Tax-advantaged accounts that save the day, tax day and everyday
Savings accounts can be like time machines, blending the past, present and future. Far-fetched sci-fi? Not so, according to Catherine Martin, senior tax research analyst at The Tax Institute at H&R Block.
“You use them to save for the future, and with the right planning, you can use them to cut down your current taxes or even last year’s taxes,” said Martin.
It’s something more than magic, because tax-advantaged accounts are governed by laws that mean anyone can master the science of their tax saving benefits. Martin explains some of the most common accounts that help save for retirement, as well as medical, education and child care expenses.
Tax-advantaged accounts for retirement
Traditional IRA. Anyone with income under the threshold, which depends on filing status and whether they’re offered a retirement plan at their place of work, can contribute to a traditional IRA and deduct the contribution. The secret sauce here is that the deduction can be taken in the current year or, until the tax deadline, in the prior year.
“Contributing to an IRA is one of the only things you can do now to change your income for 2017. And your 2017 income influences all kinds of things on your tax return: your eligibility for certain tax credits, your tax rate, and even which free filing options you can use,” said Martin. “If you start your return and realize your income was higher than you expected and you lost eligibility for a valuable credit, it’s not set in stone until April 17.”
Roth IRA. A Roth IRA is the reverse of a traditional IRA. Instead of deducting contributions in the current (or prior) year, the distributions are tax-free. It’s a payoff later versus a payoff now.
“You may want to diversify your savings so that you’re paying some taxes now and some later, or if you are betting that your tax rate will be higher when you retire, you might want to put more of your savings in a Roth IRA,” said Martin.
401(k). Many employers offer 401(k)s to their employees and some may offer matches. A 401(k) offers the same tax benefits as a traditional IRA but is tied to an employer.
Roth 401(k). Just like a Roth IRA, a Roth 401(k) allows taxpayers to take distributions tax-free at retirement.
Bonus: Saver’s Credit. Lower income earners can get a tax credit for their contributions to a retirement account, making these earners and savers the only people entitled to “double dip” on two tax benefits for the same expense. Here’s how it works: they make a contribution to a retirement account. They either deduct their contribution from their taxable income, or, they take their contributions and growth tax-free when they retire. That’s the first tax benefit. The second tax benefit is a saver’s credit of up to 50 percent of their contributions in the year they contribute to the account.
Tax-advantaged accounts for medical expenses
There are two savings options for medical expenses that come with added tax saving benefits. Flexible spending and health savings accounts are pre-tax so that taxpayers don’t pay taxes on anything they contribute to the account. Then, FSA and HSA participants can use their tax-free funds to reimburse themselves for eligible medical expenses like copays, deductibles, eyeglasses and prescriptions.
Flexible Spending Accounts. Taxpayers have access to an FSA if their employer provides one as a health care benefit. An employee funds the account primarily with contributions taken from their salary. FSA holders can get reimbursed for expenses even if they haven’t yet placed the funds in the account. For example, a taxpayer may decide to contribute $50 to a FSA each month. If the taxpayer pays $300 for glasses in February, they can use the FSA for the full expense even though the account balance would only be $100 by the end of the month.
FSAs are not for long-term savings. Taxpayers who do not use FSA funds by the end of the plan year or grace period generally lose them.
Health Savings Accounts. Taxpayers with a high-deductible health plan (HDHP) may be eligible to set up an HSA. HSA contributions can stay in the account nearly indefinitely, rolling over year to year. This allows the account holder to save for future medical needs. Taxpayers can keep the funds in the account as long as they want – even after the year is over – and use them only when they need to.
Earnings on HSA contributions are tax free as well.
Tax-advantaged accounts for education expenses
529s. 529s allow individuals to prepay or save for qualified education expenses at eligible educational institutions. The earnings on contributions grow tax-free. When they are distributed for eligible educational expenses, the earnings are excluded from the student’s taxable income. Although the contributions are not deductible on a federal tax return, they are deductible on some state tax returns.
Account holders can take up to $10,000 per student in distributions each year for elementary or secondary school. There is no limit on the annual distribution amount for college expenses. However, qualified tuition plan earnings distributed for ineligible expenses could incur a 10 percent penalty in addition to income tax on the distribution.
Coverdell education savings accounts. A Coverdell can help taxpayers save for education expenses from kindergarten and up. Taxpayers may generally only contribute $2,000 per year to Coverdell accounts for children under the age of 18. However, the beneficiary can receive distributions tax-free as long as the distributions do not exceed the qualified educational expenses. Like a traditional IRA, the deadline to contribute to a Coverdell is the April tax deadline of the following year.
Once the beneficiary turns 30, the account must be distributed or rolled over for certain family members. Distributions for qualified expenses are tax-free, while distributions for ineligible expenses will be subject to a 10 percent penalty and income tax on the earnings portion of the distribution.
Tax-advantaged accounts for people living with disabilities
ABLE accounts. Certain individuals who have been certified as disabled and their families also have a tax-advantaged way to save and pay for the costs of living with a disability by opening and contributing to an ABLE account. Similar to a qualified tuition plan, ABLE accounts grow tax free and funds used to pay for qualified expenses are distributed tax free. The accounts may have state income tax benefits as well.
Tax-advantaged accounts for child care expenses
Dependent care FSA. An employer-sponsored dependent care FSA allows parents to save up to $5,000 pretax to use toward child care expenses. This means parents in the 24 percent tax bracket could reduce income taxes by $1,200 by fully funding their FSA. To be eligible, the child care must allow the parent, or parents if married filing jointly, to work or look for work. The account does not roll over from year to year, so it may only be used to save for and pay current year expenses.
Taxes are just one part of the financial picture for anyone saving for retirement or for medical, education or child care expenses. Saving and investment decisions should not be made solely for the tax benefits alone, and similarly, tax planning should take place over at least a two-year horizon. For help with their specific tax situation, taxpayers should consult a qualified tax professional.