Interested in a relatively painless way to save money and lower your tax bill? Look no farther than your next paycheck: There are several strategies that all working people should consider that can lower their taxes and help them save money for their retirement. In this article we'll show you three savings account strategies that will help you make the most of your next paycheck with payroll deductions.
Increase Your 401(k) Contributions
A 401(k) is an excellent way for employed individuals to sock away large sums of money on a pretax basis each year. For example, the annual contribution limit in 2009 is $16,500 and individuals that are over 50 years of age are covered by the "catch-up" rule, which permits them to contribute an extra $5,500 per year.
The amount that an individual can save over time in a 401(k) varies depending upon his or her situation. For example, if a 30-year-old who makes $36,000 a year socks away 10% of her salary and earns an 8% return on her money, she will have $680,000 in her account when she turns 65.
If you aren't currently maximizing this benefit (and your employer offers such a plan), try to start - even if it's only a very small amount of money - because it can be an excellent way to bypass Uncle Sam. If you were to pay the whole $16,500 in contributions, you could easily save several thousands dollars through these deductions.
Flexible Spending = Increased Savings
A flexible spending account (or FSA) is a type of U.S. savings account that provides the account holder with specific tax advantages. Set up by an employer for an employee, the account allows employees to contribute a portion of their regular earnings to pay for qualified expenses, such as medical expenses or dependent care expenses. These types of accounts can be extremely helpful in that they allow employees to set aside pretax money several types of expenses.
- Medical FSA:
Individuals have the ability to set aside funds for healthcare related expenses such as prescription drugs and doctor co-pays. For those with kids or individuals who have prescriptions that they must refill on a consistent basis, this can be a tremendous benefit in terms of potential tax savings, and fighting the high costs of healthcare. Individuals can save quite a lot in taxes by using a medical FSA. According to Aetna, one of the nation's leading diversified healthcare benefits companies, an individual who earns $40,000 a year in the 15% tax bracket and who has health-related expenses of $2,000 may save up to $453 a year.
The IRS does not limit contributions regarding how much an individual can set aside for medical expenses; however, some employers will limit contributions to less than $5,000. Be aware that while socking away money for medical expenses through an FSA can help an individual save money, there is also a major downside. Money that is set aside in a medical FSA is intended for healthcare-related expenses only. (In other words it's not meant to be a retirement plan.) Because of this, the money must be used in the year it is saved. (On May 18, 2007, the U.S Department of the Treasury issued a notice permitting employers to modify their flexible savings account plans and extended the deadline for using the funds for an additional 2.5 months after the end of the year.) Any money remaining in the account at year's end is forfeited. The phrase most often used when referring to medical FSAs is: "If you don't use it, you lose it".
- Daycare FSA:
In today's society, mostly because of the rising cost of living, it's not uncommon for an individual or a married couple to place one or more of their children in daycare. With a daycare FSA account, individuals can pay for this expense (or at least some of it) on a pretax basis. Babysitters and camps may also have similar coverage.
Dependant children or adults that need looking after (not medical care) qualify. The caveat is that the participant in the plan and his or her spouse, if applicable, must be employed. In other words, a husband who is employed and has a stay-at-home wife cannot send the kids to day camp and get the benefit of paying that expense with pretax money.
Generally speaking, individuals or couples can set aside up to $5,000 each year for daycare FSAs. But, if one of the spouses earns less than this (say, $2,000 a year) then the contribution limit would be the lesser of the two amounts - in this case, $2,000. Total tax savings are similar to savings experienced by those using medical FSA plans. The bad news is the same too: use it or lose it.
SEE: Staying Home Vs. Daycare: A Financial Conundrum
Parking Your Money
Commuting to work had its own challenges without bringing money into the equation but, now its getting harder to get a grip on the cost of gas every day so, how do you take money out of the equation? You get a commuter savings account. Whether you take a bus, train, van, ferry, or drive and park, this savings account can help.
Estimate what you spend each month in parking and set aside that money on a pretax basis in a commuter parking savings account. According to Wageworks.com, a person who spends $200 a month on parking and is in the 28% tax bracket can potentially save $71.30 a month, or more than $855 a year.
If you aren't driving and parking, you can typically estimate the monthly cost of a ticket for your mode of transportation. You will then be able to set aside that money each month in the commuter account and pay for those expenses using pretax dollars. Potential cost savings can be (on a percentage basis) similar to the parking account plan mentioned above. And again, the commuter account is a use-it-or-lose-it type of account, so you're better off making a conservative estimate of your spending, rather than a generous one.
The Bottom Line
Employees who commute, pay healthcare expenses or spend money on dependent daycare may be able to reduce their tax burdens by establishing an FSA account. These savings, combined with regular 401(k) contributions, can allow an employee to bypass or defer taxes on literally thousands of dollars each year.