Some employers offer incentives to attract and retain good employees. Those benefits might come in the form of pretax items, which allow employees to obtain a tax advantage on their premiums. The Internal Revenue Service sets the standards that pretax plans must adhere to. For taxation purposes, an employer should consider applicable federal, state and local laws.
Normally, employees’ wages are subject to federal income tax, Medicare and Social Security taxes, and applicable state and local taxes. Employers must also pay their own share of Medicare, Social Security and unemployment taxes based on employees’ taxable wages. If an employee has a pretax item, her employer deducts the benefit from her paycheck before certain taxes are subtracted. This process causes a reduction in her taxable wages and an increase in her take-home pay. Her employer also gets a tax advantage because his portion of taxes for that employee is reduced as well.
Pretax items go by various names, such as section 125 plan, cafeteria plan, pretax plan and salary reduction plan. Regardless of the name used, the plan has the same purpose: to lower taxes for employers and workers. Under IRS regulations, qualified benefits include medical and dental insurance, short- and long-term disability insurance, group legal services coverage, group term life insurance, adoption assistance, medical and child care reimbursements, elective 401(k) contributions, education assistance and transportation expenses.
To offer employees pretax benefits, an employer must establish a plan that meets the requirements of the respective Internal Revenue Code. For example, to offer employees with pretax health insurance, the plan must fulfill the requirements of section 125 of the Internal Revenue Code. This includes establishing and maintaining an up-to-date plan document; distributing a summary plan description to all employees; and if applicable, preparing a salary reduction agreement on each enrollee and filing Form 5500, Annual Return/Report of Employee Benefit Plan. To enable employees to pay for specific transportation expenses on a pretax basis, an employer establishes a plan that meets the criteria of section 132 of the Internal Revenue Code.
An employee should not assume that because an item is pretax, it’s automatically not subject to all taxes. For example, if she has a section 125 health plan, her premiums are not subject to federal income tax, Medicare tax and Social Security tax. While many states and local jurisdictions do not subject section 125 plans to state and local income taxes, a few might. Also, pretax 401(k) contributions are not subject to federal -- and most state and local -- income tax, but Medicare and Social Security taxes apply. If an employee has any question over the handling of pretax items on her paycheck, she should consult with her state taxation agency.
If an employee has pretax deductions, box 1, the “Wages, Tips, Other Compensation” section, of her W-2 form is reduced to reflect annual taxable wages after pretax deductions. The employee may balance her last pay stub for the year with her W-2 by adding her total annual pretax deductions to the amount in box 1. A simplified way of understanding how this process works is to remember that the amount reported in box 1 of the W-2 represents taxable income. Because pretax deductions are not taxable, they are not reported as wages on the W-2.
- Patriot Software: A Look at Qualified Pretax Deductions
- Clemson University: Pretax Payroll Deductions
- IRS.gov: FAQs for Government Entities Regarding Cafeteria Plans
- Suntrust: FAQ
- HR.BLR.com: Payroll Laws: Unemployment Insurance, 401(k) and Section 125
- State of Alaska: How to Read Your Payroll Stub and Yearly W2 Earnings Statement
- Pay Stub image by Haris Rauf from Fotolia.com