Cut Your Tax Bill & Save Money: Tax-Exempt Savings Plans
One of my New Year’s Resolutions this year is to do a better job managing my money. I think I’ve always been pretty smart when it comes to finances, but I realized that I was letting some great opportunities to save money pass me by. In today and Thursday’s blog posts, I’ll talk about some of the best ways to save money and cut your taxes: tax-exempt savings plans and tax-deferred savings plans. Today’s blog focuses on tax-exempt savings plans.
Before I get into the specifics of these accounts, a quick math and tax lesson. Let’s say you earn $50,000 a year, you’re married but file separately and you claim the standard federal tax deduction of $5,700. The deduction reduces your total income of $50,000 to a taxable income of $44,300. Assuming no other credits or deductions, you’d pay $7,262.50 in federal income tax.
However, if you make payments into a tax-exempt savings plan, those contributions are subtracted from your total income. Suppose, for example, that you made a $5,000 contribution to a health savings account, also known as an HSA. The IRS allows you to deduct that contribution from your total income. In our example, the $5,000 would be subtracted from your $50,000 total income, which would give you adjusted gross income of $45,000. Once the $5,700 standard deduction is also subtracted, your taxable income is now $39,300. You’d pay $6,012.50 in taxes, compared to the $7,262.50 you would have paid if you hadn’t made the HSA contribution. In other words, your $5,000 HSA contribution reduced your taxes by $1,250, and, for all intents and purposes, it only cost you $3,750 to save an additional $5,000.
Types of Tax-Exempt Accounts
There are several types of tax-exempt savings plans, including health savings accounts (HSAs) and flexible spending accounts (FSAs). In a tax-exempt savings plan, you never pay tax on the money you contribute to the account and interest earned on that money as long as it is used for the intended purpose.
Both HSAs and medical FSAs are types of medical savings accounts.
An HSA allows you to annually put up to $3,050 (for an individual) or $6,150 (for a family) into a tax-exempt account that is used to pay qualified medical expenses. Any money you do not spend automatically rolls over to the following year. You may only make HSA contributions if you are enrolled in a high-deductible health insurance plan. If your employer does not offer HSA accounts, many banks will allow you to open one on your own.
A medical FSA is similar to an HSA in that it is used to pay for qualified medical expenses. It is different because it does not have the high-deductible insurance plan requirement. In addition, the Internal Revenue Service does not place limits on how much money can be contributed to the FSA annually (though your employer may place caps on how much you can contribute). However, all money that’s deposited into a medical FSA must be spent 2.5 months after the end of your company’s plan year or you lose any unspent money.
In the case of both HSAs and FSAs, money must be spent on qualified medical expenses. According to the IRS:
Medical expenses are the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners. They include the costs of equipment, supplies, and diagnostic devices needed for these purposes. Medical care expenses must be primarily to alleviate or prevent a physical or mental defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation.
In Thursday’s post, I’ll talk about tax-deferred savings plans, such as 401(k) plans and individual retirement accounts, that allow you to put money aside today and defer tax payments on that money until you’re ready to use it.