Many of us know the feeling. You work hard all week, you have bills and rent to pay, then you get your paycheck with that stub attached that translates to something like: “You earned $X this pay period, but you’re only receiving $Y because we sent $Z to the state and federal governments to cover your taxes.”
Paying taxes is pretty much inevitable, but you might catch a break every once in a while that lets you take home a little more pay. It depends on when your employer withholds those taxes from your earnings – before or after he makes other deductions. There’s a definitive line between pre-tax and post-tax deductions for various benefits you might receive as perks of your employment, and even for voluntary contributions and payments you make as well. Understanding the difference between these two types of deducations can help you make informed decisions about your finances throughout the year and come tax time each spring.
Pre-tax deductions come out of your pay before your employer calculates how much to withhold for taxes from the balance, but you might have to pay taxes on the money eventually.
What Are Pre Tax Deductions?
Pre-tax deductions allow you to take home more of your earnings each pay period. Let’s say your gross wages – your paycheck before any deductions are made – are $750 a week. Your employer will withhold a percentage of that $750 for taxes and give you the remaining balance if you have no pre-tax deductions. If he withholds 20 percent for taxes, including income tax, Social Security and Medicare, you’ll receive $600 as your take-home pay: $750 minus 20 percent or $150.
Now let’s say that your employer deducts $50 a week from your pay as a pre-tax contribution toward your health savings account. In this case, he’ll withhold 20 percent of just $700 for your taxes because that $50 comes off the top of what you earn before your taxes are calculated. You’re only taxed on the balance that remains.
Do the math. Only $140 is withheld for your taxes rather than $150 because 20 percent of $700 is $10 less than 20 percent of $750. You might think an extra $10 a week isn’t that big a deal, or you might be the type who carefully watches every single penny you’re entitled to. But either way, the bottom line isn’t just about your take-home pay.
You’re also getting something in exchange for that $50 pre-tax deduction – the benefits associated with your health savings account. And you’re not paying any taxes on the contributions you make to it. That’s tax-free earnings, at least at the time you make the contributions.
There’s something in it for your employer, too. He has to match your contributions to Social Security and Medicare taxes. For every dollar you pay toward these taxes, he must pay a dollar also. So your employer contributes less in taxes on your behalf when you’re lucky enough to have benefits that involve pre-tax deductions.
What Are Post-Tax Deductions?
Now let’s switch it around and consider the same scenario with a post-tax deduction. We’ll use the same pay figures but we’ll assume that you’re contributing $50 a pay period toward a retirement account that’s a post-tax deduction.
Your employer will calculate that 20-percent tax rate based on your full earnings – $750. He’ll withhold $150 for taxes and send that money to the government on your behalf. You have $600 left over. Now your retirement contribution is deducted from that $600, leaving you with take-home pay of just $550. You’ll still eventually receive the benefit of that retirement account, but you’re paying taxes on the money you contribute at the time you make the contributions.
Post-tax deductions include contributions to some retirement plans and premiums for disability or life insurance policies.
Choosing Between Pre-Tax and Post-Tax
The issue of which deductions are pre-tax and which are post-tax is not always black and white. In some cases, you or your employer can make an election to have the deductions treated one way or the other. Some types of 401(k) retirement plans fall into this category, as well as some health, dental and vision insurance policies. Parking and transportation costs can often go either way, too – they can be either pre-tax or post-tax.
It used to be that employers could also take a tax deduction for any contributions they made to an employee’s parking and transportation costs, but that changed as of 2018 under the new tax law. Employees are additionally limited to contributing no more than $260 a month in pre-tax dollars to these accounts.
A word of warning, however. Sometimes the plan or policy provider decides this issue for you. In this case, the tax treatment of the benefit should be clearly defined in the policy or plan documents, which you should have a copy of in your files or be able to online. And even if you do have a choice, you’re typically stuck with your decision for the entire year in which you make the election unless a “qualifying event” occurs that allows you to make changes to your policy mid-year. These events include things like marriage, divorce, the birth of a child or the loss of a dependent.
Understanding Pre-Tax Deductions
All this leaves a big question: Which deductions are pre-tax? Unfortunately, the list is relatively short. The pre-tax deductions list includes contributions to some, but not all, 401(k) and other retirement accounts. It depends on whether they are tax-deferred accounts, which is dictated by the nature of the plan. You can consult your plan documents or ask your human resources department about yours to make sure.
