A tax dollar saved is a dollar earned

By Andrew D. Schwartz

February 13, 2009

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Ben Franklin was a man ahead of his time. Even though he died more than 100 years before the current income tax code was put into place, one could argue that he gave some pretty good tax advice when he coined the phrase, "A penny saved is a penny earned."

Any time you take advantage of a tax savings opportunity, less of your hard-earned money goes to taxes and, therefore, more ends up in your pocket. So, let's follow another piece of advice from Ben, "An investment in knowledge pays the best interest," and review some of the tax breaks available to you these days.

Pre-Tax Opportunities

When is $100 worth $155? If you're in the 28 percent tax bracket, that's the value of paying for personal expenses with pre-tax dollars. Whenever post-tax dollars are involved, you need to earn $155 to have $100 left over after paying your federal income taxes, social security taxes, and Medicare taxes. Here are some pre-tax opportunities that might be available to you:

Medical expenses paid through a Flexible Spending Account: Most employers, as part of their benefits package, allow their employees to elect to have certain expenses paid with pre-tax dollars through a "flexible spending account (FSA)", including as much as $5,000 per year to be used for medical and dental expenses. Please beware that this benefit comes with a big caveat, you either use it or lose it. In other words, if you don't spend the money that is set aside, it won't be refunded to you. If you haven't spent all of last year's money, don't despair. Under the current rules, your employer can give you to as late as March 15, 2009 to spend any money that you set aside for this pre-tax benefit in 2008.

Childcare expenses paid through a Flexible Spending Account: If you're paying child care expenses, and both you and your spouse work, you can set aside $5,000 per household through your employer's FSA to pay for your dependent's care expenses. The catch is that you need to report the name, address, and taxpayer identification number of the care provider on your tax return, or the $5,000 becomes taxable to you again. If you only have one child, paying for the child's care through the FSA saves you a lot in taxes.

Health Savings Accounts: With health insurance premiums on the rise, more people are looking into high-deductible products. Did you know that you can couple a high-deductible plan with a special type of savings account known as a Health Savings Account (HSA)? While either you or your employer contributes pre-tax dollars into an HSA in your name, money withdrawn from the HSA for health care expenses is completely tax-free. Plus, any money remaining in your HSA once you turn 65 is available to help fund your retirement.

Business expenses paid through employer's "slush fund": If you have the option of having your employer pay for some of your out-of-pocket expenses in exchange for a reduced bonus or salary, those expenses are paid with pre-tax dollars.

Tax-Free Opportunities

Tax-free opportunities are a relatively recent phenomenon. Prior to some of the tax law changes during the late 1990's, there were very few tax-free options available to taxpayers. Even though you don't get a current tax deduction in most cases, the potential for decades of compounded growth coupled by tax-free withdrawals down the road makes them worth a close look.

Roth IRAs: For 2008, you can contribute up to $5,000 to a Roth IRA, as long as you have earned income, and your adjusted gross income doesn't exceed $116,000 if single or $169,000 if married. Anyone 50 or older can contribute an extra $1,000 annually. Amounts contributed to a Roth grow tax-free as long as you don't withdraw any of the earnings until you turn 59 1/2, use $10,000 for first-time homebuyer costs, or meet certain other exceptions.

529 Plans: College savings plans allow you to put away a sizeable amount of money for a child's education. Currently, you can contribute up to $13,000 per child per year into a 529 Account. You can even frontload five years worth of contributions, up to $65,000, all at one time, but then you can't add to that child's account for the next four years. Amounts withdrawn from your 529 plan are not taxed as long as the money is used to pay for tuition and other qualified college expenses.

Principal residence: When you sell your principal residence, you aren't taxed on the first $500,000 of gain if you are married, or the first $250,000 of gain if you are single, as long as the home was your principal residence for two out of the previous five tax years. If you sell the house in connection with a job related move or meet certain other conditions of hardship, and lived in the house for less than two years, you can exclude a prorated amount.

Other Tax-Free Opportunities: Gifts received from parents and relatives are generally not taxable to you. Instead, the donor might be subject to a "gift tax" if the value of the gift to another person exceeds $13,000 (in 2009). Life insurance proceeds aren't subject to income taxes either. Depending on who owned the policy, however, the proceeds might be subject to estate (inheritance) taxes. Make sure to talk with an estate-planning attorney about these two items.

Tax-Deferred Opportunities

With a tax-deferred savings opportunity, you save taxes today, and then generally owe taxes when you withdraw the money later on. Even so, these opportunities make sense for a variety of reasons. For starters, a dollar today is more valuable than a dollar tomorrow, due to the time value of money. Plus, the government lets you invest the taxes you save and keep the compounded earnings on that money. For both these reasons, tax-deferred savings opportunities make a lot of sense.

401(k) & 403(b) plans: These salary deferral retirement savings plans are only available through your employer's benefit package. Amounts contributed during the year reduce your taxable earnings and grow tax-deferred. For 2009, the maximum contribution into either of these plans through salary deferrals is $16,500. Anyone 50 or older by December 31st can contribute an additional $5,500 this year. If you go with the Roth version of these plans, you forego a tax savings today in exchange for a promise from the government of tax-free withdrawals down the road.

SEPs, SIMPLEs, and Solo 401(k) Plans: If you have some self-employment earnings, or own a small business, you're entitled to set up your own retirement plan. You can contribute up to 20% of your net earnings into a SEP and up to $10,500 plus 3% of your income into a SIMPLE. If you don't have access to a 401(k) or 403(b) plan through another employer, you can contribute $16,500 ($22k if 50 or older) plus 20% of your net earnings into a Solo 401(k). Amounts contributed to these plans reduce your taxable income and grow tax-deferred.

Be A "Learned Blockhead"

Ben Franklin put it best when he said, "A learned blockhead is a better blockhead than an ignorant one." And with the complexity of today's tax code, Ben warns us that, "By failing to prepare, you are preparing to fail" and will end up paying higher taxes.

Andrew Schwartz CPA is a partner in the Woburn, MA CPA firm, Schwartz & Schwartz, PC, a firm specializing in the tax issues affecting healthcare professionals and their practices. Andrew is also the founder and editor of FindAGoodCPA.com, a site where taxpayers can locate a CPAs and EAs who have decided to "commit to their niche" and have selected the one industry or profession that best reflects the focus of their practice and their client base. Today's tax code is just too complicated to not specialize. He is also a member of the Massachusetts Society of CPAs.