Offering employee benefits is an effective tool for recruiting and retaining talent for many organizations. However, every employer offering benefits has to deal with the ins and outs of pre-tax and post-tax deductions.
Both pre-tax and post-tax benefits have their pros and cons. Generally speaking, pre-tax deductions provide an immediate tax break, while post-tax deductions give employees a bigger paycheck.
But the nuances of pre-tax and post-tax benefits can be complicated, so it’s essential to understand how they work before you offer them to your employees.
In this article, we’ll define pre-tax and post-tax benefits, including typical examples of each, so that you can choose the best benefits for your organization.
What are pre-tax benefits?
With pre-tax benefits, the value of the benefit is deducted from an employee’s paycheck before federal income and employment taxes are applied. By withholding deductions before you withhold taxes, the employee’s total taxable income amount is lowered, reducing the amount of ordinary income tax the employee has to pay.
A pre-tax deduction lowers tax liabilities for employers and employees. However, the employee might owe taxes in the future when they use the benefits. For example, an employee who retires will owe taxes when they withdraw money from a pre-tax 401(k) plan.
Not all pre-tax benefits are exempt from all federal tax withholdings. For instance, adoption assistance is exempt from federal income tax. But, adoption assistance isn’t exempt from Social Security, Medicare, or FUTA tax.
Additionally, pre-tax benefits may not be exempt from all state and local taxes, so employers should check their state and local laws to find out which benefits are exempt.
Common examples of pre-tax benefits
Pre-tax benefits come in various forms, so it can be tricky to determine which ones you should offer to your employees.
To make things easier, the following common benefits involve pre-tax deductions and can lower your employee’s overall tax burden each year.
Health insurance plans
Health plans are a popular pre-tax benefit. An employer-sponsored health plan refers to health coverage that an employer purchases for their employees and their dependents. Usually, the employer splits the cost of pre-tax premiums with their employees.
Common types of pre-tax employer-sponsored health plans include:
- Group health insurance plans
- Dental insurance plans
- Vision insurance plans
Another health benefit that uses pre-tax funds is a health reimbursement arrangement (HRA). HRAs are employer-funded health reimbursement plans that help both employees and employers save on healthcare costs.
The employer contributes pre-tax dollars for employees to pay for out-of-pocket medical expenses and sometimes individual health insurance premiums. Employers are also exempt from payroll taxes on the contributed amount.
Finally, employee reimbursements are income tax-free, as long as their health insurance policy meets minimum essential coverage (MEC).
Health savings accounts (HSAs)
A health savings account (HSA) is also in the pre-tax group. This tax-advantaged employer- and employee-funded account lets employees set aside pre-tax money to pay for healthcare items.
Employee contributions deposited directly from their paycheck are from pre-tax dollars, which reduce their gross income. Withdrawals to pay for qualified medical purchases are also tax-free.
Unlike a flexible spending account (FSA), employees keep their HSA account and funds even if they quit their job or become unemployed. Money in the account rolls over yearly, and any investment growth is tax-free.
Pre-tax retirement plans
Traditional IRA plans, 403(b) plans, a Thrift Savings Plan, and many 401(k) plans are pre-tax. Every dollar deposited into one of these retirement savings plans reduces an employee’s taxable income by an equal amount.
However, employees are subject to annual contribution limits and, depending on the plan, may still have to pay taxes when they withdraw funds. Also, while these retirement plans are income-tax free, they are still subject to the FICA tax and Social Security taxes.
A pre-tax commuter benefit lets employees deduct the monthly cost of their commute to work. Employers can deduct transportation costs directly from their employee’s paycheck on a pre-tax basis for expenses like parking garage fees and transit passes.
Commuter benefits support employees by increasing their overall take-home pay and providing them with a variety of alternative commuting options, which reduces their overall car expenses.
What are post-tax benefits?
Post-tax benefit contributions, sometimes called after-tax deductions, are taken from an employee’s paycheck after taxes have already been deducted. Since post-tax deductions reduce net pay rather than gross pay, they don't lower the individual's overall tax burden.
