How to Reduce Taxes by Contributing to Tax Advantaged Accounts

Article Summary:

In order to maximize your savings and reduce your taxes, you should be contributing as much as possible to tax advantaged accounts.  Tax advantaged accounts include:

  • 401(k) Retirement Account
  • IRA (Individual Retirement Account)
  • HSA (Health Savings Account)
  • Dependent Care FSA (Flexible Spending Account)
  • Commuter Benefits FSA (Flexible Spending Account)
  • Health FSA (Flexible Spending Account)
  • 529 College Savings Plan

Potentially, you could make the following contributions each year to all of these accounts:

Contribution Tax Advantaged Account
$18,000 401(k) Plan – Employee Pre Tax Contribution or Roth Contribution
$1,500 401(k) Plan – Company Match
$33,500 401(k) Plan – Employee After Tax Contribution
$5,500 IRA
$3,350 HSA or Health FSA
$2,500 Dependent Care FSA
$3,000 Parking & Transit FSA
$14,000 529 College Savings Plan
$81,350 Total

Wow, that is a lot of money!   Of course, most of us don’t even make $81,350 each year, so you’re going to have to prioritize the contribution to each account.  Below are potential savings from each account:

 

As you can see, the potential savings from these accounts is huge.  Some accounts offer a great savings per dollar of contribution, whereas other accounts offer great savings in nominal dollar amounts (because these accounts allow such high dollar contributions, but may not offer as great of a savings per dollar).

The amount of savings that you’ll experience from these accounts depends on the following questions:

  • Do you think taxes will be higher for you today or higher in retirement?
  • Which of these accounts does your employer offer?  (Employers aren’t required to offer all of these accounts.)
  • Which taxes are each account exempt from? (Some accounts are subject to federal income tax, state income tax, and FICA taxes.)
  • Which accounts offer the opportunity to be exempt from taxes on investment gains?  (Some of these accounts are for long-term retirement plans, whereas other can be used for expenses today.)

A summary account features can be found below:

taxaccountsummary

Although it may seem that you’d want to target those accounts which are exempt from all taxes first, that’s not actually the case.  Some accounts offer tax advantages on long-term investments and the ability to defer paying taxes until retirement, which can be very valuable.  And we’ll go through different scenarios to help you decide which accounts are right for you.  Generally though, most people observe the following order when making contributions to these accounts:

  • First, make 401(k) contribution to get full employer match (if you don’t have employer match, skip this step)
  • Then, make contributions in the following order:
    • Max out HSA
    • Max out IRA
    • Max out FSA (Child Care FSA, Commuter Benefits FSA, and other types)
    • Max out 401(k) contribution (contribute money beyond employer match requirements in this step)
    • Max out After Tax 401(k) contribution
    • Max out 529 College Savings Plan

In the full article, we’ll go through each account in more detail and decide which accounts may be right for you.

Full Article:


401(k) Plan – Overview

A 401(k) plan allows you to contribute up to $18,000 (in 2016) of your own money to a tax advantaged retirement account. If you’re over the age of 55, you are eligible to also make catch-up contributions of $6,000 on top of the $18,000 contribution limit. In this retirement account, you can invest money in the stock market or other investment vehicles of your choosing. (Your employer generally chooses the options that you have in regards to investments though.) You can begin withdrawing money without penalty once you turn 59.5 years old. If you withdraw money prior to 59.5 years old, you must pay a 10% penalty on the withdrawal amount.  (So don’t withdraw money before you turn 59.5!)

401(k) plans generally allow for two types of contributions: pretax contributions and Roth contributions.

If you make a pretax contribution, the money that you contribute to a 401(k) is not subject to federal or state income tax in the year of the contribution. You will pay federal and state income tax upon withdrawal (when you are in retirement). However, you still must pay social security tax in the year of your contribution (but you don’t have to pay it when you withdraw money in retirement).

