Pre-tax deductions reduce taxable income because they are amounts withheld from an employee’s paycheck before income taxes are applied. Because these deductions lower the total amount of income subject to taxation, they can result in tax savings.
When tax season rolls around, taxpayers look for ways to legally lower their tax liabilities. One of the most effective ways to reduce taxable income is through pre-tax deductions - a term that often appears in payroll and tax documents, but may not always be fully understood.
Our aim is to explore how pre-tax deductions work, how they reduce taxable income, and which deductions qualify. Whether you’re looking to maximize your take-home pay, or an employer looking to better utilize benefits packages, understanding this topic better can lead to help you achieve your goals.
How will pre-tax deductions affect taxable income?
Pre-tax deductions directly impact gross pay by reducing the amount of taxable wages, which in turn lowers the amount of taxes withheld from a paycheck.
They are different to post tax deductions, which affect your income after taxes (net income) e.g. a garnishee order, or child support payments. Payroll deductions are the all encompassing term that describes all deductions (pre- and post-tax) taken from an employee’s paycheck.
Another example of this is a 401(k) contribution made on a pretax basis will lower taxable income, while a Roth 401(k) contribution (which is post-tax) will not.
Further helpful information: Roth vs. Pre-Tax Retirement Contributions
Breakdown of how pre-tax deductions affect taxable income
Since pre tax contributions are taken before federal, state, and sometimes payroll taxes (Social Security and Medicare) are calculated, they lower the total amount of income subject to taxation.
Example:
Category | Without pre-tax deductions | With pre-tax deductions |
Gross Salary | $70,000 | $70,000 |
401(k) contribution (pre-tax) | $0 | $6,000 |
Health Insurance Premiums (pre-tax) | $0 | $2,000 |
Taxable income | $70,000 | $62,000 |
Estimated federal tax (22%) | $15,400 | $13,640 |
Understanding taxable income
Taxable income is the portion of earnings on which an individual or business must pay taxes. The IRS determines this amount by subtracting eligible deductions and exemptions from total income.
Common pre-tax deductions
Employers offer a variety of pretax deductions as part of benefits packages. Common examples include:
Retirement contributions (e.g. 401(k), 403(b), and an IRA.
Health insurance premiums (medical and dental benefits).
Group term life insurance
Health Savings Accounts (HSA) and Flexible Spending Accounts (FSA).
Dependent Care Flexible Spending Accounts (DCFSA).
Commuter and transit benefits.
While these deductions offer tax advantages (which we will discuss shortly), it’s important to structure them properly. Hall Accounting Company can help both individuals and businesses ensure they are optimizing these tax-saving strategies. Call today, and speak to an experienced tax associate.
Retirement contribution (401(k), 403(b) and IRA)
These contributions are made before taxes, and grow tax-deferred, which means taxes are paid only when withdrawn in retirement. If an employee earns $70,000 a year and elects to contribute $10,000 to a traditional 401(k), their taxable income is reduced to $60,000.
In a very simplistic calculation, a 22% tax rate on this amount equals $13,200 in annual taxes, versus $15,400. That’s a saving of $2,200 per year.
Limitations for contributions towards retirement plans have been set at $23,500 for the current tax year. This applies to employees under the age of 50. It is also worth noting that while 401(k)s lower taxable income, they also reduce Social Security and Medicare wages, which will have a future impact on the benefits available to you.
Health Savings Accounts (HSA) & Flexible Spending Accounts (FSA)
HSA contributions which are available with high-deductible health plans are pretax, tax-free for qualified medical expenses, and also grow tax-free. An HSA contribution is viewed as a voluntary payroll deduction, since you must specifically request it to be withheld. If you elect to contribute $3,000 to an HSA, your taxable income is reduced by that amount.
Annual limitations for HSAs will increase to $4,300 for individuals and $8,550 for family coverage for 2025.
FSA contributions also lower taxable income, but they must be utilized within the plan year to be eligible.
Health Insurance Premiums
Employer-sponsored health, dental, vision life and disability insurance premiums are deducted on a pre tax basis, reducing both income and payroll taxes.
Dependent Care Flexible Spending Accounts (DCFSA)
Employees can contribute pretax dollars to a dependent care FSA to cover eligible dependent expenses (children under the age of 13, and elderly dependents). The IRS limits contributions to $5,000 a year per household.
A list of eligible expenses that can be paid using the DCFSA are:
Daycare
Preschool tuition
Au pair fees
Babysitting fees (during work hours)
Adult day care facilities
Commuter & Transit Benefits
Employers can offer pre tax benefits for public transportation, parking, and commuter expenses. The IRS sets annual limits on these benefits, but employees can still benefit from this deduction.
For example, if an employee contributes $300 monthly for public transit expenses on a pretax basis, their taxable income is reduced accordingly in that pay period.
How are payroll deductions reported?
Payroll deductions are reported on an employee’s pay stub and in the employer’s payroll records, detailing the amounts withheld with each paycheck for taxes, benefits, and other deductions. These deductions fall into the two categories that have been discussed previously, pre tax deductions and post tax deductions.
