How Tax Deductions Work

do you know how tax deductions work?

Even if you’ve filed your taxes before, you may still not be entirely sure how tax deductions work within pre-tax benefits. The principle is the same as the standard deduction and itemized deductions. At a high level, pre-tax accounts allow you to set aside money before taxes to use for qualified health, child care or transportation expenses (depending on the accounts you enroll in).

How Tax Deductions Work: Reduce Taxable Income

How much you pay in taxes is based on two factors: your taxable income and which tax bracket you are in. A tax deduction results in a reduction of your taxable income, or the money you pay taxes on, which in turn reduces how much you owe in taxes.

Apart from pre-tax benefits, there are other deductions that can reduce your taxable income. Some examples include your medical, dental and vision insurance, 401(k), and tuition reimbursement. Setting those aside, let’s look at how tax deductions work when you enroll in a pre-tax benefit account.

How Tax Deductions Work: Pre-Tax Benefits

When you sign up for pre-tax benefits, you reduce your taxable income, so you pay less in taxes. Additionally, you get to keep the money that would have gone to taxes and set it aside for medical, child care and commuting purposes.

Most people who have a pre-tax benefit account save between 30% to 40% on each dollar they put into the account. Put another way, they save 30 to 40 cents per dollar they put in the account. Using this strategy, not only can you reduce how much you will be taxed on, but you also end up with an account devoted** to paying for medical expenses.

Granted, pre-tax accounts aren’t a replacement for insurance. (Although, you might consider skipping dental insurance in favor of a Limited Flexible Spending Account.) But they can certainly save you quite a bit of money on health and medical bills or on commuting costs.

For example…

Jane enrolls in a pre-tax commuter account. She sets up a pre-tax fund to pay for her monthly transit pass, which is $120.

Without Pre-Tax Benefits With Pre-Tax Benefits
Cost of Jane’s monthly commute: $120 $120
How much Jane pays in taxes each month: $42 $0
Income needed to pay for commute: $162 $120
Annual Savings Realized: $0 $504*
How Tax Deductions Work: Calculating Savings

To get a more precise measurement of your savings, you can check which tax bracket you fall into and use the BRI Calculator tool. Finally, when calculating your pre-tax savings, remember to combine the Federal, State (if applicable) and FICA tax rates.

Want to know more about how tax deductions work? Contact us.

*For illustration only. Assumes 35% combined Federal, State & FICA tax rate. Actual savings may vary.

**What you can buy with the funds in your pre-tax account is determined by the IRS and your employer. Check your Plan Highlights for more information about your specific plan.