If you make a Roth contribution, you pay all of the usual taxes that you normally pay on your contribution. There is no upfront tax benefit. However, your money is able to grow tax-free and you won’t pay any taxes on withdrawals in retirement. You won’t pay any capital gains tax or anything on money in your Roth account. It’s completely tax free upon withdrawal.

The reason for contributing to a Roth 401(k) plan instead of a traditional 401(k) is if you believe that your tax rate will be higher in retirement than during your working years. Reasons for believing you’ll have a higher income during retirement are if you believe the government will raise taxes by the time you retire or if you believe you’ll have a higher income during retirement.

For 401(k)’s, there is a contribution limit of $18,000 which applies to both pretax and Roth contributions combined. So, you can only contribute to $18,000 to pretax and Roth 401(k) accounts combined in a single year (not $36,000).

If your employer contributes any money to your 401(k), such as through a matching contribution, the employer contribution doesn’t count towards the $18,000 limit. Also, the contribution limit is per person. Therefore if you are married and both parties work, then each party could contribute up to $18,000, or $36,000 in total. However, you cannot contribute more money than you earn. (For example, you can’t give a part-time working spouse money to maximize their 401(k).) Also, the contribution limit does not go up if you have multiple employers. For example, if you have two employers and two 401(k) plans for one person, you could still only contribute $18,000 combined to both 401(k) plans in a single year.

401(k) Plan – Potential savings

In order to evaluate potential savings, we have to look at your tax situation now and your tax situation during retirement.  The potential savings are change based on if you will pay less taxes in retirement, the same amount of taxes in retirement, or more taxes in retirement.  Another thing to consider is whether or not you pay capital gains tax in retirement.  With the current tax law, you don’t have to pay capital gains tax if you stay in the 15% federal tax bracket.  Taking all this information into consideration, we will calculate the potential savings for a traditional 401(k) account in different tax scenarios.

For 401(k) plans, we’re also going to look at your savings including an employer match and excluding an employer match.  An employer match is very valuable because you only receive the match if you contribute to your 401(k) account, so it’s an immediate “savings” because it’s free money you wouldn’t have otherwise received.

Matching contributions only usually apply to a portion of your 401(k) contribution though.  For example, your employer might only match the first $2,500 contribution to your 401(k) account (with a 60% matching contribution on that first $2,500).

To calculate the savings from a 401(k) contribution, we use the following process:

  • We will compare the 401(k) contribution to a “regular account”
    • The regular account would be subject to your usual taxes in your paycheck and would go towards a personal brokerage account
  • We will keep the money in the 401(k) and the “regular account” for 30 years
  • We will be assuming each account earns an inflation-adjusted 5% return (which is equivalent to an 8% return with 3% inflation)
  • We will be assuming tax laws do not change
    • This means that if you are in the 15% federal tax bracket during retirement, you will not pay capital gains tax on investments in the “regular account”
  • We will be assuming that the federal income tax bracket applies to all of your 401(k) contribution or withdrawals (e.g. if you are in the 15% tax bracket, your entire contribution or withdrawal is subject to 15% federal income taxes)
    • In reality, you may be paying even less in federal incomes taxes during retirement if you have a low income.  It could be closer to 5% or 10% with deductions and lower tax brackets.
  • We will be assuming that the state income taxes are a flat 4.00% of income
  • We will be assuming that FICA taxes are a flat 7.65% of income

Below are the results for of this analysis for Pretax 401(k) contributions and Roth 401(k) contributions:


401k_pretax_withmatch


401k_roth_withmatch


As you can see, you save a lot of money by making 401(k) contributions that receive matching employer contributions.  This is because your employer match earns your money a great return immediately upon contribution, and then you earn even more by utilizing the tax advantages of the 401(k) account.

Now, let’s look at similar scenarios for the portion of the 401(k) contribution that does not receive a matching employer contribution:


401k_pretax


401k_roth


As you can see, even without an employer match, a 401(k) account can still be very advantageous due to the tax savings.