You can’t contribute excessive amounts to these plans, either, taking advantage the tax savings. The Internal Revenue Service caps how much you can contribute annually. The limit is $18,500 in 2018 for 401(k), 403(b) and 457 plans, as well as the Thrift Savings Plans that are offered to employees of the federal government. This is up from $18,000 in 2017. You’re permitted an extra $6,000 as a catch-up contribution if you’re over age 50. The limit on IRA contributions is just $5,500 annually. Similarly, if you are age 50 or older at the end of the calendar year, you can make $1,000 catch-up contributions to your IRA.
Most health insurance premiums for employer-provided policies are paid with pre-tax earnings as well, but again, check with your employer to be sure. This benefit must generally be offered to all employees as a group plan to qualify as a pre-tax deduction. Contributions to flexible spending accounts and to health savings accounts are usually pre-tax deductions, and adoption assistance programs offered by your employer are tax exempt as well.
Navigating Future Tax Implications
Of course, the Internal Revenue Service isn’t going to sit idly by while you earn your income and never impose taxes on that money. Even if you’re lucky enough to make pre-tax contributions to various benefits, the tax man will come eventually.
Maybe you contributed the limit of $18,500 to your 401(k) this year. You did so with pre-tax dollars. The money is now sitting safely in your retirement account, waiting for you to punch the time clock for the last time. The IRS will have its hand out when you retire and begin taking taxes from that account. You’re not escaping taxation on those funds entirely. You’re just postponing it.
But many people find that they fall into a lower tax bracket after retirement than they were in during the years they were working, simply by virtue of earning less. You might have been spared paying a 20-percent effective tax rate on the money at age 40. You’re instead paying maybe a 10-percent effective tax rate at age 66. That’s still a good deal – you come out ahead.
There’s a silver lining to post-tax contributions to retirement plans as well. If you make contributions with taxed earnings, you can later take distributions tax-free in retirement because you’ve already paid taxes on that money.
And as for your pre-tax deduction for health insurance coverage, consider what it would cost you to purchase your own personal health insurance policy separately from your employer. It’s probably significantly more than what your employee coverage costs you, and you’d have to take those premiums out of your take-home pay, what’s left over after tax deductions, and pay them yourself. By the same token, however, you can’t claim an itemized medical expense tax deduction for your employer-provided policy premiums, although you can for private health insurance premiums, at least those that surpass 10 percent of your adjusted gross income. That would be like double-dipping into the IRS’ generosity.
Different Taxes Can Mean Different Rules
Pre-tax deductions are typically exempt from income tax withholding as well as Social Security and Medicare taxes. These include deductions for health insurance premiums. But some retirement plan contributions may only be exempt from income tax withholding. They’re subject to withholding for Medicare, Social Security and federal unemployment tax. Again, it can vary from plan to plan, so check with your employer if you have questions.
Adoption assistance contributions are exempt from federal income tax, but not from Social Security, Medicare or federal unemployment tax.
Deciphering Your Paystub
Keep in mind that these rules apply to taxes at the federal level, and they’re admittedly complex. The effect of pre-tax versus post-tax deductions might be pretty clear regarding both your current take-home pay and when you’ll eventually owe taxes on the money, but identifying which treatment your various contributions qualify for is where it can get tricky.
Your paystub should make it pretty clear – if you can decipher all those boxes. The W-2 form you receive from your employer after the end of the year should clarify things as well. And if you think you might have a choice regarding certain deductions, you can always ask someone in your human resources department about that.
State and Local Taxes
You're not just dealing with federal taxation issues. States often have their own income tax rules and your employer most likely withholds state taxes from your paychecks as well, unless you live in one of the seven states without an income tax. Some states mirror federal guidelines, while others diverge significantly from these rules.
Some states tax income according to your remaining pay after pre-tax contributions. Your employer or human relations department should be able to tell you what’s up with your state taxes as well, but you might want to consult with a local tax professional if you really want to make certain.
Some benefits exist on both sides of the pre-tax versus post-tax equation at federal and state levels, so if you have a choice, you’ll want to go with the option that personally benefits you the most.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.