Deductions Taken Before Taxes
Pretax deductions are subtracted from employees’ wages before taxes are taken out, thereby lowering their taxable wages and increasing their take-home pay.
For deductions to be eligible for pretax status, the employer must have an Internal Revenue Service-compliant plan document on file. For example, you need a Section 125 plan document to grant pretax health benefits, a 401(k) plan document to offer a traditional 401(k) plan, and a Section 132 plan document to provide pre-tax transportation benefits.
The following employer-sponsored deductions are pretax, provided they adhere to the respective Internal Revenue Code:
- Medical, dental and vision insurance
- Life insurance
- Accident insurance
- Health flexible spending accounts
- Adoption assistance flexible spending accounts
- Dependent care flexible spending accounts
- Health savings accounts
- Traditional 401(k), 403(b) and 457 retirement plans
- Expenses for transit passes, parking and commuter highway vehicles
While you can make short- and long-term disability insurance pretax, be aware that if the employee starts using the disability benefit, his or her payments received will be taxable.
As noted, if the deduction is pretax, it should be subtracted from the employee’s wages prior to taking taxes. However, there are several exceptions to this rule, as not all pretax deductions are exempt from the same taxes.
Most pretax benefits are excluded from federal income tax, Social Security and Medicare tax withholding, and federal unemployment tax. However, life insurance coverage over $50,000, traditional 401(k) contributions and adoption assistance benefits are subject to Social Security and Medicare tax withholding but not federal income tax withholding.
Further, employers must pay federal unemployment tax on traditional 401(k) contributions and adoption assistance benefits, but not on group life insurance coverage over $50,000.
Check with your accountant or state revenue agency to determine what is subject to state and local employment taxes.
Deductions Taken After Taxes
There’s a simple rule surrounding after-tax deductions: if it doesn’t qualify as pretax, then it’s post-tax and should be subtracted from wages after taxes are withheld. As a result, after-tax deductions do not reduce taxable wages nor do they increase take-home pay.
Common after-tax deductions include:
- Union dues
- Roth 401(k), 403(b) and 457 retirement plans
- Wage garnishments, including creditor garnishments, child support withholding orders, tax levies, bankruptcy orders and student loans
As previously shown, some deductions can be viewed as both pretax and after-tax — such as life insurance and adoption assistance — since they are subject to certain taxes but not others.
Also, whether certain voluntary benefits should be after-tax varies by employer. For instance, one employer may offer pretax life and disability insurances, while another might provide those benefits only as after-tax options. However, wage garnishments, union dues, and Roth retirement accounts are always after-tax.