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.
Pre Tax vs. Post Tax Benefits
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. These savings accounts allow employees to set pretax dollars aside for expenses like medical appointments, prescriptions and childcare at no additional cost to themselves or the employer. But there are pre tax or post tax health insurance savings plans because the government sets a limit on the pretax dollars that can be set aside for HSAs. As of 2018, that limit was $2,650 per year.
Post tax deductions include Roth 401(k) contributions and union dues. They also include disability insurance, health insurance and commuter benefits that do not qualify as pretax. The IRS mandates a limit to the amount of commuter benefits an employer can pay without imposing taxes. As of 2018, that exclusion is $260 per month for parking or transit passes. The expense must also qualify as covered under the IRS's rules for Qualified Transportation Benefits, as outlined in IRS Publication 15-B: Employer's Tax Guide to Fringe Benefits.
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.
Calculations and Considerations
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.