What are pre-tax deductions?

During employee onboarding, there’s one question you’ll undoubtedly hear: What’s coming out of your new employee’s paycheck?

Human resources must understand the details of pre-tax deductions for new employees so they can set clear expectations for workers about their salary. This explanation is a crucial part of the initial discussion regarding their total rewards package. Once your new team member has factored this into their larger financial goals, they can focus on their new job role.

Onboarding isn’t the only time to discuss pre-tax benefits. Employers should be up-to-date on policy changes that impact their employee’s total compensation, including retirement savings and 401(k) contributions. Don’t worry—we’ll explain everything you need to know to help your workforce make the best decisions about their pre-tax and post-tax payroll deductions. 

What are pre-tax deductions?

A pre-tax deduction includes any money subtracted from an employee’s gross pay before taxes are withheld. These deductions lower the employee’s taxable income, resulting in lower amounts owed on federal, state, and local taxes. They also reduce the employee’s required contributions to Medicare and Social Security (FICA taxes). 

Employers also benefit from offering pre-tax deductions. Retirement plans (e.g., a 401(k) or SEP IRA), health insurance premiums, and flexible spending accounts (FSAs) can yield tax savings on the Federal Unemployment Tax Act (FUTA), FICA, and state unemployment insurance (SUI). 

The primary motivation behind pre-tax deductions is to incentivize and empower your workforce to plan for financial needs like long-term retirement savings or surprise medical expenses. By reducing taxable income upfront, employees retain more earnings, which can be allocated towards essential benefits and savings. 

Pre-tax deductions vs. Payroll deductions: How they differ

The critical distinction between pre-tax and post-tax deductions is how they affect an employee’s paycheck, taxable income, and overall tax burden. Pre-tax deductions lower taxable income up front, whereas post-tax deductions directly impact an employee’s net pay. 

Employers deduct pre-tax deductions (e.g., contributions to retirement plans, health insurance, or an FSA) from an employee’s gross income before income taxes are calculated. These deductions decrease the amount of taxable income, which lowers the employee’s tax liability. 

Conversely, post-tax deductions are subtracted from an employee’s pay after income taxes and other withholdings (e.g., Medicare and Social Security tax) are applied. These deductions don’t typically reduce an employee’s taxable income, meaning they won’t directly impact the employee’s tax burden. Examples of post-tax deductions include union dues, charitable contributions, and other wage garnishments (e.g., child support and tax liens).

Types of pre-tax deductions

Retirement, healthcare, and insurance coverage are among the most common payroll deductions. Here’s how they impact employers and employees alike: 

1. Retirement contributions

Employees may opt to allocate a portion of their salary toward a retirement plan through automatic payroll deductions. The specific retirement plan typically depends on the employer’s total compensation and benefits package but often includes a 401(k), SEP IRA, or simple IRA.

Once they decide on a contribution amount, employees can earmark funds for stocks, bonds, mutual funds, or other assets depending on their risk tolerance and financial goals. The investment’s growth is tax-deferred until withdrawals are made during retirement.

Some employers match contributions up to a certain percentage. This matching contribution is essentially free money added to an employee’s retirement savings. Employer matching is a common practice to gain a competitive edge when attracting and retaining top talent. 

2. Health insurance premiums

Employer-sponsored health insurance is a pre-tax benefit many companies offer, wherein a portion of the employee’s gross income is deducted. Payroll deductions can also fund other healthcare benefits, including FSAs and health savings accounts (HSAs). These deductions allow employees to set aside pre-tax money towards qualified medical costs. 

3. Commuter benefits

An employer’s commuter benefit policy may include vanpooling, parking fees, public transportation stipends, or bicycle maintenance. The amount deducted from an employee’s paycheck depends on company policy and pre-determined contribution amounts. Commuter benefits are an attractive way to promote sustainable commuting options, lower transport costs, and incentivize workers to come into the office.

4. Insurance coverage

Robust employee benefits packages typically include other types of insurance coverage. However, the tax status of insurance coverage depends on the plan and organizational policies. For example, life insurance is generally considered a pre-tax deduction, whereas disability insurance can be categorized as a pre-or post-tax deduction. 

The federal government may change rules and regulations regarding pre-tax deductions each year. Changes typically happen at the beginning of a new fiscal year so employers can adjust payroll practices and financial planning. It’s crucial to stay informed about changes and consult with tax professionals to understand how these evolving rules impact individual contributions, paycheck deductions, and tax obligations. 

How do pre-tax deductions impact taxes?

In simple terms, money subtracted from an employee’s gross pay leaves less income for taxation. When employees contribute to pre-tax benefits (e.g., retirement plans, health insurance premiums, or flexible spending accounts), these deductions decrease their taxable income base. This leads to tax savings on state and federal income taxes. 

Pre-tax deductions vary from year to year, adjusting for inflation and costs of living. These changes will impact taxable income savings from one tax cycle to the next. 

How to stay compliant with pre-tax deductions

Employers are responsible for documenting and communicating tax information. Here are five tips to remain compliant: 

1. Properly document and store records: Employers must maintain accurate records of employee’s agreed-upon contributions to pre-tax benefits. This includes documenting an employee’s contributions to individual benefits. Documentation must remain up-to-date to simplify potential audits. 
2. Communicate tax deductions to employees: During onboarding and open enrollment periods, clearly communicate tax information to employees and independent contractors. Provide detailed information about eligible benefits, contribution limits, and tax liability, preferably in an accessible employee handbook. Clear communication mitigates legal risks associated with benefits administration and empowers employees to make smart decisions based on their personal financial goals. 
3. Add to payroll protocols: Integrate pre-tax deductions into payroll processes to ensure that payroll correctly calculates and deducts pre-tax amounts from gross pay. Include itemized deductions on pay stubs or earning statements for transparency and clarity, ensuring that employees and auditors can easily understand how deductions impact pay.
4. Check for new regulations: Your in-house payroll team should track updates to federal rules and regulations, which may change at the beginning of a new tax year. If you use a third-party service provider, choose a reputable company and periodically audit payroll reports and tax filings.

Streamline payroll and guarantee compliance with Oyster 

Compliance with pre-tax contributions and payroll taxes requires careful planning and execution. These challenges are magnified with a global workforce.

A comprehensive payroll program protects your organization and prepares your employees for financial success. Learn more about Oyster’s global payroll service and seamlessly automate deductions, invoices, and reimbursements.