Here's how to save money before you even know it's payday.
When you receive a paycheck, you may notice your paystub shows deductions for things like income tax, Social Security, wage garnishments, 401(k) contributions, and child support payments. Your employer may opt to deduct these expenses directly from your gross pay in order to help you save money. These deductions, which ultimately lower your take-home pay, are also referred to as pretax payroll deductions.
You can see how these deductions appear on your paystub in the OppU example below:
However, while pretax payroll deductions appear to impact the final dollar amount going into your checking account, they don’t necessarily translate to less money for you or your family. In fact, these deductions can actually help you save money.
Confused? Let’s break it down.
What does “pretax” mean?
The term “pretax” means your deductions (things like health insurance premiums and retirement contributions) are taken out of your paycheck before any state or federal taxes are withheld. This will reduce your taxable income and how much money you owe to the government when Tax Day comes around.
For instance, let’s say that you make $1,200 every two weeks. Your employer subsidizes your health care, but your contribution to the insurance plan is $100 per pay period. Your employer would then subtract $100 from your paycheck as pretax deduction for your health care plan. The government would then tax $1,100 of your pay instead of the full $1,200 that you earned, lowering your overall tax burden.
Generally speaking, pretax deductions consist of things like:
- Your retirement plan, such as a 401(k)
- Health insurance (medical and dental plans)
- Health savings accounts (HSAs) and flexible spending accounts (FSAs)
- Group-term life insurance
- Commuter benefits you receive from your employer.
Post-tax deductions may include:
- Wage garnishments for debts you owe
- Charitable contributions
- Small business retirement funds, such as a Roth 401(k)
- Disability insurance.
Your deductions will vary based on your employer and the benefits you have selected for the year.
Benefits of pretax deductions
You may have a choice between pretax or post-tax deductions when selecting your benefits. Pretax deductions are typically better because you will owe less in taxes upfront. They will lower your Social Security payments and Medicare costs, which are included in the Federal Insurance Contributions Act tax (FICA). There is also a benefit for employers, since pretax deductions will lower the amount they pay in State Unemployment Insurance (SUI), FICA taxes, and the Federal Unemployment Tax (FUCA). Note: When you go to file your taxes, you will not be able to claim your pretax deductions on your income tax return because you have already taken advantage of the tax benefit.
While receiving a smaller paycheck every month is not ideal, the overall tax savings could be worth a lot more than you’d end up saving from your income on your own. For instance, you may simply spend your entire paycheck, while pretax deductions automatically put your money into designated buckets. You’ll also probably end up paying less for employer-sponsored health care with your pre-tax deductions than you would if you were buying private health care with your after-tax money.
One downside is that there might be a limit to the amount of money you can withhold from your paycheck. You’ll need to ask your employer if there are limits. Also, your employer might not offer the type of retirement account or investment that you want.
Pretax deductions will change from year to year depending on what the government rules.
Making pretax investments
One of the main reasons people choose to participate in pretax-deduction benefit programs is to build up their retirement funds over time. Pretax investment accounts are those that let you fund them with your pretax dollars, and they include:
- a traditional IRA
- a Thrift Savings Plan
- traditional IRA.
It’s a good idea to set up a 401(k) with your employer, especially if they have a matching program. Then, you’ll automatically save for retirement with each paycheck and receive those extra contributions from your employer. If you work for a tax-exempt organization or a public school, you can sign up for a 403(b), which is similar to a 401(k). A traditional IRA is another solid option, but your employer may not offer to match your contributions.
The government allows for pretax deductions so that when you’re ready to retire, you won’t burden the government by applying for assistance. You won’t pay taxes on retirement funds during all those years that you’re making your pretax contributions; you’ll only pay taxes when you choose to withdraw the money from your accounts. If you are a high earner now, you’ll pay a lot more in taxes now than when you retire (if your income is lower during that time). The government will allow you to pay taxes on less income in your retirement.
Another benefit is that you typically will not have to pay tax on the interest, dividends, or capital gains associated with these accounts, which you normally have to do with your investments.
Deciding on pretax vs. post-tax investments
While the benefits of pretax investments are obvious, you should look at the whole picture before making a decision. For example, The Simple Dollar’s Trent Hamm points out in his blog:
If your employer is matching your contributions to one of your retirement savings accounts, the value of that extra employer contribution money is going to blow away any tax benefits. It’s not even close.
Therefore, you should consider going with what your employer will contribute to.
If you do invest in post-tax benefits, like a Roth IRA, you won’t have to pay taxes when you cash out upon retirement. It’s all about whether or not you want to pay taxes now or later. Keep in mind that taxes may go up in the future, so you may just want to take the benefit now.
Talking with your employer, your accountant, and/or your financial advisor will help you make the right decision for you.
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