What Is a Pre-Tax Deduction? A Simple Guide to Payroll Deductions for Small Business
Pre-tax deductions are payments toward benefits that are paid directly from an employee’s paycheck before withholding money for taxes. There are two types of benefits deductions: pre-tax deductions and post-tax deductions. Pre-tax deductions reduce the employee’s taxable income which can save them money when filing their federal income tax return. Certain benefits are eligible for pre-tax deductions according to the IRS. For small businesses, pre-tax deductions can also reduce the tax burden of the employer.
These topics will explain what a pre-tax deduction is and how it affects a business’s payroll:
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Does Pre-Tax Deduction Mean?
A pre-tax deduction means that an employer is withdrawing money directly from an employee’s paycheck to cover the cost of benefits, before withdrawing money to cover taxes. When an employee pays for benefits, such as health insurance, with before-tax payments, the deduction is taken off their gross income before taxes.
What’s the Difference Between Pre-Tax and After-Tax Deductions?
Paychecks include two types of deductions: pre-tax and after-tax. There are some work benefits that can be deducted before paying taxes and some need to be deducted after tax. Here are the differences between pre-tax deductions and after-tax deductions:
Pre-tax deductions are taken from an employee’s gross pay before taxes are withheld from the total amount. Because pre-tax deductions are withdrawn before withholding taxes, they help to lower the employee’s taxable income. That helps workers pay less income tax or Federal Insurance Contributions Act tax (FICA), which includes Medicare and Social Security.
Pre-tax deductions can also benefit businesses by lowering the taxes paid by employers, including the Federal Unemployment Tax (FUCA), State Unemployment Insurance (SUI) and FICA.
Every type of deduction has certain rules governing how it’s applied. Some deductions are classified as pre-tax for all types of tax, whereas others might still require that certain taxes be withheld.
There are a number of benefits that are commonly eligible for pre-tax deductions, including:
- Health Insurance: An employer-sponsored health insurance plan, including medical and dental benefits, Flexible Spending Accounts (FSA) and Health Savings Accounts (HSA) are typically classified as pre-tax deductions.
- Life Insurance: Group-term life insurance is exempt from all applicable taxes, up to the $50,000 worth of life insurance coverage per employee.
- Retirement Funds: Contributions that employees make toward certain retirement savings plans, such as a 401(k) plan, are often pre-tax deductions.
- Commuter Benefits: Some commuter benefits that help cover an employee’s transportation costs, including public transit passes and parking fees, are classified as pre-tax deductions.
Post-tax deductions are taken from an employee’s paycheck after all taxes are withheld. Common after-tax deductions include:
- Small business retirement funds, such as a Roth 401(k), for example
- Disability insurance
- Charitable contributions
- Garnishments for unpaid debts
Can You Claim Pre-Tax Deductions?
Can an employee claim a deduction on their income tax return for items that were already included in pre-tax deductions? Nope! If an employee’s benefits are paid with pre-tax deductions, those deductions can’t be claimed on income tax returns. That’s because the amount of the deductions isn’t included in your gross income, so you’ve already received a tax benefit by not paying tax on the funds. If you were to claim it on your taxes, you’d be double dipping.