401(k) Plan – After Tax Contributions

One lesser known strategy of 401(k)s is to make after tax contributions to a 401(k) account. An after tax contribution to a 401(k) is different than a Roth 401(k) contribution. The difference is in name mostly (in the current state of the tax code). In the past, there were no Roth accounts and after tax 401(k) contributions were just a way to utilize your employer plan for investing your post-tax money. There used to be no tax benefits associated with after tax 401(k) contributions. However, after Roth accounts were created, after tax contributions to a 401(k) account became valuable. This is because you can do in-service Roth conversion of after tax 401(k) contributions, when they essentially become another source of making a Roth 401(k) contributions. This means that after tax 401(k) contributions can grow tax-free and you won’t have to pay taxes on capital gains upon withdrawal.

Note: You have to convert after tax contributions to Roth 401(k) contributions in order for them to grow tax free.  This means your employer needs to allow in-service Roth conversions and you need to be constantly converting these funds to Roth contributions throughout the year.  Check the Summary Plan Document of your 401(k) plan to see if your plan allows after tax contributions and in-service Roth conversions.

There is no specific limit on after tax 401(k) contributions, but they are limited by the total amount of contributions a person can receive from a 401(k). For 2016, this 401(k) limit for all contributions (including both employee and employer contributions) was $53,000. This means the formula for the post-tax contribution limit is:

After Tax 401(k) Contribution Limit = $53,000 – Employee Pre-Tax or Roth Contributions – Employer Contributions

For example, if you contribute $18,000 in pre-tax 401(k) contributions and your employer contributes a matching contribution of $6,000 to your 401(k) account, then your maximum after tax contribution would be:

$33,500 = $53,000 – $18,000 – $1,500

You should check with your employer to see if they allow after tax 401(k) contributions since not all 401(k) plans offer this type of contribution. Specifically, you can find this information in the Summary Plan Document of your 401(k) plan. In addition, you can reach out to your Human Resources department and they should be able to help you.

Potential savings from after tax 401(k) contributions can be pretty big as well since they are essentially massive Roth accounts.  Below are examples:


401k_aftertax


403(b) Plan

This is a plan that is virtually identical to a 401(k) plan, but designed for nonprofit organizations.

457 Plan

This is a plan that is virtually identical to a 401(k) plan, but designed for government organizations.

SIMPLE Plan

This is a plan that is similar to a 401(k) plan, but designed for smaller employers. The maximum employee contribution is generally lower than a 401(k) plan. In 2016 ,the maximum contribution was $12,500 with a catch-up contribution for participants over the age of 50 equal to $3,000

SEP Plan

This is another retirement plan designed for small employers. SEP Plans are based on IRAs and have rules similar to traditional IRAs. However, the contribution limits are higher than a traditional IRA. In 2016, the contribution limit were limited to the lesser of 25% of compensation or $53,000.

Individual Retirement Account (IRA)

An IRA is a retirement account set up by an individual for retirement. An IRA is similar to a 401(k) plan, but it is set up by an individual (instead of a company). In addition, the contribution limits are lower than a 401(k) ($5,500 is the maximum contribution to an IRA in 2016). There are three types of IRAs:

  • Traditional IRA: Pretax contributions are made to this type of IRA (similar to traditional 401(k))
  • Roth IRA: Post-tax contributions are made to this type of IRA (similar to Roth 401(k))
  • Rollover IRA: This IRA is used when you leave a company’s qualified retirement plan (such as a 401(k)) and need an account to “roll over the money” to. A Rollover IRA could be either a Traditional IRA or Roth IRA (depending on the source of the funds).

Luckily, you can contribute to both a company-sponsored retirement plan such as a 401(k) and an IRA without the contribution limits overlapping. This means that if you make a maximum contribution to a 401(k) account, you can still make the maximum contribution to an IRA.