At the end of the year, deductions are summarized on an employee’s W-2 form, which reports total wages earned and deductions withheld for federal income tax, social security, medicare, and any applicable state taxes.
Pre tax deductions, such as traditional 401(k) contributions and health insurance premiums, are not included in taxable wages on the W-2. Furthermore, payroll deductions are reported to the IRS by filing a Form 941 each quarter, or if eligible, an annual Form 944.
How do pre tax deductions affect your tax return?
Pre tax deductions directly impact your tax return by reducing your taxable income, as we’ve been discussing. While they can help decrease your immediate tax burden and avoid you paying large amounts of tax money, they may also affect your ability to claim certain deductions and credits when filing your tax return.
These deductions affect tax withholding calculations throughout the year. This can lead to one of two scenarios:
If your employer withheld too much tax based on your original gross salary, but your taxable income was lower due to pre tax deductions, you may receive a tax refund because you technically overpaid on taxes.
If your employer withheld too little tax based on your wages after the deductions, you may owe tax when filing your return.
Pre tax deductions also do not count as itemized deductions on a tax return. For instance, if you use these deductions for health insurance, retirement, or commuter benefits, you cannot claim them again as itemized deductions.
Further helpful information: How long does an employer have to correct payroll when it is wrong: Texas
Summary: How pre tax deductions affect your tax return
Factor | Without pretax deduction | With pretax deduction |
Taxable income | Higher | Lower |
Federal tax liability | Higher | Lower |
Tax refund | Possibly lower | Possibly higher |
Eligibility for tax credits | May be reduced | May be increased |
Itemized deductions | More expenses eligible | Fewer expenses eligible |
FICA taxes | Higher | Lower (for some deductions) |
Get help with your tax return
While employers can offer many employee benefits that can help to reduce taxable income, the rules and regulations that govern how they are treated on a tax return, are enforced by the Internal Revenue Service.
Each benefit has an effect, not only on taxable income, but also on your ability to claim other deductions, credits, and exemptions. For this reason, it is advisable to seek the help of a tax professional if you want to get the most out of all allowable deductions afforded to you as a taxpayer.
Employees (Individual taxpayers)
Hiring a professional to assess your financial situation and help you with tax planning may feel out of the reach of most people. But this is not true. In fact, spending the money to hire a tax expert can lead to many benefits, such as:
A complete assessment of your financial situation and expert advice on how you can create future wealth for yourself and your family.
The added peace of mind that you do not have to understand complex IRS regulations and apply them at tax time.
A proactive approach to your taxes where you begin implementing tax strategies long before tax season, providing you the opportunity to make adjustments to your income, expenses, investments, etc.
The professional and timely completion of your tax return.
Increased potential to receive refunds, or claim tax credits.
IRS representation if there are any queries, or an IRS audit. This alone is worth the cost of professional services, as dealing with the IRS can be overwhelming (especially in complex tax matters).
Advice on how you can structure retirement benefits, investments, capital gains, and other tax related factors that affect your taxable income.
All individual taxpayers (but especially high-net-worth individuals) should consider the benefits you can get from hiring a professional vs. the cost of such services. If you would like to discuss the financial benefits, and long-term savings you can get from hiring a tax professional, schedule a no-risk, no obligation consultation today with a tax associate at Hall Accounting Company.
Further helpful information: Why are my taxes so high on my paycheck?
Employers (Business taxpayers)
Employers who offer pre-tax benefits to their workforce not only help employees reduce their taxable income but also create financial advantages for their business.
However, structuring these benefits effectively requires compliance with tax laws, payroll regulations, and employee benefit policies. This is where hiring a business tax professional can be highly beneficial.
There are four compelling reasons for investing in these services:
Compliance with tax laws and regulations: A tax professional will ensure your company follows relevant tax codes, helping to avoid costly penalties or audits due to improper deductions. They will further ensure you categorize pre-tax vs. post-tax deductions correctly to ensure accurate payroll processing.
Reduction in payroll tax liabilities: Since benefits reduce the employee’s taxable wages, they can also lower payroll tax obligations when it comes to Social Security and Medicare contributions. This is also true for FUTA, and SUTA contributions.
Improved employee retention: A tax professional can help you structure benefits that would be uniquely suitable to your industry, and the kind of talent you want to attract and retain. They can also ensure proper implementation of Section 125 cafeteria plans, which allow employees to select pre tax benefits that suit their needs.
Proper payroll processing: Payroll processing becomes more complex when numerous employee benefits are offered, and so is the filing of quarterly tax reports. A tax expert can ensure your payroll is done correctly, and submit reports on your behalf.
Further helpful information:
How much does tax planning cost: Dallas SMEs
Why you should outsource bookkeeping as an SBO
Conclusion
Our aim throughout this discussion has been to explore how pre-tax deductions work, how they reduce taxable income, and which deductions qualify. If you have more questions you’d like answered on this topic, feel free to schedule a call with us, we would be happy to assist you. We look forward to hearing from you.
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