What is Pre-Tax Income?
For individuals, there are tax benefits to using before-tax income for purchases. Knowing the tax system’s rules and loopholes can help individuals maximize their income by reducing their tax burden.
The Tax Benefits of Pre-Tax Income
If you can use pre-tax income to pay for an expense, you are getting a tax break. This is because using income considered “before-taxes” allows you to skip paying government taxes in certain situations.
Taxes can take a big chunk out of earnings, so if you can skip paying them you are saving a lot of money.
In the United States if you earn taxable income, you are responsible for paying your share of taxes on that income. However, taxable income is calculated after taking into account tax deductions and tax credits.
In situations where pre-tax income is used, that income is effectively a tax deduction that benefits the taxpayer.
When you receive your paycheck, taxes have already been withheld, which means that most paychecks are already post-tax.
There are a few situations where you can siphon off income from your paycheck into other accounts or for specific expenses. At the end of the year, income that was used for a special pre-tax situation is excluded from your total taxable income.
A common benefit of before-tax income is a 401(k) retirement account. You can contribute directly to a 401(k) from your paycheck, before taxes.
For example, if your biweekly gross salary is $2,000 and you contribute 10 percent of your income to a 401(k) account, then $200 from each paycheck will be deposited into the 401(k) account.
Your total taxable income at the end of the year would have been $52,000 if you had not contributed to a 401(k) account.
However, your taxable income for the year is reduced to $46,800, because you were able to protect $5,200 from being considered taxable.
In other words, you only have to pay income taxes for that year on $46,800, rather than on $52,000.
Some Popular Uses
Although there are limited uses for pre-tax income, a few programs do exist.
The most common programs for this kind of income are health insurance plans and retirement savings accounts. Some employers offer health savings accounts, which let you use pre-tax income to pay for medical expenses.
Many cities have programs called commuter benefits that encourage use of public transportation by letting people buy bus or train tickets with pre-tax dollars.
The table below summarizes some of these popular plans; however, this is by no means an exhaustive list.