Attracting top talent can help drive your business to success, and one way to draw in the best employees is by offering a great benefits package. Perks like health care plans, retirement accounts, dependent care FSAs, and commuter benefits ensure your employees are healthy and happy.
Many of these perks are considered pre-tax deductions and contributions, so they’re taken from the employee’s paycheck before tax is calculated. Like most things pay-related, the IRS has a few things to say about contribution limits and what’s allowable. Here’s what to know.
What are pre-tax deductions and pre-tax contributions?
A pre-tax deduction is money you take from an employee’s gross pay before calculating taxes. The employee usually agrees to contribute a certain amount toward these expenses, and your business can decide to contribute a portion as well. After withholding the funds from the employee’s paycheck, you’ll add them to earmarked accounts on behalf of the employee. Pre-tax contributions work the same way but often refer to employee payments toward a retirement plan.
Every dollar that goes toward a pre-tax deduction or pre-tax contribution lowers an employee’s taxable wages accordingly. They may also lower what you (the employer) pay toward Federal Unemployment Tax (FUTA) and state unemployment insurance dues.
There are usually caps on each type of pre-tax deduction and contribution. For instance, employees can contribute up to $23,000 toward a traditional 401(k) in 2024—whether the money comes from the employee, the employer, or both.
As you might guess, a post-tax deduction differs from a pre-tax one as it’s money you take from an employee’s net salary, which is their pay after calculating and deducting taxes. Post-tax deductions and contributions won’t lower the employee’s taxable income, but they can still benefit the employee.
Types of pre-tax deductions and contributions
Many pre-tax deductions and contributions are optional, so you can decide whether to offer them in your benefits package. Likewise, your employees can decide whether they’d like to participate. Here’s a quick rundown of some of the most common pre-tax deductions and contributions.
Health plans
When employers sponsor health insurance plans, employees can contribute toward the costs as payroll deductions without paying taxes on them. The same goes for health savings accounts (HSAs) and flexible spending accounts (FSAs). For 2024, a couple may jointly contribute up to $6,400 to an FSA per year without being subject to federal income taxes. The annual HSA limit is $8,300 per family for 2024.
Make sure your employees understand how the tax benefit works here. You’re deducting the employee’s portion of a health insurance premium, FSA, or HSA from their paycheck on a pre-tax basis. That means the employee can’t deduct those same contributions as medical deductions on Schedule A of Form 1040. That would be considered “double dipping” because the employee is already receiving the tax benefit upfront.
The employer (that’s you) may contribute to the employee’s FSA and HSA, but you’re not required to. And the portion you pay toward the health insurance premium is not considered income for tax purposes, so it’s not a pre-tax payroll deduction.
Group term life insurance
Some employers include group term life insurance as part of their employees’ benefits package. These employer-sponsored premiums should be treated as pre-tax deductions for federal income tax withholding, FUTA, and FICA. However, the employee only receives the tax benefit on premiums for the first $50,000 of the insurance policy.
Dependent care benefits
If your company offers dependent care assistance programs (DCAPs), employees can contribute pre-tax dollars to an account and use them for eligible dependent care expenses. The limit is $5,000 per household in 2024.
Child daycare costs are one popular expense, but the DCAP account can also be used for things like adult daycare, au pair fees, night care, and more. To qualify for this benefit, the employee will need to have dependent care expenses for a qualifying child, disabled spouse, or dependent who needs care.
Transportation benefits
Transportation benefits help offset the costs of traveling to and from work. These are considered qualified fringe benefits and may qualify as pre-tax deductions. For instance, you can help pay for public transit passes, parking fees, and rideshare expenses. The limit for 2024 is $315 per month for combined commuter highway vehicle transportation and transit passes, plus $315 per month for qualified parking.
You may either reimburse these expenses or help fund a commuter benefits account with pre-tax dollars.
Retirement contributions
The contributions that an employee makes to a pre-tax retirement plan—like a traditional 401(k) or traditional 403(b)—are considered pre-tax deductions for federal income tax purposes. Any contributions the employee makes to a Roth retirement plan, such as a Roth IRA, are considered post-tax deductions.
In 2024, the contribution limit for traditional 401(k), 403(b), and most 457 plans is $23,000. Traditional IRA contributions are limited to $7,000 in 2024.
Adoption assistance
Employees may also contribute pre-tax dollars to an account to pay for qualified adoption expenses. You may contribute to the account as well. For 2024, the limit is $16,810 total, though you can set a lower amount. The amount excludable from an employee’s gross income gradually phases out based on income.
How to comply with pre-tax deductions
If you decide to offer these fringe benefits, make sure you’re following compliance laws. You’ll need to:
- Stick to the contribution limits. Check any federal or state limits on pre-tax deductions and contributions, and make sure you don’t exceed them.
- Keep documentation. Outline the terms and conditions for each benefit, and make them available to anyone in your organization. For instance, you can put this information in your employee handbook.
- Follow compliance laws. You typically must offer the benefit to all eligible employees to prevent potential discrimination.
- Ensure your employees report their pre-tax deductions. You can help by distributing accurate tax forms, such as W-2s, and reports outlining any programs and changes made to the plan.
To make sure you’re following protocol, consider talking with a bookkeeper, CPA, or payroll provider.
