As year-end approaches, taxpayers generally are faced with a number of choices that can save taxes this year, next year or both years. Employees too are faced with these choices. However, employees have some special considerations to take into account that retirees and other nonworking individuals don’t face. To help our clients who are employees take advantage of these 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 account (health FSA). You save taxes because you use pre-tax dollars to pay for medical expenses that might not be deductible. They would not be deductible if you don’t itemize. Even if you do itemize, some medical expenses would not be deductible because of the 7.5% adjusted gross income floor beneath medical expense deductions. Also, a health FSA can be used to get tax-free reimbursement for over-the-counter medications and other items even though they would not be deductible as medical expenses if you paid for them outside of a health FSA.
If you have set aside funds in your employer’s health FSA, check your balance so that you have sufficient time to incur additional reimbursable expenditures to prevent loss of any unused amount under the use-it-lose-it feature of these plans. Don’t forget you can get tax-free reimbursements for aspirin, antacids and other over-the-counter items. 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 any such items.
To avoid the lose-it-use it rule, you must incur qualifying expenditures by the last day of the plan year (Dec. 31, 2009 in the case of a calendar year plan) unless the plan allows an optional grace period. Any grace period cannot extend beyond the 15th day of the third month following the close of the plan year (e.g., March 15 for a calendar year plan). An exception to the use-it-or lose-it rule allows FSAs to make distributions of all or part of unused health FSA benefits to military reservists who are called to active duty for a period exceeding 179 days (or an indefinite period ).
Examining your year-to-date expenditures now will also help you to determine how much to set aside for next year. Don’t forget to reflect any changed circumstances in making your calculation.
Dependent care FSAs. Some employers also allow employees to set aside funds in dependent care FSAs. They allow employees to use pre-tax dollars to pay for dependent care. In particular cases, participating in a dependent care FSA 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 use the FSA to pay for child care expenses. For these taxpayers, the FSA almost always provides greater federal tax savings than does the credit. Additionally, participating in a dependent care FSA can also save on FICA taxes.
However, like health FSAs, dependent care FSAs are subject to the use-it-or lose it rule. Thus, now is a good time to review expenditures to date and to project amounts to be set aside for next year.
Adoption assistance FSAs. Under an adoption assistance FSA, adoption reimbursement accounts are established for participating employees. Typically, these accounts are funded with employee pre-tax contributions uniformly withheld from each paycheck throughout the year. The balances in these accounts are used to reimburse qualified adoption expenses incurred during the year, subject to a reimbursement maximum. Like their health and dependent care FSA siblings, these accounts are subject to the use-it-or-lose-it rule. However, predicting the amount and timing of adoption expenses may be far more difficult than projecting medical and dependent care assistance expenses. As a result, the use-it-or-lose-it rule could pose a greater risk of loss with this type of FSA. This should be borne in mind in choosing the extent to which to participate in an adoption FSA.
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 (or pay estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2009.
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. In this connection, it should be stressed that the Making Work Pay Credit, which was enacted earlier this year, automatically lowered tax withholding rates for employees. However, 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.
401(k) contributions. Review and make appropriate adjustments to your contributions to you employer’s 401(k) retirement plan for the remainder of this year. Figure your contribution rate for next year as well.