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 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.
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 the current limit. You save taxes because you use pre-tax dollars in the health FSA to pay for medical expenses that might not otherwise be deductible (due to not itemizing, or due to a portion being nondeductible because of the 10% adjusted gross income floor). 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).
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, 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.
As a cautionary note, if you or your spouse intend to participate in a high deductible health plan (HDHP) in 2018, your participation in a health FSA may hamper your ability to contribute to a health savings account (HSA).
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 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 dependent care-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.
Adjustments to federal and state withholding. You can ask your employer to increase withholding of federal and/or state and local taxes by amending your federal and/or state withholding forms before year-end if a) you expect to owe federal and/or state and local income taxes when you file your return next year (this will pull the deduction of those taxes into this year) or b) if you face a penalty for underpayment of estimated tax and you want to eliminate or reduce it. 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 federal and state tax withholding form that reflects the new filing status or changed exemptions. Be sure to review your withholding if you hold multiple jobs, you and your spouse both work, or you can be claimed as a dependent by another person.
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 of income are made to you after you attain age 59 1/2). You are allowed to withdraw contributions you have previously made at any time without penalty. 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 certain amount, which is dependent upon your filing status.
Be on the watch for 2018 plan election forms to be coming from your employer. If you would like to discuss any of these matters in greater detail, please contact us.