Pre-tax vs after-tax deductions

Two deductions can take the same amount out of a paycheck and still leave different net pay. The difference is timing: a pre-tax deduction comes out before tax is worked out, so it lowers the tax, while an after-tax deduction comes out once the tax is known. This page explains the order of the calculation and works through three payrolls with real numbers.

The order of a paycheck

Every paycheck is worked out in the same order. Get the order right and the rest is subtraction.

1. Gross pay. What the employee earned for the period, before anything is taken out.
2. Minus pre-tax deductions. Amounts the employee has agreed to have taken out, such as a retirement contribution or a health premium, that the rules treat as coming out before tax.
3. Equals taxable wages. The amount the withholding rate is applied to.
4. Minus withholding. Tax worked out on taxable wages and kept back from the employee's pay.
5. Minus after-tax deductions. Amounts that come out after tax, such as a loan repayment, a gym membership or a charity pledge.
6. Equals net pay. The cash the employee actually receives.

So both kinds of deduction come out of the employee's pay. The only question is whether they come out before or after the tax calculation. A pre-tax deduction shrinks the number the tax rate is applied to. An after-tax deduction doesn't touch it.

Which deductions are pre-tax is decided by the tax rules that apply to the employer, not by the employer's preference. In these exercises, the sheet tells you which is which. Your job is to put each one in the right place in the calculation.

Worked example 1: taxable wages

Summit Bike Repair has eight employees. In this example, the retirement contribution (a percentage of gross pay) and the health premium are pre-tax. A loan repayment is after-tax. Here are three of the employees:

Start with K. Moreau. The retirement contribution is a percentage, so turn it into dollars first: $1,331.00 × 4% = $53.24. Then take both pre-tax deductions off gross pay:

Taxable wages = $1,331.00 − $53.24 − $119.72 = $1,158.04.

The $16.00 loan repayment is not in that line. It will still come out of K. Moreau's pay, but later, after the tax is worked out.

The other two show the edge cases. E. Haddad contributes 0% to retirement, so only the health premium comes off: $1,565.00 − $0.00 − $18.52 = $1,546.48. B. Chen has no health premium, so only retirement comes off: $2,189.00 × 3% = $65.67, and $2,189.00 − $65.67 = $2,123.33. A zero in a column is still part of the formula. It just subtracts nothing.

In a spreadsheet, one formula per row does the job: gross pay, minus gross pay times the retirement percentage, minus the health premium. Fill it down and every employee is done.

Worked example 2: withholding and net pay

Bluebird Veterinary uses an example withholding rate of 15% on taxable wages. F. Larsen earned $1,501.00 gross, contributes 5% to retirement, pays a $87.46 health premium before tax, and has a $64.00 gym membership taken out after tax.

Withholding is $1,338.49 × 15% = $200.7735, which rounds to $200.77. Round each amount to the cent as you go, because that is the amount actually withheld and reported.

Net pay starts from taxable wages, because the pre-tax deductions are already out: $1,338.49 − $200.77 − $64.00 = $1,073.72. You could also start from gross pay and subtract all four items. You get the same answer either way, as long as each deduction is subtracted exactly once.

What the pre-tax treatment is worth

If F. Larsen's $162.51 of pre-tax deductions ($75.05 + $87.46) had been after-tax instead, withholding would have been charged on the full $1,501.00: $225.15. The pre-tax treatment lowers withholding by $24.38, which is the example rate times the deductions: 15% × $162.51. That is the whole point of a pre-tax deduction. The money still leaves the paycheck, but less tax is withheld on the way.

Worked example 3: two taxes, two wage bases

A payroll can have more than one tax, and a deduction can be pre-tax for one and not the other. Juniper Landscaping's example shows how that works. It uses two example rates: income tax withholding at 18% and an employee social insurance contribution at 6%. In this example, the retirement contribution reduces income tax wages but not social insurance wages. The health premium reduces both.

K. Moreau earned $1,711.00, contributes 6% to retirement ($102.66), pays a $67.38 health premium and gives $55.00 to a charity pledge after tax.

• Income tax wages = $1,711.00 − $102.66 − $67.38 = $1,540.96.
• Social insurance wages = $1,711.00 − $67.38 = $1,643.62.
• Withholding = $1,540.96 × 18% = $277.37.
• Social insurance = $1,643.62 × 6% = $98.62.
• Net pay = $1,711.00 − $102.66 − $67.38 − $277.37 − $98.62 − $55.00 = $1,109.97.

The sheet now has two "taxable wages" columns, one per tax. Each tax rate is applied to its own column. This is the pattern to remember: for every tax, ask which wages it is charged on, then which deductions reduce those wages.

Notice also how net pay is built here. Starting from gross pay and subtracting every deduction and tax in turn is the safest route when there are many items, because you can tick each one off.

Where deductions go in the books

On the employer's side, the full gross pay is the expense. Every deduction, pre-tax or after-tax, is money the employer has kept back from the employee and must pass on to someone else: a retirement plan, an insurer, a lender, a charity or the tax authority. Until it is paid over, it is a liability. The entries are covered in payroll journal entries.

That is why the pre-tax or after-tax label never changes the expense. It only changes how much tax is withheld, and so how the employee's gross pay is split between net pay and the various payables.

Common mistakes

The exercises check for each of these and tell you which one you made.

Subtracting the after-tax deduction from taxable wages

For K. Moreau at Summit Bike Repair, taking the $16.00 loan repayment off as well gives taxable wages of $1,142.04 instead of $1,158.04. An after-tax deduction comes out after the tax is calculated, so it doesn't reduce taxable wages. Subtract only the pre-tax deductions.

Leaving the health premium in taxable wages

Subtracting only the retirement contribution gives $1,331.00 − $53.24 = $1,277.76. In this example the health premium is pre-tax too, so it comes off along with the retirement contribution.

Working out withholding on gross pay

For F. Larsen, $1,501.00 × 15% = $225.15 instead of $200.77. Withholding is charged on taxable wages, after the pre-tax deductions. Charging it on gross pay throws away the benefit the pre-tax deductions are meant to give.

Forgetting the after-tax deduction in net pay

Stopping at taxable wages minus withholding gives F. Larsen $1,137.72. The $64.00 gym membership still comes out of the paycheck, just after tax, so net pay is $1,073.72.

Using income tax wages for social insurance

At Juniper Landscaping, $1,540.96 × 6% = $92.46 instead of $98.62. In this example the retirement contribution only reduces income tax wages, so social insurance is charged on $1,643.62.

Leaving social insurance out of net pay

Social insurance is withheld from the employee's pay just like income tax. Forget it and K. Moreau's net pay comes out at $1,208.59, which is $98.62 too high.

How to check your work

• Taxable wages are never more than gross pay, and they equal gross pay only when an employee has no pre-tax deductions.
• After-tax deductions never appear in the taxable wages formula.
• Gross pay minus every deduction and every tax equals net pay. Add them all back and you should land exactly on gross pay.
• When there are two taxes, each rate points at its own wages column.

Next in this course: withholding with an example table, where the rate depends on how much an employee earns, and the payroll register, which puts every deduction for every employee on one sheet.