Unlocking the Benefits of Pre-Tax Deductions: A Comprehensive Guide to Utilizing These Tax Benefits

As an HR pro, you’re likely looking for ways to improve your workplace for your employees. you’re likely providing your team with top-notch benefits. Depending on the perk, you are also managing how the related taxes will work. Some benefits are often deducted before taxes while some are done post-taxes. For example, a 401k or health insurance program is likely pre-tax. Life insurance, however, is often post-tax. Each of these choices for taxation comes with some perks and drawbacks. 

Ultimately, as an HR rep, you’ll want to choose the right fit for your team. On top of that, you also want to be prepared to explain the process to your employees. Discover what pre-tax deductions are and how to leverage them to build your compensation strategy. 

What Are Pre-Tax Deductions?

Pre-tax deductions are any type of deduction taken from an employee’s deduction before any taxes are withheld. Those deductions reduce the amount of income that’s taxable—thereby reducing the amount of money due to the government. Utilizing pre-tax deductions also reduces Federal Unemployment Tax and state unemployment dues. 

Types of Pre-Tax Deductions

Pre-tax deductions can be utilized in quite a few different forms. Here are some of the main types of pre-tax deductions you can take advantage of within your benefits package: 

Retirement Contributions

You can offer perks for employees to contribute to retirement accounts. When you provide this as a pre-tax benefit, you’re also adding  a certain amount to the account for your employees. Retirement benefits might include letting employees add to their 401(k) plans or IRAs pre-tax. 

Health Plans

You can use pre-tax deductions with health benefits. There are a few ways to utilize this. One option is to allow employees to pay insurance premiums before taxes. Another would be to take care of employer and employee HSA and FSA contributions pre-tax. 

Transportation Benefits

If your employees travel to work, consider offering transportation benefits that they can even use pre-tax. For example, you could contribute funds to reimburse employees for public transportation use. That can be done by offering commuter accounts, which allow you and the employee to contribute. 

Dependent Care Benefits

If you offer benefits for employees to care for their children and other dependents, those count as pre-tax deductions too. For instance, you could offer employees a A Dependent Care FSA (DCFSA). Your company can make contributions, and the employee can use them for daycare or caretaker costs. 

How Pre-Tax Deductions Differ From Other Deductions

Pre-tax deductions differ from other deductions in one key way: they’re eligible to be taken from an employee’s paycheck before taxes are deducted. Pre-tax deductions let your employees contribute to their retirement or add to a health savings account from their paycheck before taxes are applied. Ultimately, that will mean employees owe less in taxes.  

The opposite is post-tax deductions. When you take money out after taxes, your employees get a smaller paycheck to take home. These often include life or disability insurance payments. Employees who opt into these benefits will have insurance premiums deducted after taxes are removed. That means they pay more in taxes for each paycheck. 

Staying Compliant with Pre-Tax Deduction Regulations

As an employer, you’re responsible for maintaining documentation on the terms and conditions for your deductions. It might come in the form of a plan summary. You can even put it in the employee handbook. However you do it, it must be available for all employees on a nondiscriminatory basis. You can’t, for example, offer more benefits to your C-suite employees than to your minimum wage workers. 

Organizations are also responsible for ensuring their employees accurately report pre-tax deductions to avoid financial and legal repercussions. Employees receive regular updates about their contributions, and be updated when any changes are made to plans. Their W-2 each year also ought to show pre-tax deductions and taxable compensation. 

Limitations with Pre-Tax Deductions

Pre-tax deductions reduce the amount of taxes someone owes. That’s why the federal government has put limits on how much a company and employees can contribute. In HR, it’s key to know what these are so you can guide your team.

Maximum Contribution Limits

For some benefits, there are maximum limits for how much you can contribute. For example, in 2023, the max amount you could contribute to a 401(k) plan is $22,500, or $30,000 for someone over 50. 

Limitations for High Compensation

There can be limitations to how much an employee and the employer can contribute to a particular benefit, like a 401(k) plan, depending on how much the individual is paid. The goal here is to reduce disproportionate benefits for employees who are paid less. 

Eligibility

Some pre-tax deductions have an eligibility requirement for it, like a dependent care assistance plan (DCAP). To access this benefit, an employee needs to be caring for a child under 12 or someone 13 years or older who’s physically or mentally incapable of self-care. Other pre-tax perks have age requirements that affect how much you’re able to contribute, like a 401(k). 

Specific Plan Rules 

There are some rules that will apply to specific benefits. For example, you might set up a Medicare or Medicaid plan for your eligible employees. Or you may want to deduct uniform and meal expenses. Those perks have rules that may require specialized advice. Consider meeting with a legal team before moving forward with pre-tax deductions to ensure that you’re staying compliant. 

While there are limitations to pre-tax deductions, your company can still use them to support your employees. Financial analysts estimate that pre-tax deductions can save an employee about 25% of their taxable pay.  

Pre-Tax Deductions vs. Post-Tax Deductions: Which Is Better?

Both pre-tax deductions and post-deductions have pros and cons. Pre-tax deductions give your employees some tax relief, but that extra money could be taxed later  in life. This is primarily true for retirement perks. After an employee retires, they will be taxed on the money in their account. So while they save money now, they will pay a portion of it back later in life. 

On the other hand, post-tax deductions don’t reduce what someone owes in taxes, but it won’t be taxed later. When they withdraw from their retirement accounts, it’s tax-free. Still, they pay more in taxes earlier in life. 

When deciding on pre-tax or post-tax deductions, consider what matters to your employees and how you can meet that. If you have a young workforce, they might benefit from post-tax deductions where they don’t pay taxes on decades of growth. The reverse could be beneficial, as well. If you have an older workforce, you may consider pre-tax to save them from higher taxes as well. 

Maximizing The Impact of Your Employee Benefits

Boosting the support you offer employees through pre-tax benefits is about more than the numbers — it's about taking care of the wellbeing of your people. Lightening their tax load can help them leverage essential benefits, like healthcare, that they need to take care of themselves. 

Deductions are one small part of integrating employee wellbeing into your benefits package. And fostering workforce wellness helps businesses advance — 90% of companies that measure their wellness program see a positive return on investment.

Talk to a Wellbeing Specialist today to add wellness into your benefits package!

References

• ADP. (n.d.). What are payroll deductions? Retrieved January 25, 2024 from https://www.adp.com/resources/articles-and-insights/articles/p/payroll-deductions.aspx.
• Bamboo HR. (n.d.). Pre-Tax Deduction. An HR Glossary for HR Terms. Retrieved January 25, 2024 from https://www.bamboohr.com/resources/hr-glossary/pre-tax-deduction.  
• IRS. (2023, May 24). Federal Unemployment Tax. Retrieved January 25, 2024 from https://www.irs.gov/individuals/international-taxpayers/federal-unemployment-tax.  
• Kiper, S. (n.d.). Pre-Tax Deductions. Eddy. Retrieved January 25, 2024 from https://eddy.com/hr-encyclopedia/pre-tax-deductions/.  
• Nguyen, J. (2023, July 31). What Are Pre-Tax Deductions? Forbes. Retrieved January 25, 2024 from https://www.forbes.com/advisor/business/pre-tax-deductions/
• SHRM. (n.d.). What is a dependent care assistance plan (DCAP)? Retrieved January 25, 2024 from https://www.shrm.org/resourcesandtools/tools-and-samples/hr-qa/pages/dependentcareassistanceplan.aspx. 
• Walker, E. (2023, March 6). Understanding pre vs. post-tax benefits. Retrieved January 25, 2024 from https://www.peoplekeep.com/blog/pre-tax-vs-post-tax-benefits.