One disadvantage of an IRA is that there are income limits to being eligible to make tax-deductible contributions to a traditional IRA, and income limits to being eligible to make direct contributions to a Roth IRA. However, there is a workaround available for high income individuals called a “backdoor Roth IRA”. This involves making non-tax-deductible contributions to a Traditional IRA (which is allowable) and then immediately converting the Traditional IRA to a Roth IRA (there are no income limits for this transaction). When you convert from a traditional IRA to a Roth IRA, you only have to pay taxes on the portion of funds that you claimed as tax deductible when you contributed to the traditional IRA. However, since you never claimed deductions for your traditional IRA, you can roll over the money without any tax consequences. Therefore it’s basically equivalent to making a Roth IRA contribution directly.

For whatever reason, this tax loophole exists and hasn’t been patched up. Therefore if you’re a high income individual, it’s worth utilizing since the investment gains within a Roth IRA are not taxable. Your investment company is familiar with this tactic, and companies like Vanguard can help you set up your backdoor Roth IRA with a few transactions.

IRA – Potential savings

To calculate the savings from an IRA contribution, we use the following process:

  • We will compare the IRA contribution to a “regular account”
    • The regular account would be subject to your usual taxes in your paycheck and would go towards a personal brokerage account
  • We will keep the money in the IRA and the “regular account” for 30 years
  • We will be assuming each account earns an inflation-adjusted 5% return (which is equivalent to an 8% return with 3% inflation)
  • We will be assuming tax laws do not change
    • This means that if you are in the 15% federal tax bracket during retirement, you will not pay capital gains tax on investments in the “regular account”
  • We will be assuming that the federal income tax bracket applies to all of your IRA contribution or withdrawal (e.g. if you are in the 15% tax bracket, your entire contribution or withdrawal is subject to 15% federal income taxes)
    • In reality, you may be paying even less in federal incomes taxes during retirement if you have a low income.  It could be closer to 5% or 10% with deductions and lower tax brackets.
  • We will be assuming that the state income taxes are a flat 4.00% of income
  • We will be assuming that FICA taxes are a flat 7.65% of income

Below are the results for of this analysis for an IRA contribution and Roth IRA contribution:


ira


ira_roth


Health Savings Account (HSA) – Overview

An HSA is a savings account for health-related expenses. Only individuals in high deductible health plans are eligible for this account. An HSA can pay for things like doctor’s appointments, prescription drugs, and medical treatments. For a complete list of allowable medical expenses, you can check out this IRS webpage.

Contributions made to an HSA are made on a pretax basis. Contributions are not subject to federal taxes or FICA taxes. Generally, contributions are not subject to state taxes, but three states don’t allow for a deduction for contributions made to an HSA (Alabama, California, and New Jersey).

The maximum contribution to an HSA in 2016 was $3,350 for an individual and $6,750 for a family.  Funds that are contributed to an HSA during the year but are not used will roll over to the next year. This means that you can keep your funds indefinitely until you use them.

Another benefit of HSAs are that once you reach the age of 65, then you can withdraw funds from an HSA for any reason (which means you can use the funds for non-health reasons after age 65). Because of this feature, you can basically use HSAs as a 401(k) or IRA.  Funds in an HSA can even be invested in bonds and stocks similar to a retirement account. There are a few differences between the accounts to be aware of though:

  • 401(k)s and IRAs allow withdrawals for any reason at age 59.5 without penalty, but HSAs require you to be age 65 before you can withdraw the money for any reason
  • HSAs allow withdrawals for medical expenses during your working years, whereas 401(k)s and IRAs do not
  • HSAs are not subject to FICA tax

HSAs are basically a supercharged retirement account because of its benefits.

