As year-end approaches, taxpayers generally are faced with a number of choices that can save taxes this year, next year or both years. Employees too are faced with these choices. However, employees have some special considerations to take into account that retirees and other nonworking individuals don't face. To help our clients who are employees take advantage of these special tax saving opportunities, we have put together a list of items to consider.
Please review the list and contact us if you need additional information on one or more of the items.
Health flexible spending accounts. Many employees take advantage of the annual opportunity to save taxes by placing funds in their employer's health flexible spending arrangement (health FSA). A pre-tax contribution of $2,600 to a health FSA is permitted in 2017. You save taxes because you use pre-tax dollars in the health FSA to pay for medical expenses that might not be deductible. They would not be deductible, for example, if you don't itemize. Even if you do itemize, some medical expenses would not be deductible because of the 10% adjusted gross income floor (7.5% floor for a married taxpayer in 2017 if either the taxpayer or the taxpayer's spouse is 65 or older). Additionally, the amounts that you contribute to a health FSA are not subject to FICA taxes. This would allow you to save $199 in FICA taxes alone, on a health FSA contribution of $2,600. You would save an additional $520 in income taxes based on an effective income tax rate of 20%. Total annual tax savings would equal $719 ($199 + $520).
Keep in mind that you cannot get tax-free reimbursements for aspirin, antacids and other over-the-counter items unless your healthcare provider gives you a prescription for them. Your plan should have a listing of qualifying items and any documentation from a medical provider that may be needed to get a reimbursement for these items.
To avoid any forfeiture of your health FSA funds because of application of the use-it-or-lose-it rule, you must incur qualifying medical expenditures by the last day of the plan year (Dec. 31 for a calendar year plan), unless the plan allows an optional grace period. Any grace period cannot extend beyond the 15th day of the third month following the close of the plan year (e.g., March 15 for a calendar year plan), so, if the plan allows a grace period, qualifying medical expenses that you incur through that date can be reimbursed using your prior-year health FSA account. An additional exception to the use-it-or lose-it rule permits health FSAs to allow a carryover of a participant's unused health FSA moneys, up to a $500 (or lower plan) maximum. Any amount carried forward in this manner will be added to the up-to-$2,600 amount that you elect to contribute to the health-FSA for 2017.
As a cautionary note, if you or your spouse intend to participate in a high deductible health plan (HDHP) in 2017, your participation in a health FSA may hamper your ability to contribute to a health savings account (HSA), unless it is a limited-purpose FSA (that is, it may only be used to reimburse you for qualifying dental and vision expenses for you, your spouse, and your eligible dependents).
Examining your year-to-date expenditures now will also help you to determine how much to set aside for next year. Don't forget to reflect any changed circumstances in making your calculation.
Dependent care FSAs. Some employers also allow employees to set aside funds in dependent care FSAs. A $5,000 maximum annual contribution is permitted ($2,500 for a married couple filing separately). A dependent care FSA allows employees to use pre-tax dollars to pay for dependent care. In particular cases, participating in a dependent care FSA (for a dependent-qualifying child under age 13, or a dependent or spouse who is physically or mentally incapable of self-care and who has the same principal place of abode as the taxpayer for more than half of the tax year) can yield greater tax savings than foregoing participation and claiming a dependent care credit. Taxpayers who are eligible to participate in a dependent care FSA and are (a) in a high tax bracket and/or (b) have only one dependent and more than $3,000 of employment-related expenses, should use the FSA to pay for child care expenses. For these taxpayers, the FSA almost always provides greater federal tax savings than does the dependent care credit. State income tax savings also may apply. Additionally, participating in a dependent care FSA also saves you FICA taxes on the amount of the contribution.
However, like health FSAs, dependent care FSAs are subject to the use-it-or lose it rule, but neither the grace period nor the up-to-$500 forfeiture exception applies. Thus, now is a good time to review expenditures to date and to project amounts to be set aside for next year.
Adoption assistance FSAs. Under an adoption assistance FSA, adoption reimbursement accounts are established in connection with an employee's adoption of a child, if the amounts are paid or incurred through the employer's adoption assistance program. Typically, these accounts are funded with employee pre-tax contributions uniformly withheld from each paycheck throughout the year. For taxable years beginning in 2017, employees can contribute, pre-tax, a maximum of $13,570 for amounts paid or expenses incurred for qualified adoption expenses furnished under the employer's adoption assistance program. The limit applies to the adoption of each child and is cumulative over all tax years (rather than applying an annual limit).
The balances in these accounts are used to reimburse qualified adoption expenses incurred during the year, subject to a reimbursement maximum. Like their health and dependent care FSA siblings, these accounts are subject to the use-it-or-lose-it rule (however, neither the grace period nor the up-to-$500 forfeiture exception applies). However, predicting the amount and timing of adoption expenses may be far more difficult than projecting medical and dependent care assistance expenses. As a result, the use-it-or-lose-it rule could pose a greater risk of loss with this type of FSA. This should be borne in mind in choosing the extent to which you should participate in an adoption FSA.
Health savings accounts. A health savings account (HSA) can be established only for the benefit of an "eligible individual" who is covered under a "high deductible health plan" or "HDHP." The HSA funds may be used to pay the "qualified medical expenses," including long-term care expenses, of an "account beneficiary." For purposes of determining whether the HSA has been established for the benefit of an "eligible individual" who is covered under an HDHP, an HDHP is (for 2017) a health plan:
(1) that has an annual deductible which is not less than-
(i) $1,300 for self-only coverage, and
(ii) $2,600 for family coverage, and
(2) for which the sum of the annual deductible and the other annual out-of-pocket (OOP) expenses required to be paid under the plan (other than premiums) for covered benefits does not exceed-
(i) $6,550 for self-only coverage, and
(ii) $13,100 for family coverage.
