Offering employee benefits is an effective tool for recruiting and retaining talent for many organizations. When building a benefits package, it’s important to understand which benefits can be paid for through pre-tax contributions and which are covered by post-tax deductions.
Both pre-tax and post-tax benefits have their pros and cons. Generally, pre-tax deductions provide an immediate tax break but impact an employee’s taxable income, while post-tax deductions don’t provide immediate tax relief but won’t be taxed when benefits are used in the future.
In this article, we’ll define pre-tax and post-tax benefits, including typical examples of each, so that you can determine the best benefits for your employees and optimize your tax savings.
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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, you lower an employee’s total taxable income, reducing the amount of federal 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 benefit the deduction was applied toward. 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 taxes, but it 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 determine which benefits are exempt.
Common examples of pre-tax benefits
Pre-tax benefits come in various forms, so it can take time to determine which ones you should offer to your employees. To simplify things, we’ve compiled the following list of benefits that are typically covered through pre-tax deductions.
Health insurance plans
Health plans are a popular pre-tax benefit. An employer-sponsored health plan is health coverage that an employer purchases for their employees and their dependents. Usually, the employer splits the cost of premiums with their employees on a pre-tax basis.
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 exempt from payroll taxes on the contributed amount, and 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, reducing 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 eligible retirement 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 have to pay taxes when they withdraw funds. Also, while these retirement saving plans are income-tax-free, they are still subject to FICA and Social Security taxes.
A pre-tax commuter benefit lets employees deduct their monthly work-related commute costs. 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 various alternative commuting options, reducing their overall transportation 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 that are deducted on a post-tax basis 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 preferable for employees compared to pre-tax deductions.
Because you withhold taxes before withholding benefit contributions, 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 as determined by the employer. However, stipends can also be offered as a one-time allowance or spot bonus.
Stipends allow employees to pay for various out-of-pocket expenses, such as wellness opportunities, professional development costs, fertility benefits, and remote office equipment.
Stipends are considered a form of taxable income. Therefore, employers must pay payroll taxes 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). Roth contributions use post-tax money. Earnings held in the account for five or more years grow tax-free, and there are also tax-free withdrawals. 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.
- Long-term disability insurance premiums rise the longer it 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 employees, which the employers offer as an employee benefit.
The Internal Revenue Service considers employer-provided group term life insurance tax-free if 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 a business owner to deduct an employee’s earnings due to a debt. Garnished wages are a post-tax deduction regardless of the reason.
Examples of wage garnishment include:
- Default student loans
- Child support payments
- 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 they make any adjustments. Exceptions to this are local, state, and federal taxes, other wage garnishments, and other mandatory 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 building a suitable benefits package. Pre-tax contributions can reduce your overall tax burden now, but post-tax benefits can result in tax savings in the future.
By working with a tax advisor and staying up to date on pre and post-tax benefits, common deductions, and your state and local taxation laws, you will save time and future headaches.
If you’re ready to implement an HRA or stipend at your organization, contact us, and we’ll get you started!
This article was originally published on August 20, 2015. It was last updated on March 6, 2023.