Pretax and after-tax deductions vary in that the former lowers taxable wages immediately when you make the deduction and the latter does not reduce taxable wages. An after-tax deduction is taken out of wages after taxes are computed. Pretax deductions don’t always mean that an employee will never pay taxes on his or her contributions. If taxes apply in the future, the tax liabilities are simply deferred until they are due; an example would be pretax 401(k) contributions.

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Types:

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Pretax benefits often come in the form of a cafeteria, or Section 125, plan. This plan may include qualified health, accident and life insurance, flexible spending accounts, such as childcare and medical reimbursement and adoption assistance programs.

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Other types of pretax benefits include section 401(k), 403(b), 457 plans, individual retirement accounts, transportation programs that include public transportation and parking fees.

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Taxation Rules:

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Each pretax deduction has its own tax implication. Most pretax benefits are exempt from federal income tax and Social Security and Medicare taxes. However, life insurance premiums on coverage that exceeds $50,000, and adoption assistance and retirement contributions are excluded from federal income tax, but not Social Security and Medicare taxes. These exceptions apply even if the benefit falls under a cafeteria plan. State and local income tax laws for pretax plans vary; in many cases, federal treatment of pretax plans applies. If the state or local government counts pretax deductions as taxable, you employer will include them in your taxable wages.

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Calculation Example:

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Assume that an employee earns biweekly salary of $1,500 and contribute $110 toward a pretax 401(k) plan and $50 toward a cafeteria health plan. Subtract $110 from $1,500 to get $1,390, which is subject to federal -- and likely state -- income tax. Since 401(k) contributions are included in Medicare and Social Security wages, the entire $1,500 would be subject to those two taxes. For the health insurance calculation, subtract $50 from $1,500 to get $1,450, which is subject to federal - and likely state - income tax, plus Social Security and Medicare taxes.

 

Under the new tax law, many individuals will see their deductions reduced and or eliminated. Taking advantage of pre-tax deductions, is an excellent tool to reduce your taxable income and offset some deductions you will be losing under the TCJA’s.