How Payroll Deductions Pay Off

Interested in a relatively painless way to save money and lower your tax bill? Look no further than your next paycheck. While you may not want to lose any of your take-home pay, payroll deductions can be a smart way to lower your taxes and help you save money for retirement.

Learn about the basics of payroll deductions and discover 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.
  • You can contribute up to $20,500 to a 401(k) in 2022 (increasing to $22,500 in 2023) 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 2022 is $20,500, rising to $22,500 in 2023. Individuals who are over 50 are covered by the catch-up rule, which permits them to contribute an extra $6,500 each year.

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 $20,500 or $22,500 in contributions, you could easily save several thousand dollars in taxes through these deductions.

Flexible Spending Means Increased Savings

A flexible spending account (FSA, also known as a flexible spending arrangement) 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 costs or dependent care expenses. These types of accounts can be extremely helpful because they allow employees to set aside pre-tax money for common 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 $2,850 in pre-tax dollars to a medical FSA for the 2022 tax year (increasing to $3,050 in 2023). 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 2022, you may be able to carry over up to $570 (increasing to $610 in 2023) of any unused amount to the next year. Your employer may also offer a grace period of up to 2.5 months after the end of the plan year in which you can use your remaining funds.

Neither of these plan features is mandatory, and some FSA plans will not include them. It's a good idea to check with your benefits department to see if these special rules apply to your FSA account. Otherwise, if you put more money than you need in your FSA, you will lose it at the end of the year.

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 spouse with a stay-at-home partner cannot send the kids to day camp and get the benefit of paying that expense with pre-tax money.

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.

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 for 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 $280 in 2022. This rises to $300 per month in 2023. 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 2022 is $20,500. In 2023, it is $22,500. If you are aged 50 or older, you can contribute an additional $6,500.

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 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. "401(k) Limit Increases to $22,500 for 2023, IRA Limit Rises to $6,500."

  2. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500."

  3. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2023."

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

  5. National Institutes of Health. "Flexible Spending Accounts Program - New 2022 Limits for the HCFSA and LEX HCFSA."

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

  7. Wageworks. "Commuter Savings Calculator."

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

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