How Payroll Deductions Pay Off

Interested in a relatively painless way to save money and lower your tax bill? Look no farther than your next paycheck. There are several strategies that all working people should consider that can lower their taxes and help them save money for retirement. In this article, we give you the basics of payroll deductions and show you three strategies that will help you make the most of your next paycheck.

Key Takeaways

  • Payroll deductions occur when your employer withholds from your paycheck for involuntary or voluntary reasons, including taxes and benefits programs.
  • Contribute a maximum of $19,500 for the 2021 tax year to a 401(k) (increasing to $20,500 in 2022) through payroll deductions and save for your retirement.
  • Many employers offer flexible savings accounts for medical costs, dependent care expenses, and the cost of commuting.

What Is a Payroll Deduction?

A payroll deduction refers to money that your employer withholds from your paycheck for a number of different reasons. This includes mandatory deductions that are taken for tax purposes or voluntary deductions for various benefit programs, such as retirement plans or healthcare contributions. Most benefit-related deductions involve pre-tax dollars, which means you end up paying less income tax on the part of your salary that remains.

Increase Your 401(k) Contributions

A 401(k) is an excellent way for employed individuals to sock away large sums of money on a pre-tax basis each year. For example, the annual contribution limit in 2021 is $19,500 (increasing to $20,500 in 2022). Individuals who are over 50 are covered by the catch-up rule, which permits them to contribute an extra $6,500 each year for 2021 and 2022.

The amount that an individual can save over time in a 401(k) varies depending upon their situation. Let's say a 30-year-old makes $36,000 a year and socks away 10% every year. If this individual earns an 8% return on that money, they will have $680,000 in their retirement account at the age of 65.

If your employer offers this kind of plan and you aren't maximizing this benefit, try to start. Even if it's only a very small amount of money, it can be an excellent way to bypass Uncle Sam. If you were to pay the whole $19,500 in contributions, you could easily save several thousand dollars through these deductions.

Flexible Spending Means Increased Savings

A flexible spending account (FSA) is a type of savings account that provides the account holder with specific tax advantages. Set up by an employer, it allows employees to contribute a portion of their regular earnings to pay for qualified expenses, such as medical or dependent care expenses. These types of accounts can be extremely helpful because they allow employees to set aside pre-tax money for several types of expenses.

1. Medical FSA

Individuals have the ability to set aside funds for expenses related to healthcare, including prescription drugs and copays. This can be a big benefit for those with kids or individuals who require regular refills on their prescriptions, especially when it comes to tax savings and lowering healthcare costs.

According to the Internal Revenue Service (IRS), employees can contribute up to $2,750 in pre-tax dollars to a medical FSA for the 2021 tax year (increasing to $2,850 in 2022). Employers decide whether they also make contributions to their employees' health FSAs. Some may do a dollar match, a defined contribution only, or a crossover, which combines a minimum contribution with a dollar match.

Be sure to keep any receipts for expenses that you want to be reimbursed for from your medical FSA.

But be aware there is a downside to socking away money for medical expenses through an FSA. This money is intended for healthcare expenses only, so you can't use it as a retirement plan. And typically, the money you do save must be used in the year it is saved. You may be required to forfeit any money remaining in the account at year's end.

There is a saving grace, though. In 2021, you may be able to carry over up to $550 (increasing to $570 in 2022) of any unused amount to the next year or use the balance up to 2.5 months after the end of the plan year (as long as your employer's plan allows it).

For plan years 2021 and 2022, though, special rules apply to both the carryover amount and the grace period. Employers have the option of allowing all unused funds to be carried over from 2021 to 2022. Or employers can extend the grace period to 12 months, rather than 2.5 months. The effect of either decision is the same: all unused funds can be carried over and used throughout the entire year.

It's a good idea to check with your benefits department to see if these special rules apply to your FSA account.

2. Daycare FSA

It's not uncommon for an individual or a married couple to place one or more of their children in daycare. Individuals can pay for this expense or part of it through a daycare FSA account on a pre-tax basis. Babysitters and camps may also have similar coverage.

Dependent children or adults that need looking after qualify as long as they don't require medical care. The caveat is that the plan participant and their spouse, if applicable, must be employed. In other words, an employed husband with a stay-at-home wife cannot send the kids to day camp and get the benefit of paying that expense with pre-tax money.

For most plan years, including 2022, individuals or married couples filing jointly can set aside up to $5,000 each year for daycare FSAs while married individuals filing separately can set aside $2,500. However, for the 2021 plan year only, the dependent care FSA contribution limit was increased by the American Rescue Plan Act to $10,500 for single filers and couples filing jointly and $5,250 for married couples filing separately.

The total tax savings are similar to savings experienced by those using medical FSA plans. If your employer does make contributions on your behalf, the combined total cannot exceed the annual limit.

Park Your Money

With the ever-changing price of gas, how do you bring commuting costs into focus? Try a commuter savings account. Whether you take a bus, train, van, ferry, or drive and park, this type of savings account can help.

Estimate what you spend each month in parking and set aside that money on a pre-tax basis in a commuter parking savings account. You can set aside a maximum monthly limit of $270 (increasing to $280 in 2022). According to Wageworks.com's Commuter Savings Calculator, a person who spends $200 a month on parking and is in the 24% tax bracket can potentially save $48 a month, or more than $576 a year.

If you don't drive and park, you can estimate the monthly cost of a ticket for your mode of transportation. You can then save that money every month in the commuter account and pay for those expenses using pre-tax dollars. Potential cost savings can be similar to the parking account plan mentioned above.

The commuter account is another use-it-or-lose-it type of account, so you're better off making a conservative estimate of your spending, rather than a generous one.

What Are the Mandatory Payroll Deductions?

The standard payroll deductions are federal income tax, state income tax, Social Security, and Medicaid. Some cities and counties incorporate other income taxes.

What Are Voluntary Payroll Deductions That Reduce Taxes?

Voluntary payroll deductions that can benefit an employee and reduce the amount of taxes owed are 401(k) plans, a health savings account (HSA), healthcare insurance, a flexible spending account (FSA), commuter benefits, and childcare expenses.

What Is the Contribution Limit for a 401(k) Account?

The annual contribution limit for a 401(k) account in 2021 is $19,500. In 2022, this increases to $20,500. If you are aged 50 or older, you can contribute an additional $6,500 for both 2021 and 2022.

The Bottom Line

Employees who commute, pay healthcare expenses, or spend money on dependent daycare may be able to reduce their tax burdens by establishing an FSA account. These savings, combined with regular 401(k) contributions, can allow an employee to bypass or defer taxes on literally thousands of dollars each year.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500."

  2. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."

  3. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2021."

  4. Internal Revenue Service. "New Law Provides Additional Flexibility for Health FSAs and Dependent Care Assistance Programs."

  5. Internal Revenue Service. "Additional Relief for Coronavirus Disease (COVID-19) Under § 125 Cafeteria Plans: Section 214 Carryovers for Health FSAs and Dependent Care Assistance Programs," Page 5-9.

  6. Internal Revenue Service. "Looking Ahead: How the American Rescue Plan Affects 2021 Taxes, Part 1."

  7. Internal Revenue Service. "IRS Provides Tax iInflation Adjustments for Tax Year 2022."

  8. Internal Revenue Service. "Publication 15-B (2021), Employer's Tax Guide to Fringe Benefits."

  9. Wageworks. "Commuter Savings Calculator."

  10. Internal Revenue Service. "Understanding Employment Taxes."

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