What Is a Pre-Tax Deduction?
Most taxpayers are always on the hunt for ways to owe less money to the Internal Revenue Service (IRS) each year at tax time. One of the most effective and fiscally healthy ways to reduce your taxable income is to start making "pre-tax" deductions to some sort of retirement savings plan, like a 401(k), 403(b), TSP, or an individual retirement account (IRA). A pre-tax deduction is a contribution you make to such an account directly from your paycheck. This money is untaxed at the time of its entry into the said account, and this is why it is called a "pre-tax" deduction — it's placed at full value into your account of choice before any taxes have been taken out of your paycheck.
How does this help you at tax time? There are two big benefits to making pre-tax deductions. The first is that, as this money is pulled from the total amount of your wages before any taxation is applied, it reduces the amount the IRS refers to as your "taxable income."
Let's say you're a freelance photographer making $60,000 per year, and you have put $8,000 away in a pre-tax account throughout the year. The IRS can only tax you for $52,000 for that year. In turn, this reduction in gross pay reduces the amount you owe in income tax while allowing you to put more money into your retirement savings account than you would have been able had that money been taxed first.
The second major way that pre-tax deductions are beneficial pertains to employers and small business owners. If you are an employer who is responsible for employee payroll and benefits, taking out these pre-tax deductions as specified by your employees reduces your business's taxable income, as well. This means that the tax liabilities your business will face for that fiscal year will be significantly less than without the pre-tax deductions.
Equipping yourself with as much knowledge as possible regarding how pre-tax deductions can improve your overall financial well-being and remove stress at tax time allows you greater freedom over your finances and the ability to save more effectively. This article will offer further details about the nature of pre-tax deductions, the difference between pre-tax and post-tax deductions, and examples of each.
Pre-Tax vs. Post-Tax Deductions
The first connection to make between pre-tax and post-tax deductions is that both are taxed; it's just a matter of when. Pre-tax deductions go into whatever eligible savings plan you choose before having any taxes touch them. However, don't take this to mean that you will never pay taxes on pre-tax contributions. Uncle Sam always gets his cut, and in the case of pre-tax deductions, that will occur when it's time for you to draw that money out.
Imagine that you have been a self-employed electrician for 15 years, and you have dutifully placed $5,000 worth of pre-tax income into your IRA every year. This means that you currently have $75,000 of your pre-tax contributions in this account, plus whatever interest you accrued over that amount of time. When you get ready to retire and start deciding on an amount you want to take out of that IRA each month, that figure will be considered taxable income on your tax return.
By contrast, post-tax deductions are made to savings plans once the IRS has already gotten its share. The term "Roth" attached to any type of retirement saving plan is a general signifier that this account is designed to house post-tax deductions. With post-tax deductions, you're taxed directly when the money goes in rather than when it comes out. This means that the same freelance electrician could elect to place $5,000 of post-tax money per year into the IRA and never have to worry about the original sum being taxed again or the interest accrued being taxed. However, the total take-home pay for each paycheck would be reduced.
Both of these options have their allures. However, the decision on which tax option is best is a personal one that should be weighed against whether you need more funding now or later. For small business owners, the chance to lower their Federal Insurance Contributions Act (FICA) tax, state unemployment insurance, and federal unemployment tax immediately may be crucial to the fiscal comfort of their businesses.
The major difference is that pre-tax deductions will lower your taxes right now but raise tax liabilities later, and post-tax deductions will not give you a tax break now but will allow you to lower your tax burden in the future.
Pre-Tax Deduction Examples
Many common deductions, such as health savings accounts (HSAs), flexible spending accounts (FSAs), and commuter benefits, are classified as pre-tax deductions. Here, we will examine a few of the most common examples of pre-tax deductions, which small business owners and freelancers are likely to have.
- Retirement plans: Savings plans geared toward retirement are not all pre-tax. It's important to recognize what kind of account you have before deciding how to make contributions to it. The most common forms of pre-tax retirement plans are 401(k)s, 403(b)s, and traditional IRAs. Note that 401(k)s and traditional IRAs impose restrictions on withdrawals before the account holder reaches the age of 59.5 and/or can prove that full retirement has occurred before that age.
Bear in mind that no matter when you begin making withdrawals on these types of pre-tax accounts, you will be taxed on those withdrawals as if they were a standard paycheck. The taxation will include both the sum you put in and any interest you have earned since.
- Health insurance: If you are a small business owner offering benefits to your employees, you can provide pre-tax health insurance by creating what is referred to as a " cafeteria plan " — so long as it abides by the requirements outlined in Section 125 of the Internal Revenue Code. Money taken out for cafeteria plans is debited from employees' gross incomes, and premiums paid toward a Section 125 health plan enjoy exemption from Medicare tax, Social Security tax, and federal income tax.
By the same token, let's say you are self-employed and set up a pre-tax family health plan such as this, earning $2,000 biweekly and putting $300 each pay period into the health plan. That means only $1,700 worth of your total salary is subject to taxation.
- Life insurance: Perhaps the most frequently evaluated pre-tax or post-tax deduction is life insurance. Many small business owners decide to offer the first $50,000 of group life benefits on a pre-tax basis at their own cost because that sum can then be legally excluded from employee compensation for tax-reporting purposes.
Post-Tax Deduction Examples
Suppose you save for your golden years via contributions to retirement funds via a Roth 401(k) or Roth IRA. In that case, post-tax deductions will be taken from your paycheck or checking account and taxed before entry into those types of retirement accounts. Whatever interest or capital gains build over the life of these accounts is yours to keep, and no further taxation is imposed on the original sum. Other common post-tax deduction examples include charitable contributions, disability insurance, and any garnishments that may be in place.
Taxes on life insurance premiums can be set up on a post-tax basis, as well. Business owners who plan to pay for more than $50,000 of group term life insurance premiums for their employees must do so on a post-tax basis, and these payments are then taxed as income at your normal tax rate. If any interest has been earned for prepaid insurance, that money is taxed as interest income. Whole life insurance policies are considered tax-deferred because any growth in the plan's cash value will not be taxed until the policy is fully cashed out.
Seek Good Advice on Deductions
While some people may feel more comfortable than others when it comes to understanding tax structures, it is always pertinent to seek professional tax advice, particularly if you are a small business owner or freelancer. There are so many ways to set up tax credits and manage your business to your best fiscal advantage.
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Seek additional tax resources and information from tax professionals so that there is no pre- or post-tax deduction on your sanity at tax time.