I am getting insurance for about 4 months, the length of my contract with a company. I am given the option of having the cost deducted from my paycheck pre-tax or post-tax. What is the difference? There is a link about Section 125 of the IRS code concerning Cafeteria Plans, but a lot of it is foreign to me and I can't find much about it online.
Most people elect to have these deducted pre-tax because it reduces your taxable income. That mean that it is pulled from your income before social security, medicare, state and federal taxes are calculated. The reduction of pre-tax income can also make other deductions possible if it keeps your annual taxable income low enough, this really only impacts a few people, and would be considered a bonus benefit. Bottom line for most people pre-tax payments results in a higher take home pay.
The only reason I could find to make your health insurance premiums post-tax would be because that keeps your wages high when calculating monthly income for social security benefits. This would only impact people who were either near retirement, or were close to not making enough money in a quarter to potentially not get credit for the quarter.
One other distinction was that if the premiums were made pre-tax you can only change your insurance if you had a life event. Post-tax premiums did allow you to make insurance changes without needing a life event. Again this would only impact a small number of people.
Pre-tax deductions are taken out before taxes, and therefore reduce the amount of income that you have to pay taxes on, known as your taxable income. Post-tax deductions come out after taxes and don't have an effect on your taxable income.
If you're going to have the deduction anyway, pre-tax deductions can save you the amount of the deduction times your marginal tax rate. I'll give a simple example. Say you earn $70,000 a year in taxable income. As of 2013, you'll pay a 25% marginal tax rate on any of your taxable income above $36,250. In other words, you'll owe 25% of
70,000 - 36,250 = $33,750, i.e. $8,437.50 in taxes within that bracket (in addition to the lower tax rates on income below $36,250).
If you have a pre-tax deduction of $5,000, you only owe 25% in taxes on
70,000 - 36,250 - 5,000 = $28,750, i.e. $7,187.50. Your take-home pay in that tax bracket, after the deduction and taxes are taken out, is
28,750 - 7,187.50 = $21,562.50.
If you have a post-tax deduction of $5,000 instead, you still owe taxes of $8,437.50 on the $33,750, and after the taxes are taken out, you also face the deduction of $5,000. Your take-home pay in the 25% tax bracket is now
33,750 - 8,437.50 - 5,000 = $20,312.50.
It's no coincidence that the amount you saved when taking the pre-tax vs. post-tax deduction, i.e.
21,562.50 - 20,312.50 = $1,250, is equivalent of the marginal taxes you owe on the $5,000 amount of the deduction:
25% * 5,000 = $1,250. Remember that in these examples, I'm only talking about your income in the 25% tax bracket. Per the Fairmark chart linked above, you'll still owe $4,991.25 on your income below $36,250, whether or not you take a pre-tax or post-tax deduction.
Note that some pre-tax deductions are phased out at certain levels, in which case there might not be as much of a difference between the savings of the pre-tax vs. the post-tax deduction. This occurs with traditional IRA's, for example.
Also, the pre-tax deduction may be enough to lower your taxable income into another tax bracket. For example, if you earned $40,000 in taxable income, you would normally owe 25% of
40,000 - 36,250 = $3,750 in taxes, or $937.50. Add this to the $4,991.25 that you owe on your income below $36,250, and your total tax bill is $5,928.75. However, if you took a pre-tax deduction of $5,000, you would reduce your taxable income to $35,000, in which case you would owe 15% on the income above $8,925 (again, see the Fairmark table). Following the table for the amount of your income, you would owe
892.50 + 15% * (35,000 - 8,925) = $4,803.75 in taxes.
Also, there are situations where taking pre-tax deductions may reduce your taxable income enough to open up other opportunities in the tax code. For example, if your income is above a certain level, you may not be able to make the full contribution to a Roth IRA. However, if you have enough pre-tax deductions, your adjusted gross income may decrease enough to allow you to make these contributions.
Pre tax example: Pre (before) tax dollars for health insurance are deducted from gross pay first before Social Security and Medicare are calculated. Example: weekly gross pay is $500, pre tax health insurance is $60. $500 - $60 = $440 social security and medicare taxable wages. $440 x 6.2% = $27.28 for Social Security tax $440 x 1.45% = $6.38 for Medicare tax. All pre tax dollars including Social Security, Medicare and traditional 401k are deducted from gross pay resulting in federal taxable wages for a pay period. $500 x 4% = $20.00 traditional 401k. $500 - $60 - $20.00 = $420 federal taxable wages.
Post tax example: Post (after) tax dollars are deducted from gross pay after social security and medicare have been calculated . Weekly gross pay is $500. $500 x 6.2% = $31.00 for social security tax $500 x 1.45% = $7.25 for medicare tax. $500 x 4% = $20.00 Roth 401k Because there are no pretax dollars, the whole $500 is federal taxable wages. $500 x 1.45% = $7.25