As year-end approaches, taxpayers are generally faced with a number of choices that can save taxes this year, next year or both. To help you take advantage of some 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 $2,750 to a health FSA is permitted in both 2020 and 2021. 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 but instead use the favorable standard deduction. Even if you do itemize, only medical expenses that exceed 7.5% your of adjusted gross income (AGI) (10% of AGI in 2021) are deductible. Additionally, the amounts that you contribute to a health FSA are not subject to FICA taxes. This would allow most employees to save $210 in FICA taxes alone on a health FSA contribution of $2,750. You would save an additional $550 in income taxes based on an effective income tax rate of 20%. Total annual tax savings would equal $760 ($210 + $550).
Keep in mind that you cannot get tax-free FSA reimbursements for aspirin, antacids and other over-the-counter items except for menstrual care products 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.
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 consider using 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 only the grace period relief applies, not the up-to-$550 forfeiture exception. Thus, now is a good time to review expenditures to date and to project amounts to be set aside for next year. As with the COVID-19 relief for health FSAs, the IRS is allowing employers to permit employees to make prospective mid-year elections and changes to dependent care FSAs, giving them added flexibility in meeting their dependent care needs. It is also allowing unused dependent care amounts at the end of their grace period in 2020, e.g., March 15 for calendar year plans, to be used to reimburse qualifying expenses through the end of 2020.
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 2021) a health plan:
- (1) that has an annual deductible which is not less than—
- (i) $1,400 for self-only coverage, and
- (ii) $2,800 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) $7,000 for self-only coverage, and
- (ii) $14,000 for family coverage.
The maximum contribution an individual may make to an HSA, in 2020, is $3,550 ($3,600 for 2021) for an individual with self-only coverage under an HDHP and $7,100 ($7,200 for 2021) 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 the year.
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 2020, 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 2021, 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 2020 and for 2021 is $19,500. Employees age 50 or older by year-end are also permitted to make an additional contribution of $6,500, for a total limit of $26,000. 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 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 2020 and 2021 Roth contribution limit is $6,000, rising to $7,000 if you’re age 50 or older by the end of the year. Your ability to make a Roth IRA contribution in 2020 will be reduced if your adjusted gross income (AGI) in exceeds:
- (a) $196,000 and your filing status in 2020 is married-filing jointly ($198,000 in 2021), or
- (b) $124,000, and your filing status in 2020 is that of a single taxpayer ($125,000 in 2021).
Your ability to contribute to a Roth IRA in 2020 will be eliminated entirely if you are a married-filing-jointly filer and your 2020 AGI equals or exceeds $206,000 ($208,000 for 2021). The cut-off for single filers is $139,000 or more ($140,000 for 2021).
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 totaled 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.
The CARES Act provides some relief: Coronavirus related distributions made during 2020 from a qualified retirement plan are not subject to the 10% extra tax on early distributions up to $100,000. These distributions can be repaid under special, relaxed rules, or will be taxed over three years instead of all in the distribution year. Also, the maximum limit on plan loans for Coronavirus affected individuals has doubled from $50,000 to $100,000, and there is a moratorium on plan loan repayment from March 27, 2020 through the end of the year. Check with your plan for details if you would like to take advantage of these breaks before year-end..
If you would like to discuss any of these matters in greater detail, please give me a call at your earliest convenience.