Last Updated Oct 26, 2010 10:41 AM EDT
A record federal deficit and expiring tax laws have put the spotlight on income taxes this year, with many predicting rising rates for at least some well-heeled filers. That's got experts urging high-income individuals to quickly review their employee benefit plans to see if they can use little-understood programs that can save thousands of dollars in taxes.
You may have to take action within the next few weeks: Your ability to use these tax breaks in 2011 hinges on signing up during this year’s open enrollment period, which has already begun at many companies.
“People are focused on the higher taxes that may be in the offing — [and] this is something you can do to counteract that,” said Philip J. Holthouse, a partner at the Santa Monica tax law and accounting firm of Holthouse Carlin & Van Trigt. “Everyone should spend a few minutes reading through their paperwork to figure out what they have available and sign up for as many of these plans as they can use.”
There are five potential tax shelters buried in your employee benefit plan. Only one — the 401(k) plan — is widely understood and commonly used. But the other four options provide even sweeter tax benefits, Holthouse said. That’s because they come out of your check before both income taxes and employment taxes — that’s the 7.65% of your wages that you pay into Social Security and Medicare — are figured. Moreover, reducing your income with contributions to these plans can help you qualify for other tax breaks. That means that each $100 you contribute can be worth as much as $35 to $40 in tax savings for upper-middle-income taxpayers.
Yet less than one-quarter of all employees who are offered these accounts use them, said Barry Schilmeister, a partner at the national employee benefits consulting firm Mercer Inc. Why? Experts can only speculate, but a recent survey by Wage Works found that 86% of respondents had at least one misconception about how they work.
So what are these accounts and how could they help you?
1. Flexible Spending Accounts
- What to do: Go through this past year’s out-of-pocket expenses and project where you might spend more or less in 2011. Pay particular attention to dental costs, which often leave you with bigger co-payments, and orthodontia, which is often not covered at all. Then use your employer’s benefits system to fund a flexible spending account with that amount.
- Drawbacks? The one catch is that any amount you don’t use by year end is forfeit. But because the money can be used for everything from eyeglasses to bandages, it’s pretty easy to use every dollar. Anyone who is using one of these plans should be aware of a change for next year: As of January 1, over-the-counter medicines will not be eligible, unless you have a prescription. (Here’s a list of what products are, and are not, eligible for flexible spending accounts.)
Also known as medical and health care spending accounts, these are offered by about 85% of large employers, Schilmeister said. The accounts allow workers to set aside their own money to cover co-payments, deductibles and other uninsured medical expenses ranging from dentistry to prescriptions.
You decide how much to contribute; the company deducts a pro-rata share of that contribution from each paycheck. If you get paychecks every two weeks and wanted to contribute $1,300 a year, for instance, they’d take $50 out of each check.
To use your savings, you’re usually given a debit card loaded with the entire year’s worth of savings, said Joe Jackson, CEO of WageWorks, which provides the administration services for many employer plans. When you have an eligible expense, you swipe and go. No paperwork necessary.
The plans are particularly helpful for people with big planned expenses — the $3,000 upcoming expense for your child’s orthodontia or speech therapy, said Jackson. They’re also good for chronic ailments that require regular prescriptions; or to handle costly elective (but not cosmetic) procedures such as Lasik eye surgery.
But even if you just want to cover co-payments, it’s worth using these accounts, Jackson said: “If I gave you a card that allowed you to save 40% on groceries every time you used it, there’s no question that you’d use it,” Jackson said. “This is no different.”
2. Health Savings Accounts
- What to do: If you have only minor medical bills, consider enrolling in your employer’s high-deductible plan. Pairing it with a HSA will allow you to save money today for bills you might have when you’re older.
- Drawbacks? If you have lots of current medical needs, you’ll probably pay more with a high-deductible than a traditional plan.
These are relatively new savings plans that are paired with high-deductible health insurance plans. Next year, consumers will be able to save up to $3,050 per person or $6,150 per family, in an HSA, Schilmeister said. This money can be used to cover deductibles and co-payments — just like the savings from the health care accounts — but it doesn’t have to be used up in one year. In fact, HSA savings can be rolled forward indefinitely and eventually even used as additional retirement savings.
