Managing employee benefits and staying on top of tax rules can feel overwhelming. Pre-tax deductions may sound like a small detail, but they have a big impact on your payroll, your compliance risk, and your team’s take-home pay.
Understanding how they work helps you offer better benefits, reduce tax liabilities, and avoid costly errors. It is not about mastering tax law. It is about putting a simple, effective system in place that works for everyone.
What are pre-tax deductions?
A pre-tax deduction is money taken out of an employee’s paycheck before taxes are calculated. That lowers the income used to figure out tax withholding. Common examples include health insurance premiums, 401(k) contributions, and commuter benefits.
By contrast, after-tax deductions come out of the paycheck after taxes are applied. These do not reduce taxable income.
Examples of typical pre-tax deductions:
- Health insurance premiums
- 401(k), 403(b), or SIMPLE IRA contributions
- Qualified transit and parking expenses
Using pre-tax deductions reduces taxable income for your employees and lowers your share of payroll taxes as well.
How can pre-tax deductions lower taxes for everyone?
When you apply pre-tax deductions correctly, both you and your employees benefit.
- Employees pay less in income taxes because their taxable income is lower. That means they take home more of each paycheck.
- Employers pay less in payroll taxes. Since Social Security and Medicare are based on wages after pre-tax deductions, your contribution goes down too.
Example
If an employee contributes $500 per month to a health insurance plan on a pre-tax basis, that $500 is not subject to federal income or payroll taxes. That saves you money and increases their take-home pay.
This is one of the few areas where both sides can save money without cutting any corners.
Which pre-tax benefits should you know about?
Not every benefit qualifies as pre-tax. And for the ones that do, annual limits apply.
Most common pre-tax benefits:
- Health insurance premiums: Usually handled through a Section 125 or Cafeteria Plan
- Retirement contributions: 401(k), 403(b), SIMPLE IRA accounts (limit for 401(k) in 2024 is $23,000, with catch-up contributions allowed for those 50 or older)
- Commuter benefits: Qualified transit and parking expenses (capped at $315 per month in 2024)
Check IRS updates each year. The rules and limits change; keeping your plan up to date protects you and your team.
What rules do I need to follow?
Offering pre-tax deductions comes with some requirements. They are manageable but skipping them can lead to penalties.
What you need to do:
- Create a formal written plan for each benefit
- Conduct annual nondiscrimination testing to make sure benefits are offered fairly
- File any required forms, such as ACA 1094/1095 reports or ERISA disclosures
- Stay within IRS limits for contributions and plan benefits
Many payroll and HR systems include tools to manage these tasks. You do not have to handle them all manually, but you do need to keep your records accurate and up to date.
What records should I keep?
Good recordkeeping helps you avoid problems if questions ever come up from the IRS or another agency.
Documents to keep on file:
- Employee elections and any changes
- Plan documents and amendments
- Payroll records that show contributions
- Results from nondiscrimination testing
Keep all documents for at least four years after filing related tax returns. Six years is safer, especially if other employment laws apply.
You will also need to report these deductions in:
For Affordable Care Act compliance, Applicable Large Employers (ALEs), those with 50 or more full-time equivalent employees, must maintain monthly records for at least six years to support their annual reporting to the IRS. For self-insured plans, certain records must be kept for up to ten years.
Organizing this now is much easier than hunting for it later under pressure.
How do I get the most out of pre-tax deductions?
To get full value from these benefits, be proactive.
- Choose benefits that your employees actually want and use
- Make the savings clear when discussing compensation or during open enrollment
- Use payroll software to automate and track deductions accurately
- Review plan details once a year to adjust for any IRS rule changes or shifting business needs
Small steps like these make your plan stronger and your team more informed.
The Bottom Line
Pre-tax deductions are not just for accountants. When used the right way, they help everyone save money, improve job satisfaction, and reduce your business’s tax burden.
Start by reviewing what you currently offer and how it is structured. Then take a few minutes to check that your documentation is current and that your payroll system is tracking deductions correctly.
A little attention now can prevent big problems later and put more money back into the pockets of your team and your business.
