If your employer chooses to offer voluntary benefits it can do so on a pretax or post-tax basis. The Internal Revenue Service and applicable state and local governments have different taxation rules for pretax benefits, which reduce taxable wages. Post-tax benefits do not lower taxable wages.
Pretax benefits include qualified 401(k) contributions and parking and transit fees. They also include section 125 cafeteria plans that include health, life and accident insurance, health savings accounts and adoption and dependent care assistance. Post-tax benefits include Roth 401(k) contributions, union dues. They also include disability insurance, health insurance and commuter benefits that do not qualify as pretax.
Your employer takes pretax premiums out of your wages before it withholds taxes from your paycheck. This process lowers your taxable wages and gives you more take-home pay than if the benefit were post-tax. Under federal law, many pretax benefits are not subject to federal income tax or Social Security and Medicare taxes. However, there are exceptions. For example, premiums on group-term life insurance that exceed $50,000 in coverage and qualified adoption assistance and 401(k) contributions are subject to Social Security and Medicare taxes, but not federal income tax. Many state and local governments follow federal rules for state and local income tax purposes. But again, exceptions may apply. For example, the state of Pennsylvania and the city of Pittsburgh both include pretax deductions as taxable wages for state and local income tax purposes.
Calculating these benefits is not difficult. For example, assume that you earn $900 biweekly and elect 6 percent of your wages toward your pretax 401(k) plan. Multiply $900 by .06 to get $54, which is your biweekly 401(k) contribution. Subtract $54 from $900 to arrive at $846, which is the amount subject to federal income tax. If you had a Roth 401(k) account, the entire $900 would be subject to federal income tax. The key to figuring which benefit yields tax savings is to determine which ones are pretax and post-tax and the taxes they are subjected to. If necessary, consult your payroll department or the respective administering agency for this information.
It might appear that after-tax benefits do not have tax advantages, but this is not true. You can often claim these deductions on your tax return. Although pretax 401(k) contributions are not subject to federal -- and in most cases state and local -- income tax, these taxes are due when you withdraw your money from the plan. With a Roth 401(k), you do not pay taxes on your contributions when you withdraw your money, as you already paid the taxes through payroll deduction. Also, if you have a pretax 401(k) account and the tax rate will be higher in the future, you’ll end up paying more tax when you withdraw your money.
- IRS.gov: FAQs for Government Entities Regarding Cafeteria Plans
- The McClatchy Company: Pre-Tax Parking/Transportation Benefit 2012 Contribution Limits
- Upstate Medical University: Health Insurance Frequently Asked Questions (FAQs)
- American University: Benefits and Deductions Related to Pay
- American Funds: Traditional vs. Roth 401(k)/403(b) analyzer
- Pittsburgh Department of Finance: FAQ - Business and Wage Tax