income and social security taxes are mandatory deductions, but other deductions are for benefits that the employee can use such as health insurance premiums. Some types of deductions can be pre-tax, which reduces the cost to the employee.

Significance

Your take home pay is after the applicable income taxes have been deducted. Taxes must be paid on any salary and wages that are earned. This means that if you are in the 25-percent income tax bracket and want to buy something that costs $75, you must earn $100 to pay for it. First, $25 in taxes must come out of the $100, leaving you the $75 to spend.

Function

Income tax rules allow certain payroll deductions to be subtracted from wages or salary before the amount of income tax is calculated. Payroll deductions elected that meet the requirements are called pre-tax deductions. Pre-tax deductions will reduce the amount of wages that are taxable and the amount of income taxes to be paid.

Types

There are several payroll deductions that qualify to be deducted pre-tax. The major types are health insurance, vision and dental insurance, flexible savings accounts for health or dependent care, health saving accounts and commuter costs. If you elect to participate in any of these types of plans offered by your employer, they will be deducted pre-tax from your wages.

Effects

An example will illustrate the savings. Assume your gross wages are $2,000 per pay period, and you are in the 25-percent tax bracket. The payroll benefits you want to have deducted from your check cost $400. If the deductions were taxable, your check would look like this: $500 in taxes deducted plus $400 in elected deductions result in a take home amount of $1,100. Taking your elected deductions pre-tax produces these results: $400 in deductions from gross income leaves $1,600 taxable income. New taxes are 25 percent of $1,600 or $400, leaving a take home check of $1,200. Taking deduction pre-tax increased your take home by $100.

Considerations

Your employer may not offer all of the possible pre-tax deductible programs. Check with your human resources department to determine which programs are offered. Not all pre-tax deductions make sense for everyone. Use the deductions that make sense for you, and you will benefit from the program. A flexible savings account for dependent care does not make sense if you do not have dependents. Try to maximize the pre-tax deductions that you can use. The money in a health savings account, for example, can accumulate until you need it, even in your retirement years.

References

• AARP: Sould I Sign up for Pre-tax Deductions?