A Small Business Guide to Pretax Deductions

Pretax deductions reduce both employers’ and employees’ tax liabilities. The Ascent explains how pretax deductions work and how they can benefit your company’s bottom line.

Pretax deductions are a treat to employers and employees. Employees get to make tax-advantaged contributions to health and retirement plans while employers enjoy lower payroll costs.

Overview: What are pretax deductions?

The gross amount specified in your employees' employment contracts isn't the same as what they ultimately receive in their bank accounts. Prior to disbursement, their earnings are subject to various taxes and deductions.

A pretax deduction is an amount removed from an employee’s gross earnings before any taxes are withheld. These deductions are beneficial for both employees and employers because they help reduce the amount of taxable income. By lowering taxable income, pretax deductions can decrease the amount owed for Federal Insurance Contributions Act (FICA) taxes, as well as federal and state income taxes, not to mention certain employer-paid payroll taxes, such as those under the Federal Unemployment Tax Act (FUTA).

Common types of pretax deductions include contributions to health insurance and retirement plans, but there are many others. The specifics of what can be considered a pretax deduction can be intricate, as the IRS sets the criteria for what qualifies as a pretax deduction for each type of tax, and these criteria can vary. For instance, employee contributions to a traditional 401(k) retirement plan may qualify as a pretax deduction for federal income tax purposes but do still incur FICA taxes.

Navigating these details can be complex, but fortunately, payroll software is designed to manage these rules efficiently. Once properly set up, it automatically calculates and applies the correct deductions, ensuring compliance and accuracy in payroll processing.

Pretax deductions vs. post-tax deductions: What's the difference?

Pretax and post-tax deductions bookend the paycheck calculation. The middle of the deduction sandwich is payroll tax withholding, where you calculate and withhold a portion of employee pay for federal and state income taxes. This intermediate step is where you withhold and remit FICA taxes.

Pretax deductions are tax-advantaged because they aren’t subject to all the payroll taxes the rest of your earnings are. Post-tax deductions are the equivalent of an employee immediately spending a portion of his or her paycheck, offering no payroll tax benefit.

Say Ricky earns $1,000 per pay period in gross wages, earnings before paycheck deductions. He contributes $30 per pay period for health insurance costs. His taxable earnings are $970 ($1,000 gross pay - $30 pretax deductions).

FICA and federal income taxes are based on $970 of wages, not $1,000. As a business owner, you’re responsible for paying half of FICA, so his contribution to a health insurance plan brings down your business’s payroll taxes.

Ricky’s wages are also garnished by $50 per pay period due to unpaid child support. Since wage garnishments are post-tax deductions, it doesn’t affect the payroll tax calculation, even though Ricky never sees the money in his bank account.

Types of pretax deductions

Pretax deductions are a powerful tool to reduce your income tax, but not all pretax deductions are made equal. These deductions have restrictions, so check with a tax professional before processing payroll that includes them.

You can find a list of pretax deductions and restrictions in IRS Publication 15, Section 15.

1. Health plan contributions

An employee’s contribution to certain health plans may qualify as pretax deductions. Contributions to health, vision, and dental insurance plans, Health Savings Accounts (HSA), and Flexible Savings Accounts (FSA) may be taken as pretax deductions.

Except for some restrictions, employer-paid healthcare is not considered income to the employee and is not a pretax payroll deduction. Instead, businesses deduct health plan costs on their business taxes.

The Affordable Care Act requires employers to list their contributions to health plans on employees' Form W-2, but that doesn't mean it's taxable.

2. 401(k) contributions

When an employee pays into a pretax retirement account, it reduces his or her federal income tax bill.

Not all retirement accounts are pretax. Whenever you see the word “Roth,” it means you’re contributing after-tax money. The traditional 401(k) is the most common pretax retirement plan.

Like health plans, an employer’s contribution to an employee’s pretax retirement account doesn’t qualify as a pretax deduction. Your business writes off the contribution as a business expense.

Employee 401(k) contributions are pretax deductions for federal income tax purposes, but not for FICA taxes. Both your business and your employees pay FICA taxes on employee pretax retirement contributions.

Your employee will owe income tax on 401(k) contributions as they’re withdrawn during retirement.

3. Commuting programs

Certain commuting programs qualify as pretax deductions. Washington, D.C., where I live, lets employees make a pretax deduction up to $265 per month to put toward their daily commute, from parking to bus fares.

Not all areas have a commuting program that qualifies for a pretax deduction, and not all employers must offer the program. Check with your local government to see what’s offered.

4. Group-term life insurance contributions

Contributions to group-term life insurance are pretax deductions for federal income tax withholding, FUTA, and FICA. The catch: Only the first $50,000 of coverage is considered a pretax deduction for FICA.

An example of a pretax deduction

The key to getting pretax deductions right is determining the taxable wage base for every payroll tax. Follow these steps the next time you do payroll.

1. Identify potential pretax deductions
2. Identify applicable payroll taxes
3. Calculate the employee’s gross wages
4. Calculate the taxable wage base for each payroll tax

Meet Sara, an employee at local craft store, Holy Craft. She earns a $48,000 annual salary and is paid twice monthly.

1. Identify potential pretax deductions

Some facts about Sara’s pretax deductions:

• Sara pays $40 toward her health insurance premiums out of each paycheck
• She contributes $100 per paycheck to a traditional 401(k)

2. Identify applicable payroll taxes

Like most employees, Sarah’s earnings are subject to the following payroll taxes. Some taxes are employer-paid, employee-paid, or paid by both.

• Medicare and Social Security, collectively called FICA
• Federal Unemployment Tax Act (FUTA)
• State Unemployment Tax Act (SUTA)
• State income tax
• Federal income tax

3. Calculate the employee’s gross wages

Divide Sara’s annual salary by the number of times she’s paid during the year. Her gross pay for the period is $2,000 ($48,000 annual salary / 24 pay periods).

4. Calculate the taxable wage base for each payroll tax

As I mentioned, not all pretax deductions work the same. For this example, we’ll look at just federal-level taxes. Check with your state and local tax offices for the regulations on payroll deductions.

Sarah’s health insurance contribution is a pretax deduction for all three federal-level taxes, making her taxable wage base $1,960 across the board ($2,000 gross pay - $40 health insurance contribution).

Her 401(k) contribution, though, is still subject to FICA and FUTA taxes. Holy Craft won’t withhold federal income tax on her 401(k) contribution.

You’re a third of the way there

Pretax deductions are just one facet of running payroll. If you’ve followed to the end, move on to our guide to doing payroll manually.

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