Pre-tax benefits, or pre-tax deductions, are just one way to build strategic, competitive compensation plans for your employees. Although beneficial for employers and employees alike, the world of pre-tax benefits is complex.
Some benefits are excluded from all federal taxes, while some are excluded from only certain federal taxes. Others are only excluded up to a certain amount, and state tax exemptions vary by state.
Need help understanding what pre-tax benefits are? We got you covered.
Pre-Tax Benefits Defined
Pre-tax benefits are benefits that employees can contribute to before taxes are calculated and deducted from their paycheck. They can also be referred to as pre-tax deductions because they’re payroll deductions.
How Do Pre-Tax Benefits Work?
When employees pay for benefits on a pre-tax basis, they’re able to reduce their total income for purposes of tax deductions, which are calculated based on percentages.
For example, if an employee’s total salary was $42,000 in 2020, but they paid $4,000 towards pre-tax benefits, then their tax deductions will be based on a total income of $38,000. The employee will pay fewer taxes not only because their total income is lower, but also because they’ve dropped into a lower federal income tax bracket.
Which Taxes?
Some pre-tax benefits are only exempt from federal taxes, but not state taxes. Whether a pre-tax benefit is exempt from state taxes will vary from state to state. Others are only exempt from certain federal taxes.
Also, in some cases, only a certain maximum amount is exempt. For example, generally, only up to $5,000 is exempt from federal taxes for dependent care assistance expenses.
Pre- and Post-Tax Deductions
Pre-tax deductions include all pre-tax benefits the employee contributes to. Post-tax deductions include other benefits that aren’t exempt from taxes, amounts contributed to a pre-tax benefit that exceed the federal limit, wage garnishments, among others.
Most importantly, post-tax deductions will not reduce an employee’s taxable income, which means it won’t reduce employer-paid taxes.
Pre-Tax Deductions List
Below is a list of pre-tax deductions, or pre-tax benefits available to employers.
This list refers to benefits that are exempt from federal taxes. State tax exemptions vary. To find your state’s tax exemptions, visit your state’s government website.
Accident and Health Insurance
Pre-tax health benefits are one of the most common types of pre-tax benefits employees can pay for. Health insurance plans can be structured in a variety of ways depending on the company’s chosen provider. Common types of insurance plans include Preferred Provider Organizations (PPO), Health Maintenance Organizations (HMO), Point-of-service (POS) plans, Exclusive Provider Organizations (EPO), and High-deductible Health Plans (HDHPs).
Accident insurance can be used to cover costs in case you or another covered person is injured in an accident. Further details about accident and health insurance as a tax-free benefit can be found in IRS Publication 15-B.
Commuter Benefits
Pre-tax commuter benefits help employees who commute to work save money on transit passes, qualified parking, and rides commuter highway vehicles to and from work. In 2021, employees could exclude up to $270 for these benefits.
De Minimis Benefits
De minimis means “minimal”. De minimis benefits provided to an employee using their pay are exempt from federal taxes so long as they meet the definition of de minimis. According to the IRS, a de minimis benefits is a benefit that, “considering its value and the frequency with which it is provided, is so small as to make accounting for it unreasonable or impractical.”
Dental Insurance
Group dental insurance coverage, which is a common benefit offered as part of a “cafeteria plan”. Employees can also pay for certain kinds of dental care using their Flexible Spending Account (FSA) contributions.
Disability Insurance
Disability insurance is another type of supplemental insurance coverage. Both short-term disability (STD) and long-term disability (LTD) insurance plans are eligible as pre-tax benefits.
However, both types of insurance plans have tax consequences. If employees pay for premiums on a pre-tax basis, then benefits payments will be taxable. If employees pay for premiums on an post-tax basis, then they will not have to pay taxes on their benefits payments. EIther way, employees will have to pay taxes for their STD or LTD insurance.
Education Assistance
Up to $5,250 of benefits for educational assistnace can be deducted on a pre-tax basis. Educational assistance includes expenses such as costs of books, fees, tuition, and supplies. Certain expenses are excluded, including the cost of tools and supplies (excluding textbooks) the employee is a allowed to keep after completing the course.
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) recently expanded the definition of “educational assistance” to include some student loan assistance. This new exclusion will continue through January 1, 2026.
Flexible Spending Accounts (FSA)
FSA benefits are special savings accounts that employees can contribute to on a pre-tax basis. Funds can then be used to reimburse employees for qualifying medical or dependent care expenses. Although both FSA accounts, Health Care FSAs and Dependent Care FSAs are separate pre-tax benefits.
Health Care FSA (HCFSA)
Health Care FSA benefits can be used to pay for deductibles, co-payments, certain dental expenses, and other medical expenses. The maximum contribution for HCFSAs in 2021 was $2,750. Employees with HCFSA benefits can’t also have a Health Savings Account (HSA).
Limited Expense Health Care FSA (LEX HCFSA)
LEX HCFSA benefits can be used to pay for qualified dental and vision care expenses. These types of savings accounts are used when the employee has elected a high-deductible health insurance plan along with an HSA.
Dependent Care FSA (DCFSA)
DCFSA benefits are pre-tax benefits that allow employees to set money aside for qualifying childcare and dependent care expenses. This includes care for children under 13 years old, and qualifying dependents 13 and above.
To promote the use of DCFSA funds, the Helpr app includes a built-in tool that allows families to pay for care directly with their DCFSA debit card.
Health Savings Accounts (HSA)
Like FSAs, HSAs are savings accounts that employees can make pre-tax contributions to in order to pay for qualified medical expenses. They’re generally only available to employees who have a High Deductible Health Plan (HDHP). HSA funds are often used to pay for deductibles, copayments, and other expenses.
Life Insurance
Group-term life insurance plans are qualified pre-tax benefits if they comply with Section 135 of the IRC, which provides the framework for cafeteria plans. However, the maximum exemption from Social Security and Medicare taxes is $50,000 of coverage.
Retirement Accounts & Planning Services
Certain retirement funds, like most 401(k) plans, are exempt from federal taxes. Other tax-advantaged retirement plans include IRA, 403(b), and 457 plans. As with other benefits, whether certain retirement funds are exempt from state taxes will vary by state. Retirement planning is also tax-exempt, with exceptions.
Supplemental Insurance Coverage
Supplemental insurance is insurance added to an employee’s primary health insurance plan. Accident insurance is considered supplemental insurance. Whether supplemental insurance may be treated as a pre-tax benefit depends on the type of coverage offered.
For More on Pre-Tax Benefits: IRS Publication 15-B
IRS Publication 15-B is the IRS’s employer’s guide to fringe benefits. Publication 15-B includes a full list of pre-tax benefits.
