Flexible spending accounts (FSA) and health savings accounts (HSA) are creatures of the federal tax code, which is notoriously complicated. To try to make things easier, we in the benefits industry sometimes use shorthand, but sometimes these only complicate things further, especially to those unfamiliar with benefits suchs as FSAs and HSAs.
Especially confusing are the terms pre-tax, post-tax and non-taxable, which are often used interchangeably in industry communications, and often incorrectly.
Let’s start with this basic principle: Federal law imposes a tax on taxable income received by an employee in return for work done for an employer. As a general rule, taxable income is any cash or other thing of value paid to an employee for work done.
So (to be very simplistic), if employer Fantastic Widgets pays employee Jane Taxpayer $100,000 in salary for work she does, she will owe taxes on that $100,000 in the form of federal income tax. This tax is paid over the course of the year via “withholding,” wherein the employer withholds part of Ms. Taxpayer’s salary and sends it to the Internal Revenue Service (IRS) throughout the year on Ms. Taxpayer’s behalf. If, at the end of the year, it turns out there was too much withholding, the IRS will settle up with Ms. Taxpayer after she sends in her tax return for the year (i.e., she will get her refund).
But that’s not the only tax imposed upon Ms. Taxpayer’s $100,000. There is also the FICA tax, also known as the payroll tax, which is generally 7.65% of her earnings (in this case, $7,650). The FICA tax funds Social Security and Medicare and is matched by her employer, who also must pay 7.65% of her earnings for FICA. So, Ms. Taxpayer and Fantastic Widgets will combine to pay a total of $15,300 of FICA taxes for this year.
Thus, all else being equal, Ms. Taxpayer and Fantastic Widgets will combine to pay $15,300 plus whatever Ms. Taxpayer’s ultimate federal tax liability is for the year to the federal government. Just for purposes of this discussion, let’s assume that after exemptions, deductions and so forth that Ms. Taxpayer’s federal income tax liability comes out to 15% of her total income, or $15,000. If so, then her total tax liability for the year will be $15,000 in federal income tax plus $7,650 in FICA tax, or $22,650.
But wait: Don’t forget Fantastic Widgets’ share of the FICA tax, which is another $7,650, resulting in the federal government receiving a total of $30,300 based upon Ms. Taxpayer’s $100,000 income for the year through the income tax on Ms. Taxpayer and the FICA tax on Ms. Taxpayer and Fantastic Widgets.
Is there a way to lower this tax liability for Ms. Taxpayer and Fantastic Widgets. Yes: It’s commonly called a cafeteria plan, and it allows Ms. Taxpayer to reduce her salary in return for certain nontaxable benefits, the most common being health insurance. If Fantastic Widgets offers a cafeteria plan, Ms. Taxpayer can elect to reduce her pay in the amount needed to pay her share of her health insurance premium, which, in turn, would lower her taxable income. Why? Because that money would be diverted to the health insurance premium payment before becoming subject to the federal income tax (hence the label pre-tax).
This also has the added benefit of lowering Ms. Taxpayer’s FICA tax, because that amount will not be included in that calculation either. And the same goes for the Fantastic Widgets portion of the FICA tax, creating a savings for the company as well.
To illustrate, let’s suppose Ms. Taxpayer pays $500 a month for her portion of the Fantastic Widget’s health insurance premium, or $6,000 a year, on a pre-tax basis. By doing so, she reduces her annual salary to $94,000 ($100,000 – $6,000 = $94,000). That means Ms. Taxpayer’s taxable income is also reduced to $94,000 and neither she nor Fantastic Widgets have to pay FICA tax on that $6,000. Thus, Ms. Taxpayer reduces her income tax liability by $1,349 ($900 in federal income tax plus $459 in FICA tax). And Fantastic Widgets saves $459 as its share of the FICA tax as well.
So, essentially, pre-taxing, which can also be used for life insurance, disability insurance, FSA contributions, dependent care contributions, health savings account contributions, and commuter account contributions, means taking income that would otherwise be taxable and diverting it to something else before it becomes taxable.
So what’s the difference between pre-tax and post-tax? Simply put, anything that is post-taxed is paid for after it has already been included in taxable income. Anything paid for on a post-tax basis (contributions to charities and gym memberships are some of the most popular types of these) are not subject to the typical rules of pre-tax contributions because they have already been subject to the federal income tax and FICA tax.
And that leaves us with the phrase non-taxable, which means any thing of value given to an employee that is not subject to taxation at all. The most common example of this is any direct employer contribution made toward health insurance premiums. While these monies are provided to employees in consideration for their employment, and would therefore otherwise be considered taxable income, the tax code specifically exempts those payments from taxation altogether, making them by definition non-taxable.
So, in summary:
If an employee diverts compensation (cash) from an employer to a nontaxable benefit such as health insurance before that money is paid to the employee, that’s pre-tax money.
If an employee directs money to a benefit or another place after that money has been paid to the employee, that’s post-tax money.
And, finally, any compensation paid by an employer on behalf of an employee that is not subject to taxation (such as insurance premium payments) is nontaxable income.