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Should I Sign Up for Pre-Tax Deductions?

Between your federal and state income tax and FICA (Federal Insurance Contributions Act, for Social Security and Medicare) withholding, most of us take 18- to 33-percent deductions from our gross pay in our final paychecks. The remainder of our salary probably goes to paying bills, and with luck, into savings.

Around this time of the year, we get reminders to sign up for benefits at the office. Some benefits are paid with pre-tax dollars instead of after-tax dollars. What does that mean, and what are the consequences of pre-tax deductions and contributions?

Pre-Tax Payroll Deductions

The total amount you're paid, before taxes and other deductions, is called "gross wages." Tax laws permit you to deduct certain items from gross wages so the amount you pay or reserve for those items is not counted toward your income for federal and state income-tax withholding. There are other allowances that give you pre-tax deductions to "shelter" your gross income from FICA taxes, too.

Pre-tax payroll deductions enable you to pay for certain items from gross income before your taxable income is calculated. Think of these deductions as non-taxable dollars. In general, these are pretty good deals; however, there can be a catch you should be aware of.

If through your employer you participate in one of the following (note 2010 maximums):

  • Health Benefit Premiums (No limits)
  • Vision and Dental Care Premiums (No limits)
  • Flexible Savings Accounts for Health Care (No IRS limit, limits set by employer)
  • Flexible Savings Accounts for Dependent Care ($5,000)
  • Health Care Savings Accounts ($3,050 for self, $6,150 for family)
  • Commuter Costs ($2,760 limit for parking or transit)

You do not pay taxes on these items, because they are deducted on a pre-tax basis from your wages.

So let's say you had $6,000 in pre-tax deductions for these items. If your income-tax and FICA-tax rate is 25 percent, you just saved $1,500 ($6,000 x 25 percent = $1,500) by reducing your taxable income. Ah, the magic of paying with pre-tax dollars. There is a downside to reduced FICA wages for some, though.

Reduced FICA Wages

"FICA Wages" is defined as "the amount of earned income on which you pay FICA tax" (6.20 percent Social Security Retirement and 1.45 percent Medicare). By making pre-tax payroll deductions for the items in the bulleted list above, you reduce the amount of wages (FICA wages) used in determination of your ultimate Social Security retirement benefit amount.

Your Social Security retirement benefit is based on your 35 highest-earning years. If you have had low to moderate earnings throughout your work history (under about $40,000 in current dollars), you are most susceptible to having your Social Security benefit reduced because of pre-tax deductions. Your pre-tax deductions, while they saved you in FICA taxes along the way, could mean lower benefits. Higher wage earners are less likely to see any decline in benefits, because Social Security replaces a lower percentage of their FICA wages.

So, should you take advantage of pre-tax deductions, reduce your income and FICA taxes, and thereby risk having lower Social Security benefits later? To get reliable guidance on this question, you need to examine your Social Security Statement, which provides a projection of your benefits and an annualized listing of your FICA wages. You should receive this statement annually, or you can request it online from the Social Security Administration.

You can also use the Social Security Benefit Estimator to do hypothetical calculations of the impact of pre-tax deductions on your final benefits. Most people will find that the income-tax and FICA-tax savings will outweigh most reductions in benefits. For people who do not see the tax savings, they should consider paying for some of these benefits in after-tax dollars.

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