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. Lets take a look at the difference between pre-tax and post-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. In fact, these types of deductions are beneficial to both the employer and employee as it lowers 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.
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.