The accounts can only be opened by those who couple them with a high-deductible health insurance plan, however.
3. Dependent Care Accounts
- What to do: If you have kids in daycare, find out if your employer or your spouse’s employer offers a plan and sign up for the maximum contribution.
- Drawbacks? There’s some paperwork and, like health savings accounts, amounts not spent are lost. But daycare expenses are predictable, so losses are rare.
These accounts allow workers with children under the age of 13 to set aside as much as $5,000 annually to cover day care expenses for families in which both parents work. This includes summer day-camp programs, but does not include tuition for private schools or overnight camps.
4. Transportation or “Commuter” Accounts
- What to do: Call your benefits representative and find out how to sign up.
- Drawbacks? If you pay for parking or mass transit, there’s no catch. This just allows you to pay with pre-tax dollars. It’s a no-brainer.
Workers are also commonly offered so-called commuter benefits that allow them to set aside as much as $230 per month to pay for public transit or parking, said Jackson.
You should never contribute more to these accounts than you’re likely to use. But, if you pay for parking or daily commuting expenses in a high-cost city such as Los Angeles, San Francisco, New York or Boston, it’s not difficult to spend that full $230 on commuting — a total of $2,760 a year. Paying these bills through an employee account just lets you save taxes on that expense.
5. 401(k) Plans
- What to do: Reconsider how much you’re contributing, particularly if you’re among the many people who cut back on contributions when the economy tanked and the market soured. You should contribute at least enough to get the full company match – and more if you can afford it.
- Drawbacks? The savings are mostly locked up until retirement, but some companies let you borrow from your accounts to finance college and home purchases. Any amount permanently withdrawn is subject to tax and tax penalties,
Yes, we know you know about this: Roughly 65 million 401(k) plan participants have already socked away $3.4 trillion in retirement savings through 401(k)s, according to the Profit Sharing/401(k) Council of America. That’s partly thanks to a tax break that allows contributions to come out of pay before income taxes are computed, so each $100 in savings only costs you about $75, after you take into account the $25 in federal income tax savings. (This assumes a 25% federal bracket, which applies to singles with up to about $83,000 in taxable income and married couples with up to $138,000 in income. Higher income filers get a bigger break.)
Still: As long as you’re meddling with your benefits elections, you might want to give your 401(k) a quick look. Are you contributing as much as you can? Also, check to see if your company offers automatic increases whenever your pay goes up: You won’t miss money that was never in your pocket to begin with.
Adding Up the Impact
Why do these five deductions make such a difference? An increasing number of income tax breaks are “income-tested” these days, which means that you lose the benefits if you earn more than set amounts. These are not. Most large employers offer them and anyone with a plan available can use them, regardless of how much they earn.
Better yet, because they reduce your taxable income, they also allow you to qualify for those income-tested breaks that you might otherwise earn too much to get.
Consider, for example, a married couple living in suburbs of New York and earning $200,000 annually, with two children in college. There’s a lucrative tax break called the American Opportunity Tax Credit for people paying their kids’ college bills, but married couples earning more than $180,000 are locked out of it. In fact, you lose a portion of the break for every $1,000 you earn over $160,000. (This credit is slated to expire in 2011, but Obama plans to reinstate it.)
If both spouses contributed $16,500 to their respective 401(k) plans and $200 each month to their respective transportation accounts; and one spouse puts $2,200 into a health savings account to pay medical co-payments, deductibles and dental bills, they would reduce their taxable income by $40,000 — bringing them to the magic $160,000 level.
What does that save them in tax? It saves $11,200 in federal income tax; $535.50 in employment taxes; and it allows them to claim American Opportunity Tax credits for both of their children. Total savings: $16,735. And that’s before state and local taxes are considered.
“These accounts give employees a tremendous opportunity to save on their taxes,” said Schilmeister. “Everyone should be participating in these plans.”
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