Pretax deductions lower your taxable wages, because the deduction is taken out of your wages before taxes are withheld. These deductions are offered through an employer, at its discretion. Pretax plans must meet the Internal Revenue Service’s requirements to qualify as such.
If you work for a large company, you might receive a wide range of pretax benefit choices, including medical, dental, vision, life and accident insurance; retirement plans; health savings accounts; dependent care and adoption assistance; and commuter benefits that include parking and transit or van-pooling expenses. A small company might offer basic health and retirement benefits.
IRS criteria for pretax benefits vary by plan. For example, cafeteria plans must meet the requirements of Section 125 of the Internal Revenue Code, which is why they are often called Section 125 plans. Commuter benefits, however, must meet the requirements of Section 132 of the Internal Revenue Code. If you participate in your employer’s pretax plan, it must give you a copy of the written summary plan description. You should receive a new copy whenever the document is updated or changed.
The difference between pretax deductions and after-tax deductions is that, unlike the former, the latter does not lower taxable wages. This is because after-tax deductions are taken out of wages after taxes are withheld. Pretax deductions are voluntary, so you can stop them at some point; however, some restrictions might apply. For example, early withdrawal from your employer-sponsored 401(k) plan comes with a 10 percent additional tax penalty from the IRS unless you qualify for an exception.
Whereas some pretax deductions are excluded from the same taxes, others are not. Many benefits offered under a cafeteria plan are excluded from federal income tax, Social Security tax and Medicare tax. However, an exception applies to adoption assistance, which is subject to Social Security and Medicare taxes, but not federal income tax; the same goes for group-term life insurance coverage that exceeds $50,000 in coverage and pretax 401(k) and individual retirement account contributions. State and local revenue agencies have their own rules for whether pretax deductions are excluded from state and local income tax. Your payroll department or the administering taxation agency can tell you which deductions are taxable.
Let’s say you earn $1,600 semi-monthly and pay $100 toward your pretax 401(k) plan. Subtract $100 from $1,600 to get $1,500, which is subject to federal income tax. If the state regards 401(k) contributions as taxable, your entire salary of $1,600 would be subject to state income tax; if not, only $1,500 would be taxed. Since 401(k) contributions are subject to Social Security and Medicare taxes, the entire $1,600 would be taxed for those purposes.