What Are Pre-Tax Deductions: Definition and How to Calculate It

Tax deductions are a pivotal part of every employee’s paycheck – after all, the average American tax rate stands at 14.5%. This averages at around $13,890 in taxes paid in 2022, and professionals foresee that the tax adjustments will see a 2.6% increase for the tax year 2025.

That said, though, these deductions are only made after the taxes have been filed. There are deductions that should be accounted for before an employee receives their take-home pay – which means that it’ll help reduce an employee’s taxable income. These are called pre-tax deductions, and they can range from healthcare to even commuter benefits.

Continue reading to learn more about the pre-tax deduction definition, examples, how to calculate it, and how it can help with pay equity in the long run.

What are pre-tax deductions?

Pre-tax deduction can be summarized as the amount of money that’s deducted towards an employee’s initial payroll. These include everything from healthcare, 401(k), retirement plans, and everything else that employers can take from the initial salary.

The reduction of take-home income also means that the employees will owe less in income taxes in the long run, which can save more money in the long run. This can help both companies and employees gain better pay equity in the long run as well.

Pre-tax deductions vs. payroll deductions

Although it’s already included in payroll deductions, there are still some differences that should be noted, especially for employees. The key thing to remember is pre-tax deductions’ definition can be the same for payroll deductions.

This means that pre-tax deductions are already included in payroll deductions. However, that does not mean that all pre-tax deductions are payroll deductions. Certain deductibles, like healthcare insurance and the like are counted as pre-tax deductions since they’re not included in an employee’s overall gross pay.

What is the standard percentage for pre-tax deductions?

Keep in mind that the pre-tax basis is set at a standard percentage per tax bracket, the rates are applied progressively. This means that the deductions are charged at the lowest rate possible before moving into the next bracket.

Typically, the standard percentage deduction ranges from a 10% marginal rate to as much as 37%. This ensures pay equity among employees and ensures that everyone receives a good baseline pay.

This can change from one company to another, especially considering that not everyone uses the same payroll service. Utilizing companies that offer pay equity services can help provide a good baseline for pre-tax deductions among employees, along with helping them communicate it properly to the rest of the company.

Examples of pre-tax deductions

Although there are plenty of samples to be considered, these five examples are some of the most prevalent ones that most companies have in place for their employees.

• Health insurance

  With the federal government mandating employers to provide health insurance to their employees – and some states like New Jersey and California penalizing employers for not providing coverage – it’s no surprise that the most common deduction goes to health insurance.

  The pre-tax premium varies per company and health insurance plan, but a 2023 study found that single taxpayers pay 17% of their annual taxable income, which goes up to 27% for family premiums. This percentage translates to $1,401 and $6,575, respectively. These fees are paid over the course of a year, and some employers cover a percentage of them as well.

• Retirement plans

  Retirement plans are also pre-tax deductions, working similarly to health insurance but serving as an employee’s backup plan after retirement. Employees contribute an exact dollar amount, typically $100 per month at retirement. However, some employers use a different formula, such as 1% of the average salary for the last years of employment for every year in service with the employer.

  Retirement plans also vary per company, with 401(k)s being the most common one with almost 71.5 million Americans having one set up by their company. Profit-sharing plans are also a form of retirement plan for both regular and higher-up employees and similarly isn’t taxed as well.

• Commuter benefits

  With 76% of Americans commuting to work as of 2022, commuter benefits are becoming more prevalent. In fact, a 2024 study shows that nearly 72% of employers offer commuter benefits to their employees in one form or another.

  Pre-taxed commuter benefits can include transit passes, parking costs, and mileage reimbursement. Other similar benefits, such as carpooling perks, ride-share costs, use of company cars, toll reimbursement, and vehicle or bicycle maintenance, are considered taxable benefits by the IRS.

• HSAs

  Health Savings Accounts (HSAs) are a common form of pre-tax deduction, with research showing that at least 61 million Americans are covered by HSAs.

  Although HSAs and health insurance serve similar purposes, HSAs are becoming the preferred method of saving for future medical expenses. Unlike health insurance, where the insurance company covers only part of medical expenses in exchange for a monthly premium, HSAs allow employees to contribute directly to an account.

This means that employers enrolled in HSAs can have better healthcare coverage overall, especially if the account has a good amount saved up in the account.

How can you calculate pre-tax deductions?

As mentioned above, they vary from one company to another. However, the general formula when calculating an employee’s taxable income with pre-tax deductions considered can be seen below.

Gross monthly - healthcare deduction - retirement deduction - commuter benefits - HSA contribution = take-home pay.

To provide a real-life example, let us use Salary.com’s data for Financial Accountants.

Salary.com’s data shows that financial accountants earn a median salary of $64,070 in a year. This means that on average, they would earn a gross salary of $5,339 a month. The data also shows that the percentage for healthcare, retirement, and pensions would amount to 8.8%, 2.9%, and 3.7%, respectively.

This would mean that the calculations for a financial accountant’s pre-tax deduction on their monthly salary can be seen below.

$5,339 (gross monthly salary) - $470 (health insurance deductible) - $154 (retirement fund) - $197 = $4,158

This means that the average financial accountant in the United States will have a take-home pay of $4,158 if pre-tax deductions are already taken out of their gross monthly salary.

This makes filing for every individual employee become significantly more complicated, especially when pay equity becomes involved in the process. Thankfully, there are programs that companies can use to help them process an employee's pay, manage payroll taxes, while maintaining pay equity and provide continuous pay analysis in the long run.

FAQs

Here are some common questions about pre-tax deductions:

How do pre-tax deductions work?

The definition of pre-tax deductions can be summarized simply as the money taken from an employee’s gross pay before taxes hit their paycheck. This means that every employee eligible for pre-tax deductions will reduce taxable income, which in turn lessens their overall tax burden.

What is an example of pre-tax deductions?

Retirement funds, healthcare insurance, and commuter benefits. There are some more, but that would vary from one company to another. Charitable contributions are also pre-tax payroll deductions since they count as voluntary deductions. Keep in mind that retirement funds can be considered as post tax deductions if filed under Roth contributions.

Do pre-tax deductions show on W2?

Yes, they show up on W2 forms. This is because the form includes everything from employee's wages, federal income tax to voluntary payroll deductions.