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Since the day you received your first paycheck, your pay stub is a recurring reminder of how much of your paycheck heads to tax coffers before you even get a chance to spend it. A pretax deduction is a payroll deduction your employer withholds from your paycheck before it assesses income taxes against your earnings. While these deductions can help you set aside money for a variety of expenses, they can also be used to allow you to harness greater amounts of your earnings.
Pretax Deductions Basics
If you are earning at the 25 percent income tax bracket, you will pay Uncle Sam 25 cents for every dollar for income taxes, and payroll taxes – Social Security and Medicare – take another 6.65 percent. State and local agencies may take their own share, too, so you may end up paying 35 cents in taxes for every dollar you earn. Pretax deductions allow you to divert portions of your paycheck into qualified accounts before your employer assesses income taxes on your earnings – the Internal Revenue Service still requires your employer to withhold payroll taxes on all earnings.
Those withholding amounts can create a significant change in your after-tax earnings, also known as your net pay. The most immediate benefit is that the money contributed to a pretax deduction is earned nearly tax free. Instead of paying 35 percent for state and federal income taxes, you pay only about 7 percent for payroll taxes. In turn, this has the effect of lowering your effective tax rate when all your earnings are considered. For example, if you earn $2,000 each paycheck and your employer withholds $300 in pretax deductions, you pay a total of $21 in payroll taxes for the deducted amount and $595 on the remainder, if federal, state and payroll taxes total 35 percent, for an overall tax rate of 30 percent. Without the deduction, you’d pay $700 in taxes.
Pretax Retirement Contributions
As nice as it would be to funnel all your money into pretax accounts, the IRS places strict limits on what types of funds may be pretax and how those funds can be spent. One of the most common pretax deductions are employer sponsored retirement plans, such as 401(k)s. While your plan administrator may limit the amount you may contribute and the rules about hardship distributions, you will typically need to wait until you reach retirement age to access these funds. At that point, you will owe income taxes on any money you withdraw from it.
HSAs and FSAs
The IRS also allows employers to offer health savings accounts, which are often called HSAs, and dependent care flexible savings accounts, or FSAs. Your employer withholds money on a pretax basis, depositing it into these accounts. Once in the account, you can only access it to cover approved expenses, such as medical procedures and bills or care for dependent children or adults. The downside of these accounts is that you lose any money you leave in them longer than two months and 15 days after your benefit year ends.
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