Health Savings Account (HSA) – Potential Savings

To calculate the savings from an HSA contribution, we will look at two scenarios:

  • Using an HSA for medical expenses in the current year
  • Using an HSA for retirement expenses in future years

When we look at using an HSA for retirement expenses, we will need to project out the contribution over a 30-year time horizon.  To do this,  we will make the following assumptions:

  • We will compare the HSA contribution to a “regular account”
    • The regular account would be subject to your usual taxes in your paycheck and would go towards a personal brokerage account
  • We will keep the money in the HSA and the “regular account” for 30 years
  • We will be assuming each account earns an inflation-adjusted 5% return (which is equivalent to an 8% return with 3% inflation)
  • We will be assuming tax laws do not change
    • This means that if you are in the 15% federal tax bracket during retirement, you will not pay capital gains tax on investments in the “regular account”
  • We will be assuming that the federal income tax bracket applies to all of your HSA contribution or withdrawal (e.g. if you are in the 15% tax bracket, your entire contribution or withdrawal is subject to 15% federal income taxes)
    • In reality, you may be paying even less in federal incomes taxes during retirement if you have a low income.  It could be closer to 5% or 10% with deductions and lower tax brackets.
  • We will be assuming that the state income taxes are a flat 4.00% of income
  • We will be assuming that FICA taxes are a flat 7.65% of income

Below are the results for of this analysis for an HSA contribution for medical expenses and an HSA contribution for retirement expenses:


hsa_medical


hsa_retirement


Health FSA (Flexible Savings Account) – Overview

This is an account offered by employers that can be used for qualified medical expenses. For a complete list of allowable medical expenses, you can check out this IRS webpage.

Contributions made to an Health FSA are made on a pretax basis. Contributions are not subject to state, federal, or FICA taxes.

If your employer doesn’t offer an HSA, then they probably offer a Health FSA. However, a Health FSA is different than an HSA. Generally, a Health FSA does not allow you to roll unused money from one year to another (some plans allow you to roll over up to $500 from one year to another). In addition, Health FSAs do not allow you to invest the money and only allow you to withdraw the exact amount of money that you contributed to the plan. The maximum contribution to a Health FSA is lower than an HSA too. In 2016, the maximum contribution to a Health FSA was $2,550 (whereas an HSA allowed a contribution of up to $3,350).

The potential savings for a Health FSA are similar to an HSA account used for medical expenses.  Please see the preceding section titled Health Savings Account (HSA) – Potential Savings for the savings from this account.

Dependent Care FSA (Flexible Savings Account) – Overview

This is an account offered by employers that can be used for dependent care expenses while the guardian is at work. In most cases, this account is used to pay for daycare of children. However, this account can also be used for daycare of a disabled or elderly dependent. To use this account, you must be able to claim the person in daycare as a dependent on your tax return. In addition, this account cannot be used to pay for summer camp for kids or long-term care facilities for dependents.

Contributions to this account are made on a pretax basis. Contributions are not subject to state, federal, or FICA taxes. The maximum contribution to this account is $5,000 in 2016. This maximum contribution applies to the contribution from both spouses. If you’re a single mother or father with full custody of the children, you have a maximum contribution of $5,000. If you’re a married couple, then you still also have a maximum contribution of $5,000 combined.

If you’re married, both spouses must earn income in order to be eligible for this contribution. If one of the spouses earns very little income (such as $1,000), then your contribution will be limited. For married couples, the maximum contribution is limited to the lesser of $5,000 or the lowest individual income in the marriage. For example, if your spouse earns $2,000, then your maximum contribution to this account would be $2,000 instead of $5,000

Funds in a Dependent Care FSA that are not utilized within the year of contribution will be forfeited and lost. There is no option to roll funds over to future years. In addition, you cannot do any investing of funds. The amount of withdrawals available from an FSA are exactly equal to the contributions made.

