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.
Pre-Tax Vs. Post-Tax Deductions
Pre-tax deductions are taken out of your gross wages before your wages are taxed. Conversely, post-tax deductions are taken out of your wages after your wages are taxed.
Common post-tax deductions are life insurance, disability insurance and certain retirement plans such as a Roth 401(k). Since you pay income tax on these retirement plan funds as you contribute to the plan, you'll enjoy tax-free withdrawals. A benefit of post-tax income deferrals is that, typically, retirees are in a lower tax bracket at retirement, which means that the income tax they pay on withdrawals is lower.
Pretax Deductions and Taxable Earnings
Pretax benefits offered under a cafeteria, or Section 125, plan are excluded from federal income tax. Health insurance is subject to a pretax employer health insurance tax deduction, for example. Other such benefits include 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.
How States Treat Pretax Plans
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, 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.
Determining Which Taxes Apply
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. 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.
FICA Pretax Exceptions
Deductions for FICA are different from those for ordinary income tax, and some benefits that are pretax for other income taxes aren't for FICA.
An exception applies, for example, to adoption group term life insurance coverage that exceeds $50,000 in coverage; in that case, premiums are taxable for FICA purposes. Note that 401(k) contributions are subject to FICA taxes as well, through employer matching.
Sample Taxable Income Calculation
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.