Pre-Tax Me, Please! The Ins and Outs of Payroll Deductions

October 11, 2018

Payroll deductions can be confusing. Learn the differences between pre and post tax deductions, and how the calculations impact your paycheck.

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Paychecks can be the best things about a job. They can also be one of the most confusing things about a job. After all, only a fraction of the workforce is in an accounting profession. So most of us are probably not experts where accounting and payroll is concerned.

While there are many employees who never question their paycheck (they might not even realize they receive a pay stub with details pertaining to the check), some employees pay attention to every single item in the calculation.

Those employees might even call Human Resources or from time to time for clarification and questions. All of this effort to ensure employees receive proper pay and that net checks reflect the greatest amount possible.

So, what is possibly the most confusing thing on a pay stub?  The verdict:  pre- and post- tax deductions!

Payroll Deductions 2

Deductions in general can be a little confounding because the descriptions are often abbreviations and challenging to decode. However, it’s the calculating of the taxable portion of the deduction that can really drive someone crazy.

Nevertheless, there is a method to the madness! Understanding where to place variables in the equation will help provide clarity where payroll deductions are concerned.

What is a payroll deduction?

It would certainly be lovely if we all received our paycheck with that robust gross amount intact.  Unfortunately, unless we are contract workers, it is likely that there is a pretty big disparity between the gross and net amounts.  For that difference, we can thank… the payroll deductions (cue ominous music).

Employers know that payroll deductions tend to get employees thinking (and some even saying), “They took that much out for that?!” Rest assured that there is a silver lining: some payroll deductions are not taxable for certain taxes.  That means the deduction is made before taxes are calculated.

The payroll tax deductions that may be itemized on an employee’s paystub include Federal Income Tax (FIT), State Income Tax (SIT), local taxes, State Disability Insurance (SDI), and Medicare and Social Security (FICA).  The assessment of these taxes vary from state-to-state, so be sure to check with a tax professional to ensure that your payroll is assessed properly.)

What is a post-tax deduction?

Payroll Deductions 1The easiest payroll deductions to understand are the post-tax deductions, which you will also hear referred to as after-tax deductions.  Post-tax deductions are a simple subtraction problem.

For example, if your employee’s gross paycheck is $1,000, and your employee has a deduction for a garnishment in which the liability is $192, that deduction will be taken after the taxes are calculated (which is why these deductions are called post- or after-tax deductions).

Some common post-tax deductions include:

  • Certain retirement plans, such as the Roth 401(k)
  • Disability insurance
  • Life insurance
  • Garnishments

What is a pre-tax deduction?

The pre-tax deduction is a little more complicated than the post-tax deduction, because it involves an in-and-out, and then a back in again.  In other words, the deduction is made before the taxes are calculated, so the tax calculation doesn’t look as clean.

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Some common pre-tax deductions include:

  • Health insurance premiums
  • Dental insurance premiums
  • Retirement plans such as the Simple IRA and 401(k)
  • Health Savings Account
  • Dependent Care Allowance
  • Transportation reimbursement or commuter benefit programs

How are pre-tax deductions calculated?

Seeing a sample pre-tax calculation is something that can help clarify the confusion surrounding a pre-tax deduction.

For example, let’s start with the gross $1,000 paycheck again, and pretend your employee uses a Dependent Care Account in order to be eligible for a reimbursement for childcare payments.

The equation would start with the $1,000 gross, followed by a subtraction for the $192 DCA amount, and then a calculation for the taxes based on $808 (which is $1,000 minus $192).  Then the equation would return to that $1,000 gross, subtract the tax amount, and then subtract the remaining deductions.

Payroll deductions tables

What is the most noteworthy thing about the two sample deductions?  Most people will notice right away that the calculation is longer for the pre-tax example, but the net paycheck at the end is $38.40 more.  Multiplied out over 26 pay periods in a year, that ends up being $998.40 extra that the employee takes home.

The only other place that money would have gone would have been into the government’s pockets.

Why do we have pre- and post-tax deductions?

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Ashlee Faulkner, President of Business Development & Regional Shareholder, Journey Payroll Colorado

As if life isn’t confusing enough, why must we have different types of deductions?  Why not just simplify things and stick with one or the other?

The simple truth of the matter is that pre-tax deductions are the government’s way of encouraging both the employer and the employee to participate in certain plans.  The government also benefits in various ways from each type of pre-tax deduction.

As Ashlee Faulkner, President of Business Development for Journey Payroll Colorado explains,

Knowing what is mandatory and what is optional is the biggest part of understanding deductions on your paycheck. There are tax benefits to some deductions that really help you save money each year. There are also perks to having insurance deductions, 401k deductions, and even HSA deductions come right out of your check. Then there’s the compliance piece of having garnishments or child support amounts held from employees’ checks and sent straight to the garnishee. Getting the right advice is huge in making sure your mandatory deductions line up for each individual!

How employers benefit

Employers are continuously looking for a ways to lower costs and increase revenue or profit.  In other words, the focus is always on their bottom line.  So, the government gives businesses the opportunity to offer fringe benefits whose costs may be tax-deductible, and also may not be subject to certain taxes.

When the employee isn’t required to pay FICA for a pre-tax deduction, the employer is not required to pay FICA on that portion of the earnings, either.

Furthermore, while fringe benefits in general entice good candidates to a company and help aid in employee retention, pre-tax benefits are even more enticing because they lower the taxable income for the employee and raise their take-home pay.

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How employees benefit

Payroll Deductions 4As mentioned, employees benefit from pre-tax deductions because their net paycheck is effectively more than it would have been had all the deductions been post-tax.  While some people enjoy getting a nice, fat tax refund at the end of the year, others recognize that refund as repayment from the government on a loan that was given to them without interest.

Yes, you heard correctly:  if you receive a huge tax refund at the end of the year, you have essentially given the government an interest-free loan.  Taking advantage of pre-tax opportunities allows you to hold on to your money, and—here’s an idea—maybe even save or invest it!

How the government benefits

It might not seem like the government is benefiting when they aren’t collecting taxes up front. However, they often make up for it on the back-end by the trickle-down effect of plan they are offering.  For example, the government encourages pre-tax deductions for health insurance premiums. Therefore, they know, based on the data, that a certain number of people have health insurance.Payroll Deductions 5

People covered by health insurance typically do not become as much of a social or economic burden. The reason being you cannot have coverage under government healthcare assistance and employer-provided or private healthcare at the same time. That’s just one way the government benefits from the favor of allowing pre-tax deductions.

There is one thing to keep in mind: at the end of the year, you may not double-dip on taxes.  In other words, if you maxed out your contributions for itemized pre-tax deductions one year, you can’t consider them for a tax refund when you file your taxes for that year.

Being the bearer of good news

Now that you know the difference between a pre-tax and post-tax payroll deduction, and you understand the calculations, hopefully you will not feel so intimidated if an employee approaches you with a question.

You can explain what the deduction is and ways in which each type can benefit employee’s pocketbooks.  Heck, this wealth of knowledge might even cause you to take a second glance at your own pay stub.

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