Dependent Care FSA (Flexible Savings Account) – Potential Savings

Potential savings from a Dependent Care FSA are shown below.  All of the potential savings for a Dependent Care FSA are due to contributions being exempt from federal income, state income, or FICA tax.


fsa_child


Commuter Benefits FSA

This is an account offered by employers that can be used for expenses related to traveling to work, such as public transit costs and parking costs. Contributions to this account are made on a pretax basis. Contributions are not subject to state, federal, or FICA taxes.

Funds in a Commuter Benefits FSA that are not utilized within the year of contribution will be forfeited and lost. There is no option to roll funds over to future years. In addition, you cannot do any investing of funds. The amount of withdrawals available from an FSA are exactly equal to the contributions made.

Potential savings from a Commuter Benefits FSA are shown below.  All of the potential savings for a Dependent Care FSA are due to contributions being exempt from federal income, state income, or FICA tax.

fsa_commuter

529 College Savings Plan – Overview

This is an account offered that can be used for expenses related to higher education. The expenses that qualify include the cost of tuition, books, room, board, and more. The benefeciary of the plan can be pretty much anyone in your family (including your cousins) or even yourself.

Contributions to a 529 plan are not exempt from most taxes. Most states allow for contributions to be deducted, so contributions can be exempt from state taxes. However, contributions are not exempt from federal or FICA taxes. The main tax benefit is that money contributed to this account can be invested and the earnings are not taxed upon withdrawal.

529 College Savings Plan – Potential Savings

To calculate the savings from an 529 College Savings Plan contribution, we use the following process:

  • We will compare the 529 College Savings Plancontribution to a “regular account”
    • The regular account would be subject to your usual taxes in your paycheck and would go towards a personal brokerage account
  • We will keep the money in the 529 College Savings Planand the “regular account” for 10 years
  • We will be assuming each account earns an inflation-adjusted 5% return (which is equivalent to an 8% return with 3% inflation)
  • We will be assuming tax laws do not change
    • This means that if you are in the 15% federal tax bracket at the time of withdrawal, you will not pay capital gains tax on investments in the “regular account”
  • We will be assuming that the state income taxes are a flat 4.00% of income

529collegesavingsplan

 

Other Considerations

In this article, we’ve only talked about the direct tax savings from different strategies due to decreased income taxes or decreased capital gains taxes.  However, another thing to consider is how each account contribution affects AGI (Adjusted Gross Income) or MAGI (Modified Adjusted Gross Income) on your tax return (either in the current year or in retirement).

  • Pretax contributions reduce your AGI in the current year, and increase AGI in retirement
    • By reducing AGI in the current year, this may…
      • Make you eligible for certain tax credits or deduction in the current year
      • Make it easier to take medical tax deductions in the current year (medical expenses greater than 10% of AGI are deductible)
    • By increasing AGI in retirement, this may
      • Make you ineligible for certain tax credits or deduction in retirement
      • Make it harder to take medical tax deductions in retirement (medical expenses greater than 10% of AGI are deductible)
      • Make more social security benefits taxable in retirement
  • Post tax contributions (such as Roth contributions) do not reduce AGI in the current year, but withdrawals won’t count increase your AGI in retirement
    • By reducing AGI in retirement, this may….
      • Make you eligible for certain tax credits or deduction in retirement
      • Make it easier to take medical tax deductions in retirement (medical expenses greater than 10% of AGI are deductible)
      • Make less social security benefits taxable in retirement
    • By increasing AGI in the current year, this may…
      • Make you ineligible for certain tax credits or deduction in the current year
      • Make it harder to take medical tax deductions in the current year (medical expenses greater than 10% of AGI are deductible)

Overall, these “other considerations” generally have a smaller effect than the direct tax savings, so these other considerations shouldn’t influence your strategy too much.

Summary

Putting together all of the calculations in the preceding sections, we obtain this table of potential savings for each scenario:



The tax advantaged accounts you ultimately choose depend on your own personal situation.  Good luck and happy saving!


 



You May Also Like

Leave a Reply

Your email address will not be published. Required fields are marked *