Benefits with a post-tax deduction result in the employer and employee paying more income, payroll, and employment taxes. But the employee typically won’t owe any income tax on the benefits when they use them in the future.
For example, an employee who retires will not owe additional taxes when they withdraw money from a post-tax retirement plan. This can make a post-tax deduction more preferable for employees in comparison to pre-tax deduction.
Because taxes are withheld before benefit contributions are withheld, all federal, state, and local taxes are already paid on the contributions.
Common examples of post-tax benefits
Now that you know how post-tax benefits work, how do you know which ones to choose? When considering what post-tax benefits you want to offer at your organization, an excellent place to start is with popular options.
Below we’ll go into detail on common post-tax benefits that employers offer to their employees.
A stipend is a fixed sum of money offered to an employee in addition to their regular wages. Sometimes called an allowance or fringe benefit, a stipend is usually provided on a regular basis, determined by the employer.
Stipends allow employees to pay for various out-of-pocket expenses, such as wellness opportunities, fertility benefits, and remote office equipment.
Stipends are considered a form of taxable income. Therefore, employers must pay payroll tax on stipend reimbursements totaling a tax rate of 7.65% (6.2% for Social Security and 1.45% for Medicare).
Employees are taxed between 20% to 40% on the total amount they receive as income at the end of the year.
Post-tax retirement plans
While some retirement plans are pre-tax,, that’s not the only option. A retirement contribution paid by employees into an account after income taxes get deducted from their paycheck is called a post-tax retirement contribution.
The two types of post-tax retirement accounts are a Roth IRA and a 401(k).
A Roth contribution is made with after-tax dollars. Earnings held in the account for five or more years grow tax-free and qualified withdrawals are tax-free. Roth IRAs are preferable for many individuals compared to traditional IRAs, which require taxes upon withdrawal.
Certain 401(k) accounts are structured similarly. Once an employer deducts payroll taxes from an employee’s wages, the employee can make additional 401(k) contributions.
After-tax 401(k) contributions empower employees to invest more money into their retirement fund and provide them with tax-deferred growth until withdrawals begin.
Employees who purchase disability insurance through their company’s group medical plan can choose to pay for its premium with pre-tax or after-tax dollars. Employees make their deduction choice upon signing up for the benefit.
The two types of disability insurance an employee can have are:
- Short-term disability insurance: This type of insurance usually covers employees' wages from three months to a year.
- Long-term disability insurance: This type of insurance provides coverage for at least 90 days and, depending on the disability, can provide income replacement up to age 65.
- The premium rises the longer the benefit has been in place.
Life insurance premiums are tax-deductible as a business-related expense, typically called a life insurance post-tax deduction. The most common type of post-tax life insurance deduction is group-term life insurance.
Group-term life insurance coverage is a contract issued to employers, which the employers offer as an employee benefit.
The Internal Revenue Service considers employer-provided group term life insurance tax-free as long as the policy's death benefit is less than $50,000. Coverage over $50,000 must be paid post-tax.
Wage garnishment occurs when the court orders an employer to deduct an employee’s earnings due to a debt. If wages are garnished, it’s a post-tax deduction regardless of the reason.
Examples of wage garnishment include:
- Default student loans
- Child support
- Prior medical debt
- Court-ordered fines or restitution
If an employee has pre-tax deductions in place, wage garnishments are taken out of their paycheck based on their total income before any adjustments are made. Exceptions to this are local, state, and federal taxes, other wage garnishments, and other legally required deductions.
Employers must send the payment to the appropriate legislative authority or credit institution until the employee’s debt clears.
Understanding the difference between pre and post-tax benefits is crucial to running a successful business. Pre-tax contributions reduce overall taxable income, but post-tax benefits can result in tax savings in the future.
As an employer, working with a financial professional and getting your payroll deduction right to avoid costly penalties is key. Staying up to date on pre and post-tax benefits, voluntary deductions, and your state and local taxation laws will save you time and future headaches.
This article was originally published on August 20, 2015. It was last updated on April 15, 2022.