Participating in employer pretax plans allows you to receive coverages and benefits designed to enhance the medical and financial health of you and your family. Pretax benefits you elect to purchase reduce your taxable income, which in many cases means you'll pay less for your coverages than you would if you bought into a private plan funded with after-tax dollars. Some plans have a limit to the amount you can contribute pretax each year, so in most cases you won't receive an unlimited advantage from this type of deduction.
A tax deduction reduces taxable income. Tax credits reduce the amount of tax you owe.
Pretax Plans and Tax Deduction Definition
Pretax deductions are deducted from gross wages before the calculation of taxes and after-tax deductions. This reduces the income amount your employer uses to base your tax withholdings from. When you receive your W-2 at the end of the year, the gross income you report to the Internal Revenue Service doesn’t include the income used for your pretax deductions. Depending on how close your income is to a lower tax bracket, you may realize significant tax savings when you purchase pretax benefits.
You can’t deduct any items on your tax return that you paid for with pretax deduction dollars. For example, amounts you pay for health insurance, flexible spending account contributions, and 401(k) contributions are excluded from additional tax deductions. This is because you already receive a benefit for these expenses by not paying tax on the money used to purchase them.
Tax credits also work differently, enabling you to offset a dollar of taxes owed rather than a dollar of taxable income for each dollar of tax credit.
The pretax dollars you use to purchase certain benefits may be limited to annual contribution amounts. The IRS sets the annual limits for maximum contributions, but your employer may set its own maximums for some plans, as long as those limits are less than the IRS limits. Examples of pretax deductions with limits include retirement plan contributions, dependent care assistance, education assistance, and transportation benefits.
Social Security and Medicare Exceptions
Some pretax deductions, such as 401(k) contributions, are still subject to Social Security and Medicare tax. This doesn’t affect the taxable income you report on your tax return, but you may notice that the Social Security and Medicare tax you pay during the year is based on a higher gross income amount than that computed for income taxes. This is in some ways an advantage because it increases your Social Security credits and your future Social Security benefits.
2018 Tax Law Changes
The basic rules around pretax employee benefits aren't changing much for 2018, but tax rates are generally going down, meaning many workers will see slightly less tax benefit from claiming this kind of tax relief.
Some types of programs allowing you to make pretax contributions for transit and parking and medical flex spending accounts have slightly increased pretax contribution limits for 2018. Check with your employer to understand the most you can contribute with each paycheck.
2017 Tax Law
As of 2017, tax rates are generally higher than in 2018, meaning there's more financial benefit to taking a particular tax deduction or using employee pretax payment opportunities.
Tax credits are equally beneficial, as long as they haven't themselves changed, since they offset tax rather than taxable income.