Your employer takes pretax deductions out of your gross wages before applying taxes, which generally include federal and state income tax and Federal Insurance Contributions Act taxes (which fund Social Security and Medicare). This process can get confusing, as not all pretax deductions are subject to the same taxes.
Federal Income Tax Application
Pretax benefits offered under a cafeteria, or Section 125, plan are excluded from federal income tax. These benefits include qualified medical, vision, dental and accident insurance; group term life insurance; adoption and dependent care assistance; and health savings accounts. Pretax deductions also include qualified 401(k) and individual retirement account contributions and commuter benefits. If you have any of these deductions, subtract the amount from your gross pay before calculating federal income tax. This process lowers your taxable earnings.
State Income Tax Treatment
Most states adopt federal income tax treatment of pretax plans, but a few do not. State laws vary, so contact the state revenue agency for clarification on which pretax deductions are exempt from state income tax. For example, in Pennsylvania, only some Section 125 benefits are excluded from state income tax. This includes employee premiums for coverage for disability, death, hospitalization or sickness. Note that in Pennsylvania, 401(k) contributions are subject to state income tax. If your state deems the benefit as not taxable, subtract it from your gross pay before calculating state income tax. If it’s taxable, subtract it from your gross pay after deducting state income tax.
FICA Application and Exclusions
FICA taxes include Social Security and Medicare taxes, which do not apply to pretax commuter benefits and most benefits offered under a Section 125 plan. An exception applies to adoption assistance and group term life insurance coverage that exceeds $50,000 in coverage; in these cases, premiums are taxable for FICA purposes. Note that 401(k) contributions are subject to FICA taxes as well.
The key to applying federal and state income tax and FICA taxes properly to pretax deductions is to figure which taxes apply to each one. Your payroll or human resources department should have this information.
Assume that you earn $1,350 biweekly. You pay $50 toward your pretax health plan and $60 toward your 401(k). Subtract $50 and $60 from $1,350 to get $1,240, which is subject to federal income tax, and if applicable, state income tax. Since 401(k) contributions are subject to FICA, subtract only your health premium of $50 from $1,350 to get $1,300, which is subject to Social Security and Medicare taxes.
- IRS.gov: FAQs for Government Entities Regarding Cafeteria Plans
- University of California: Pretax Transportation Program
- Patriot Software: What Are Taxable Wages?
- IRS.gov: 401(k) Resource Guide — Plan Sponsors — 401(k) Plan Overview
- Pennsylvania Department of Revenue: IRC Section 125 Cafeteria Plans or Flexible Spending Plans