Most businesses provide benefits to their employees. These benefits must be withheld from employee’s pay properly, according to the IRS, for businesses to stay tax compliant. Certain benefit deductions are considered pre-tax deductions while others are considered post-tax deductions. In this article, we will take a look at the difference between pre-tax and post-tax deductions. After reading, you should have a better understanding on which deductions are considered pre-tax and which are post-tax, as well as how that impacts ones’ taxable income.
What are payroll deductions?
Payroll deductions are amounts withheld from an employee’s paycheck by the employer. These deductions can vary significantly based on the type of deduction, employee benefits, and legal requirements. Broadly, payroll deductions fall into two categories: pre-tax and post-tax deductions.
Pre-tax deductions
Pre-tax deductions are withholdings from an employee’s paycheck that are taken from the employee’s wages before you withhold payroll taxes on their wages. It is important to note that certain pre-tax deductions are exempt from only income taxes but are subject to FICA (Social Security and Medicare tax) while other deductions are exempt from income and FICA taxes. In fact, these types of deductions are beneficial to both the employer and employee, as they lower the tax liability for both parties. Although the tax liability may be lower in the short term, certain benefit deductions require taxes to be paid in the future. For example, 401(k) contributions are pre-tax deductions, but when an employee retires and begins withdrawing their retirement money, they will then be required to pay taxes on that money. In order for certain qualified benefits to be considered pre-tax deductions, your business must have a Section 125 plan in place.
Examples of pre-tax deductions include:
- Certain retirement plans (like a traditional IRA or 401(k))
- Health insurance
- Dental insurance
- Vision insurance
- Health savings accounts (HSA)
- Flexible spending accounts (FSA)
Let’s look at a quick example:
Joe Smith earns $1,000 per week. He contributions $50 per week to his 401(k) plan and his health insurance costs him $50 per week. This $100 is taken from Joe’s weekly salary of $1,000, then he is taxed on the remaining $900.
Post-tax deductions
On the contrary, post-tax deductions are withholdings from an employee’s paycheck that are taken from an employee’s wages after you have withheld payroll taxes on their wages. These types of deductions do not have an effect on the employer or employee’s tax liability. Subsequently, post-tax deductions do not require future tax payments.
Examples of post-tax deductions include:
- Certain retirement plans (like a ROTH IRA or employer-sponsored pension)
- Life insurance
- Disability insurance
- Charitable contributions
- Wage garnishments
Let’s continue with our example from before:
Joe still earns $1,000 per week. Joe would have payroll taxes withheld on the full $1,000. Then, the $50 in ROTH IRA contributions and $50 in garnishments would be taken from the amount remaining after taxes are withheld.
Conclusion
In conclusion, understanding the distinction between pre-tax and post-tax deductions is crucial for businesses to maintain tax compliance and optimize benefits for both employers and employees. Pre-tax deductions, such as contributions to certain retirement plans and health-related insurances, reduce taxable income, thus lowering immediate tax liabilities. However, they may incur taxes in the future, as seen with 401(k) withdrawals. On the other hand, post-tax deductions, which include life insurance premiums and charitable contributions, do not affect taxable income but also don’t offer immediate tax benefits. The example of Joe Smith’s salary deductions clearly illustrates how these deductions are applied and their impact on taxable income. It’s essential for businesses to properly classify and handle these deductions to ensure compliance with IRS regulations and to effectively manage employee benefits.
Contact our team here for help managing your payroll and deduction process!