Reducing Tax Burden Ex Post Facto
Happy New Year! Congratulations on another year of success. It’s finally time to set easily breakable resolutions and begin pre-emptively preparing your gingerly worded letters of disagreement to the IRS.
Since the tax year is already closed, you cannot unmake the money you earned in 2015, however there are still a few ways you might be able to reduce your tax burden for the year.
Health Savings Account (HSA) and Traditional Individual Retirement Account (IRA) contributions made through April 15, can be used to reduce Adjusted Gross Income (AGI) and, in turn, your overall tax liability. The Catch – only certain taxpayers may take advantage of these deductions; and for those who can benefit from them, there are limits to the amount you can contribute. In this article we will look at some basic eligibility provisions and highlight key attributes of HSAs and IRAs. Afterward, we will look at potential tax savings common to many taxpayers, followed by an example that illustrates potential indirect benefits and places these benefits in context. This article provides a broad overview and is not intended to be used by itself to determine eligibility for any deductions or credits.
HSA Overview and General Requirements
Purpose – Encourage savings for health expenses for taxpayers with High Deductible Health Plans (HDHP).
Max Contribution – $6,650 for family coverage, $3,350 for self-only coverage. $1,000 catch-up contribution for each spouse who turned 55 before the end of the tax year. While the family-coverage contributions can be made to either spouse’s account, the catch-up contributions must be made to the account of the spouse for which the contribution applies. So if only one spouse is eligible to make catch-up contributions, that spouse will need to have an account in their name.
Distributions – Must be made for qualified health expenses/reimbursements originating after the HSA was opened. Keep in mind the difference between “opened” and “funded.” An HSA merely needs to be open by the time health expenses are incurred. However, the HSA does not need to be funded beyond any minimum that is necessary to keep the account open.
Eligibility – Must be covered under a HDHP, must not be covered by any other plan that is not a HDHP, must not be enrolled in Medicare, and cannot be claimed as a dependent on someone else’s return. A HDHP must meet certain criteria, one of which is that the health insurance must have a deductible of at least $2,600 for family coverage ($1,300 for self-only). Additional special eligibility rules can be found in IRS Publication 969.
Traditional IRA Overview and General Requirements (This article does not cover Roth IRAs)
Purpose– Encourage retirement savings for taxpayers with modest income and who are not either active participants in a qualified retirement plan or ineligible to participate in an employer sponsored-plan.
Max Contribution – $5,500 per individual. $1,000 catch-up contributions for each spouse who turned 50 by the end of 2015. Additionally, contributions cannot exceed earned income. In determining earned income, married individuals may consider their spouse’s earned income to the extent that the income exceeds the spouse’s allowed IRA contributions. The phase-out for married filing joint taxpayers who are eligible to participate in employer plans, starts when Modified Adjusted Gross Income (MAGI) exceeds $98,000 and the benefit completely phases-out when MAGI reaches $118,000.*
*Note that MAGI is calculated by adding back to AGI, certain deductions and excluded income that are taken into account in arriving at AGI. The calculation for MAGI is different depending on what the calculation is for but, suffice it to say, MAGI is just AGI with a few adjustments.
Distributions – with a few exceptions, made before reaching 59 ½ years of age are subject to a 10% excise tax, in addition to the normal taxes on those distributions. Once a taxpayer reaches 70 ½ years of age, annual minimum distributions become mandatory. When distributions are taken, they are taxable as ordinary income except for amounts allocable to non-deductible contributions (i.e. contributions that did not qualify for the tax deduction).
Eligibility – Must be under 70 ½ years old at the end of the tax year. Taxpayers who are eligible to participate in other retirement plans may have their benefit phased-out depending on their MAGI. Even so, non-deductible contributions are allowed as long as IRA contributions (including Roth) do not exceed the maximum contribution described above.
Potential Tax Savings
For a young married couple whose taxable income falls within the 25% tax bracket, a maximum contribution to an HSA can cause a reduction in tax liability by over $1,500. That same couple, if eligible, could also save over $2,500 in taxes, by maxing out their IRAs. In certain instances, taxpayers may be able to save even more. Keep in mind that AGI and MAGI are very important in computing certain exclusions, deductions, and credits. Taxable social security, the tuition and fees deduction, the student loan interest deduction, even the IRA deduction itself is affected by MAGI. The Child Tax Credit, the American Opportunity Credit, and the Premium Tax Credit are just a few of the credits that phase-out as AGI exceeds applicable thresholds.
Let’s take for example, ideal candidates, Liz and Tom:
Liz and Tom are both 56 years old, married, have one dependent, and have healthcare through the Washington State Exchange. For 2015, their AGI is $80,000 and taxable income is $55,400. They do not qualify for any tax credits and their total tax liability for the year is approximately $7,400.
However, Liz and Tom have some money in savings, are eligible to make contributions to their IRAs and HSAs, and believe they will have substantial medical costs in the foreseeable future.
Liz and Tom decide to max out their contributions to each account. Between the two of them, they contribute $21,650. As a result, their AGI falls to $58,350, and their taxable Income to $33,750. The reduced AGI, causes a reduction in tax liability and qualifies them for the Premium Tax Credit (through the Affordable Care Act). The tax liability before the Premium Tax Credit falls to approximately $4,150. The Premium Tax Credit, based on an estimate from the Kaiser Family Foundation Website (PTC calculator found on www.kff.org) would be $5,600. This estimate is meant only to be used for illustrative purposes, as health costs can vary widely.
Putting this all together, Liz and Tom can reduce their tax liability from $7,400 to -$1,450, a net reduction in tax of $8,850. Their savings account would be $12,800 lighter than it would have been otherwise, but their IRAs would each be $6,500 heavier and they would also have $8,650 available for those health expenses they foresaw.
Thanks for reading!
Understanding that taxes rules can often be very technical, I hope you were able to get something out of this article. At the very least, for those taxpayers who determine that they are eligible to contribute to an HSA, I hope that I have encouraged you enough to open an HSA account before your next doctor appointment. Many banks offer these accounts, and it does not take too long to set them up. If you are interested in finding out if you are eligible, it would be a great idea to see your tax preparer or CPA.
Matthew Whitlock, CPA