How Pre-Tax Deductions Work
When an employer sets up pre-tax contributions, he makes payments on the employee's behalf before withholding any federal, state or payroll tax. In effect, it's tax-free money and represents a savings equal to whatever the taxes would have been on the income. If your tax rate is 15 percent, for example, and the employer sets up $10,000 in pre-tax contributions throughout the year, you save $1,500 in taxes -- in addition to any savings on payroll and state income taxes.
Some Common Pre-Tax Benefits
Federal tax law allows pre-tax contributions to support the use of insurance and retirement pensions by wage-earners. The most common pre-tax benefits are health insurance, dental insurance, vision insurance, disability insurance and life insurance. Under the IRS rules, contributions to flexible spending accounts, which the employee can use to pay for medical costs, can also be paid on a pre-tax basis. The contributions are always "elective," or voluntary, and the employer may also contribute a portion of the cost. If you exceed the annual limit on these contributions, the employer must include the excess amount in taxable wages.
Retirement Plan Contributions
Employees can also make qualified retirement plan contributions on a pre-tax basis. Individual retirement accounts, or IRAs, for example, are funded -- up to an annual limit -- with money that is not subject to tax. If you contribute on your own, you deduct the amount from your gross income on your 1040 return before figuring taxable income. The pre-tax contribution recorded on a paycheck stub works the same way: The money is not counted toward your taxable wages and doesn't show up on your W-2 as income. The IRS slaps a few conditions on qualified retirement plans, of course; check with your benefits administrator if you have any questions about how it works.
The Downside: Social Security Wages
There's a slight catch to pre-tax contributions. The income counted as pre-tax is not counted by Social Security (or, in some cases, your employer's pension plan) as part of your wages. This reduces the amount you're earning on your Social Security record, which in turn may reduce your ultimate retirement benefit. To get a handle on how pre-tax contributions are affecting your Social Security wage record, request a benefit statement either online or by phone from the agency. This will show the amounts you've been making annually and project your monthly Social Security check amount based on what age you start the benefits.