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Pre-tax deductions are deductions that can be used to discount the amount of taxable wages a person will owe taxes on. Without these deductions, an individual, in most cases, would owe income taxes on all their gross wages. However, with these deductions, that amount is lowered, becoming a tax benefit. A number of things can qualify as pre-tax deductions.
One of the major confusions in tax code terminology is the confusion between the terms pre-tax deduction and tax credit. A tax credit is a direct value based on the taxes owed. For example, a $100 US Dollar (USD) deduction means a taxpayer does not owe money on that $100 USD of income. If the person was in a 10-percent tax bracket, the value would be $10 USD. However, a $100 USD credit means there is $100 USD taken off the amount of taxes owed. Thus, a $100 USD tax credit, in this hypothetical situation, is 10 times more valuable than a $100 USD tax deduction.
Pre-tax deductions may also affect more than income tax. FICA, which includes taxes for Social Security and Medicare, is also affected. These pre-tax deductions can significantly lower the amount of money paid into this program as well.
The purpose of pre-tax deductions is to create an incentive for people to be responsible with their money and plan ahead for certain eventualities. These include health care expenses and retirement. Theoretically, even if the government takes in less money because of these deductions, it still is a net benefit to the government because individuals who plan ahead will not need as much government assistance in the future.
One of the most common pre-tax deductions is for healthcare expenses. This may include premium payments for health insurance or money that is placed into a health savings account. In some cases, benefits used from pre-tax deductions may be subject to income taxes at either the federal or the state level.
Pre-tax deductions are also used when the employee is investing in a retirement savings account, such as a 401(k). These often have the added benefit of having employer contributions as well. Together, this provides a great incentive for those to delay the benefits of the income in order to take advantage of it later on.
Another common pre-tax deduction is for flexible spending accounts. These accounts can be used for medical expenses, childcare expenses or even preschool expenses at a private school. However, those using such an account must be sure to spend the money by the end of the calendar year. Failure to spend all the money in the account will result in a forfeiture of that money.