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How Three Accounts Could Help Lower Taxes, Protect Your Health, and Save For Retirement

October 12, 2018
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With tax season around the corner I wanted to take a deeper dive into some ways you can use a few accounts we've covered in the past - HSAs, FSAs, and Dependent Care FSAs - to potentially benefit your finances. I am not obsessed with these accounts, at least not in the literal sense. As a matter of fact, as an independent contractor in the state of Tennessee, I don't even have access to them myself (don't take those company benefits for granted). But I wish I did, and maybe that's why I'm so adamant about making sure high income earners know how using them to pay for things they already pay for could work to their advantage. Before we get into the details of each account, I want to note that all three of them allow you to contribute money on a pretax basis; since pretax may not be a term you hear every day, let's do a quick recap on what it means. 

What Does Pretax Mean?

If you're a visual person, I recommend you check out the YouTube video we did on pretax deductions a while back. But as a quick refresher, pretax means that the money you put aside is contributed before you pay taxes on your income. As a quick example, if you make $100,000 and contribute $5,000 to a pretax account, you'll only pay taxes on $95,000 of income. Since the taxes are assessed against a lower number, you pay less of them.

So, since we have that out of the way, and all of the three accounts we'll cover are pretax, let's get into the details of the other ways they can potentially benefit your finances. 

Health Savings Account (HSA)

Health Savings Accounts are accounts where you can save money pretax that can be used for certain qualified medical expenses, such as a visit to the doctor or filling a prescription. In 2018, individuals can contribute up to $3,450 pretax into their HSA, or $6,900 if you are on a family plan (account owners over 50 can contribute an additional $1,000). If you have an HSA, you deposit funds into your account before they're taxed, and those funds can be invested just like in your 401(k). It's important to note that to be eligible for an HSA, you have to be utilizing a high-deductible health plan (HDHP). This wrinkle can benefit high-income earners who are responsible for their own insurance, as the premiums for health insurance can be astronomically high for those who don't qualify for a subsidy. By using a HDHP, your premiums will likely be lower, sometimes significantly so. But even if you're on an employer plan that's relatively affordable, there are a number of reasons high income earners should consider using an HSA, the last of which we'll spend a little more time on:

1. The funds "roll over": unlike some of the other accounts we'll cover, you don't HAVE to use up all the funds in your HSA each year. If you put $5,000 into your family HSA but only use $1,000 towards your health costs, the remaining $4,000 will rollover to be used in future years.

2. Triple tax benefits: the money in your HSA isn't taxed when it's deposited, isn't taxed as it grows, and isn't taxed when you use it for qualified medical expenses. 

3. Medicare Premiums: unfortunately, one of the things we'll all pay for in retirement that I rarely see people prepared for is healthcare. Fortunately, once you're eligible for Medicare, the funds in your HSA can be used to pay for your health insurance premiums, and won't be taxable to you when withdrawn for eligible expenses.

4. Extra Retirement Savings: here's the big one. Once you've turned 65, you can use the funds in your HSA for anything you want to, even if it has nothing to do with your health. This allowance means that your HSA could serve as an extra tool for retirement savings. In my opinion, it's especially useful for investors who have chosen Roth retirement accounts, where you put money aside for retirement POST-tax in exchange for not paying taxes on these monies in retirement. When you use a Roth account, you don't get the upfront tax deduction that comes with pretax investments. But by utilizing an HSA alongside your Roth, you still have a vehicle to get a decent tax deduction to help with your current taxes. It's important to point out that if you do use your HSA funds for non-eligible medical expenses after 65, you won't pay a penalty, but you wil pay income taxes on these funds.

The long and short of it is that whether or not you're likely to use all of the funds in your HSA each year, it represents an opportunity to potentially decrease your taxes and offer an additional vehicle for investing in the market.

Flex Spending Account (FSA)

FSAs are accounts that can also be used for qualified medical expenses and more, even expenses related to adoption. While the contribution limits for FSAs are lower than HSAs ($2,650-5,300), they do NOT have to be paired with a high-deductible health plan, which can be useful for professionals who want to use a pretax account to save for health expenses but may live in an area without high-deductible plan ( ... professionals like me). But the largest difference between an HSA and an FSA is that FSA funds don't rollover in full; each year you can rollover $500 of unused FSA contributions, without impacting the amount you can contribute the following year. While this does mean that FSAs are not a tool for retirement planning in the same way as HSAs, their usefulness as a pretax deduction still makes them worth your consideration.

Dependent Care Flex Spending Account

I probably tell a high income-earner once or twice a week they should consider using a Dependent Care Flex Spending Account if one is made available to them.The point is, if you're already paying a ton of money for things related to your child's care, it's worth considering a tool that gives you a tax deduction when paying for those expenses. And in 2018, the increase in the Child and Dependent Care Credit has presented an additional opportunity. First, let's cover the subtle but important differences between the two:

A Dependent Care FSA is an account that allows you to put money aside - $2,500 - $5,000 in 2018 depending on your tax status - to pay for eligible expenses related to child care.

In my opinion, the sheer number of allowable expenses under Dependent Care FSAs covers the majority of things you spend money on for a child. Daycare? Check. Tuition? Check. After-school program? Summer camp? Babysitter while you're at work? Check, check and check. 

The Child and Dependent Care Credit works differently. Rather than allowing you to pay for expenses pretax, this Credit simply offers a 20% - 35% tax credit towards eligible expenses up to $6,000. 

Here's an illustration of the difference between pretax contributions and a 20-35% tax credit: let's say you earn $100,000 and pay $5,000 towards childcare costs that are eligible under both the Dependent Care FSA and the Child and Dependent Care Credit. If you solely use the Dependent Care FSA, contributing the $5,000 pretax means your taxable income will be reduced by $5,000 (see example in first paragraph). If you didn't use a Dependent Care FSA and chose to use the Child and Dependent Care Credit, you would provide proof of the $5,000 in expenses and, if eligible, receive a $1,000 - $1,750 credit (20% - 35% of $5,000) towards the amount you owed in taxes. To keep this round-numbered example going, this credit would mean that if you owed $10,000 in taxes, the credit would reduce this amount to $8,250 - $9,000. 

So where's the opportunity? Well, even though you can't claim both the Dependent Care FSA and the Child and Dependent Care Tax Credit for the same expense, you CAN claim the Tax Credit for expenses above the $5,000 limit set by the Dependent Care FSA. This means eligible families could use the Dependent Care FSA to pay for the first $5,000 of expenses, and then use another $1,000 of the Child Tax Credit before you reach its $6,000 limit. 

Please note a few things about all of this information: one, I don't try to be something I'm not, and I'm not a CPA. Many of these concepts have income limitations and/or details that are best planned out under the guidance of a tax professional. Secondly, you may not have the bandwidth or desire to put this type of strategy in place. All I want to do is give you the options, and we feel that these three accounts offer a number of features that can potentially benefit your finances, should you choose to accept them.