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.

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 2023 is $22,500, rising to $23,000 in 2024. Individuals who are 50 and over are covered by the catch-up rule, which permits them to contribute an extra $1,000 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 nearly $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 $22,500 or $23,000 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.

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 $3,200 in pre-tax dollars to a medical FSA for the 2024 tax year (increasing to $3,300 in 2025). Internal Revenue Service.

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.

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 2024, you may be able to carry over up to $640 (and projected to increase to $660 in 2025) 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.

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 who 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 $6,000 each year for daycare FSAs while married individuals filing separately can set aside $3,000.

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 $315 in 2024. This rises to $325 per month in 2025.

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.

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.