As a small business owner, taxes and payroll are probably some of the most yawn-inducing aspects of the job, but of course, they are central to a successful business. As you take on more permanent staff and offer better benefits to retain those great people, you have a duty to advise them on pre-tax and post-tax deductions (while, of course, still looking after your business).
So let’s quickly run through the different types of payroll deductions and how they relate to employee benefits and employer tax liability. And yes, that awful word, liability it is the employer who is liable for any missing taxes...I know it sucks to be the boss.
What are pre-tax or post-tax payroll deductions?
People often call pre-tax and post-tax deductions voluntary payroll deductions (why so many names!). This is because they are not mandatory tax withholdings, such as state and local taxes that are required by law. They are usually withholdings related to retirement plans, health insurance and life insurance.
So in short:
Pre-tax deductions: Are taken out of an employee’s gross pay before any mandatory taxes are calculated from a paycheck. The benefit is that these deductions can reduce the employee’s overall taxable income.
Post-tax deductions: Are taken out of an employee’s net pay after all required taxes and mandatory payroll deductions have been withdrawn. Post-tax deductions do not reduce the individual’s overall tax bill and therefore do not provide any tax breaks.
Whichever healthcare or retirement options your employees take, it’s a big discussion. You might want to consider a presentation for your workers explaining the options and providing them with information to look through.
This would also be a good opportunity to get the written permission you will need from your employees for any voluntary payroll deductions. It is, of course, illegal for an employer to take anything other than mandatory taxes from a paycheck. So get permission and keep those records.
What are mandatory payroll deductions?
As you would imagine mandatory payroll deductions are just that—mandatory and required by law. They are the all-important federal, state and local taxes. These taxes pay for public schools, health and welfare benefits, and the operation of state government.
The Federal Insurance Contributions Act or FICA is the most costly federal tax, as it collects money for Medicare and Social Security. As an employer, you must match these employee deductions.
The other mandatory tax is income tax, determined by gross pay and the information the employee provided to you at the start of their employment on their Form W-4. If you are in California (just to keep you on your toes), a DE 4 form is now needed for the 2020 tax year. Try and help your employees keep up to date with any changes to local or state taxes (you can pat yourself on the back for reading all these tax blogs). If you are worried about employees filling out these forms correctly you can send them a link to our guide to filling out a W-4.
Are there any other mandatory deductions beside tax?
Why yes there are. Wage garnishments are court-ordered deductions taken from an employee’s paycheck. This could be for a court-ordered settlement such as a fine, unpaid debt or child support.
Are mandatory payroll deductions affected by pre-tax vs post-tax?
Now here's the good news, pre-tax deductions can benefit both you and your employee. It does this by reducing the amount of taxable income the employee has. That means they will pay less on their mandatory payroll deductions such as income tax and/or FICA tax. When you (the employer) match these deductions, you also pay less!
It is also worth remembering that an employee typically pays lower premiums for health and life insurance when these benefits are paid for with pre-tax dollars.
So what are the most common pre-tax deductions?
- Retirement Funds and 401(k) contributions (this can also be post-tax)
- Health Insurance Premiums
- FSA (Flexible Spending Account)
- HSA (Health Savings Account)
- Life Insurance Premiums
- Commuter Benefits
What are the most common post-tax deductions?
- Individual Retirement Account. (IRA)
- Disability Insurance
- Union Fees
- Wage Garnishments
Although an IRA and Disability Insurance can be paid for both pre- and post-tax, some opt to pay them post-tax, after their mandatory deductions (so that it is part of their taxable income). They do this because it optimizes any potential money they may receive in the future. Understandably—If you have a life-changing event and can no longer work, you don't want to be paying tax on any benefits you receive.
Unionized Employees - Union dues are deducted from payroll on a post-tax basis, they lower an employee’s take-home pay, which is why so many people opt out of unions.
Pre-tax vs post-tax: which is best?
While it's true that the majority of people take mostly pre-tax deductions, in reality, everyone has different circumstances and plans for the future. Pre-tax contributions may help reduce taxes in pre-retirement years while after-tax contributions may help reduce individual tax burden during retirement. Most people try and plan to have multiple revenue streams for their retirement such as retirement savings accounts, Roth IRAs or traditional IRAs.
As an employer, it is so important to get payroll deductions just right. When you do, you avoid costly penalties for your business and mountains of personal stress for yourself. Many companies choose payroll software to mitigate errors and keep up to date with tax laws. Hourly’s payroll software automatically calculates any mandatory and/or voluntary payroll deductions for each employee. It then withholds the correct amount before issuing paychecks.
What's more, Hourly syncs your payroll data directly to your workers’ comp policy so you only pay exactly what you owe on your premiums, not an estimate. Hourly's goal is lower audit risk, faster payroll runs, and better claims and safety services for small businesses everywhere. Hourly is a licensed insurance agent with products underwritten by various insurance companies.