The maximum contribution an individual may make to an HSA, in 2017, is $3,400 for an individual with self-only coverage under an HDHP and $6,750 for an individual with family coverage under an HDHP. A "catch-up" contribution will increase each of these limits by $1,000 where the taxpayer is 55 or older by the end of 2017.
Within the IRS dollar limits, an "above-the-line" tax deduction (that is, not requiring the itemization of deductions) is allowed for an individual's contribution to a HSA. Contributions are deducted from the individual's total income in arriving at the individual's adjusted gross income (AGI). Employer contributions to an HSA under a cafeteria plan, on an employee's behalf, are neither included in the employee's income, nor subject to employment taxes. Similarly, an employee may contribute to an HSA under a cafeteria plan with pre-tax dollars. HSA earnings accumulate tax-free and may be carried over from year-to-year. Distributions to pay qualified medical expenses are also tax-free.
Qualified transportation/parking benefits. The exclusion from income for "qualified transportation fringes," which includes mass transit passes, parking, vanpooling and bicycle commuting reimbursement, will allow the benefit to be paid tax-free by the employer, under a bona fide reimbursement arrangement, or through a salary reduction arrangement funded on a pre-tax basis by the employee. In 2017, the aggregate fringe benefit exclusion amount for transportation in a commuter highway vehicle (i.e., vanpooling) and any transit pass, is $130/month. The monthly limitation regarding the fringe benefit exclusion for qualified parking is $255 in 2017, and is $20/month for a bicycle commuting reimbursement.
Adjustments to state withholding. If you expect to owe state and local income taxes when you file your return next year, ask your employer to increase withholding of state and local taxes, by amending your state withholding form (or pay estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into this year. If you become married or single in 2017, or have added or lost a dependent, you should be sure to provide your employer with an updated state tax withholding form that reflects the new filing status or changed exemptions.
Adjustments to federal withholding. If you face a penalty for underpayment of federal estimated tax, you may be able to eliminate or reduce it by increasing your withholding by amending your Form W-4. You should especially review your withholding to ensure that enough tax is withheld if you hold multiple jobs, you and your spouse both work, or you can be claimed as dependent by another person. If you become married or single in 2017, or have added or lost a dependent, or expect increased deductible itemized deductions, you should be sure to provide your employer with an updated Form W-4 that reflects the new filing status or changed exemptions.
Increase 401(k) contributions. The pre-tax and Roth 401(k) contribution limit for 2017 is $18,000. Employees age 50 or older by year-end are also permitted to make an additional contribution of $6,000, for a total limit of $24,000 in 2017. If your employer makes a matching contribution to your contribution, your total retirement savings will increase even faster. Review and make appropriate adjustments to the contributions you make to your employer's 401(k) retirement plan for the remainder of this year, and next year. It's also a good idea to review your investment elections, and their periodic performance. Keep in mind the amount you need to save for the age at which you plan to retire and consider seeing a financial planner to set, and keep to, your savings goals.
Make Roth IRA contributions. The ability to make a Roth IRA contribution (which is a special after-tax contribution) continues even if you're participating in an employer savings plan (like a 401(k)), so it is not subject to the "active participant" rules that may prevent employees who participate in an employer plan from making a deductible contribution to a traditional IRA. The benefit of the Roth IRA is that the earnings on the IRA will not be taxable to you on distribution (provided, generally, that distributions are made to you after you attain age 59 1/2). The 2017 Roth contribution limit is $5,500, rising to $6,500 if you're age 50 or older by the end of 2017. Your ability to make a Roth IRA contribution in 2017 will be reduced if your adjusted gross income (AGI) in 2017 exceeds:
(a) $186,000 and your filing status in 2017 is married-filing jointly, or
(b) $118,000, and your filing status in 2017 is that of a single taxpayer.
Your ability to contribute to a Roth IRA in 2017 will be eliminated entirely if you are a married-filing-jointly filer and your 2017 AGI equals or exceeds $196,000. The cut-off for single filers is $133,000 or more.
Consider converting your traditional IRA to a Roth IRA, or making an "in-plan" Roth conversion. Amounts held in your traditional IRA may be converted to a Roth IRA. The "conversion" of a traditional IRA to a Roth IRA is treated as a distribution from the traditional IRA to the Roth IRA, and will result in taxable income (except to the extent of after-tax contributions made to your traditional IRA). The same may be done for amounts that you may hold in a SEP IRA or a SIMPLE IRA. If your employer plan permits and has a "qualified Roth contribution program," you may direct an "in-plan" conversion of taxable amounts in your employer plan to a designated Roth account in the same plan. Like the conversion of the traditional IRA to a Roth IRA, this conversion will result in a taxable distribution to you for the taxable amounts that are converted.
Consider taking out a 401(k) plan loan instead of taking a distribution, if you need funds. If you need money, you may be tempted to take a plan distribution, to the extent permissible, to satisfy an imminent financial need. If you are under age 59 1/2, this distribution may not only constitute taxable income, but it also will be subject to the 10% premature distribution tax. Thus, if your effective Federal and state income tax rate totalled 25%, you'd have a total tax rate of 35% and would only get use of 75 cents for every $1 distributed from your 401(k) account. A better way to get financial assistance is to borrow from your 401(k) plan, if your 401(k) plan has a loan feature. The amount that you can borrow is subject to certain plan and IRS limits, but you'll generally have five years to repay the loan (or longer, for a home loan), and the interest that you pay will go back into your account. This is a sound way to avoid immediate income taxation on the amount that you require to satisfy your financial need.
If you would like to discuss any of these matters in greater detail, please give me a call at your earliest convenience.