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.
2019 Pretax Deductions
Adjusted for costs of living, 2019 pretax deductions are higher than the previous year. Examples of allowable pretax deductions include a fringe benefit exclusion program that allows some workers to make pretax deductions for transit and parking -- up to $265 monthly. If you have an eligible 401(k), 403(b) or 457 retirement plan, you'll be able to contribute up to $19,000. And eligible taxpayers can claim up to $14,080 for adoption assistance.
Check with your employer to understand the most you can contribute with each paycheck.
2018 Pretax Deductions
Pretax deductions were slightly lower for tax year 2018. Transit and parking benefits for employees topped out at $260; eligible 401(k), 403(b) and 457 retirement plan contributions were capped at $18,500; and adoption assistance was a $13,840 maximum.
With a background in taxation and financial consulting, Alia Nikolakopulos has over a decade of experience resolving tax and finance issues. She is an IRS Enrolled Agent and has been a writer for these topics since 2010. Nikolakopulos is pursuing Bachelor of Science in accounting at the Metropolitan State University of Denver.