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 retirement. In this article, we give you the basics of payroll deductions and show you three strategies that will help you make the most of your next paycheck.

Key Takeaways

  • Payroll deductions occur when your employer withholds from your paycheck for involuntary or voluntary reasons, including taxes and benefits programs.
  • Contribute a maximum of $19,500 for the 2021 tax year to a 401(k) through payroll deductions and save for your retirement.
  • Many employers offer flexible savings accounts for medical costs, dependent care expenses, and the cost of commuting.

What Is a Payroll Deduction?

A payroll deduction refers to money that your employer withholds from your paycheck for a number of different reasons. This includes mandatory deductions that are taken for tax purposes or voluntary deductions for various benefit programs, such as retirement plans or health care contributions. Most benefit-related deductions involve pre-tax dollars, which means you end up paying less income tax on the part of your salary that remains.

Increase Your 401(k) Contributions

A 401(k) is an excellent way for employed individuals to sock away large sums of money on a pre-tax basis each year. For example, the annual contribution limit in 2021 is $19,500. Individuals who are over 50 are covered by the catch-up rule, which permits them to contribute extra money each year.

The amount that an individual can save over time in a 401(k) varies depending upon their situation. Let's say a 30-year-old makes $36,000 a year and socks away 10% every year. If this individual earns an 8% return on that money, they will have $680,000 in their retirement account at the age of 65.

If your employer offers this kind of plan and you aren't maximizing this benefit, try to start. Even if it's only a very small amount of money, it can be an excellent way to bypass Uncle Sam. If you were to pay the whole $19,500 in contributions, you could easily save several thousand dollars through these deductions.

Flexible Spending Means Increased Savings

A flexible spending account (FSA) is a type of savings account that provides the account holder with specific tax advantages. Set up by an employer, it allows employees to contribute a portion of their regular earnings to pay for qualified expenses, such as medical or dependent care expenses. These types of accounts can be extremely helpful because they allow employees to set aside pre-tax money for several types of expenses.

Medical FSA

Individuals have the ability to set aside funds for expenses related to health care, including prescription drugs and copays. This can be a big benefit for those with kids or individuals who require regular refills on their prescriptions, especially when it comes to tax savings and lowering health care costs.

According to the Internal Revenue Service (IRS), employees can contribute up to $2,750 in pre-tax dollars to a medical FSA for the 2021 tax year. Employers decide whether they also make contributions to their employees' health FSAs. Some may do a dollar match, a defined contribution only, or a crossover, which combines a minimum contribution with a dollar match.

Be sure to keep any receipts for expenses that you want to be reimbursed for from your medical FSA.

But be aware there is a downside to socking away money for medical expenses through an FSA. This money is intended for health care expenses only, so you can't use it as a retirement plan. And, typically, the money you do save must be used in the year it is saved. You may be required to forfeit any money remaining in the account at year's end.

There is a saving grace, though. In most plan years, you may be able to carry over up to $550 of any unused amount to the next year or use the balance up to 2.5 months after the end of the plan year (as long as your employer's plan allows it).

For plan years 2020 and 2021, though, special rules apply to both the carryover amount and the grace period. Employers have the option of allowing all unused funds to be carried over from 2020 to 2021 and from 2021 to 2022. Or, employers can extend the grace period to 12 months, rather than 2.5 months. The effect of either decision is the same: all unused funds can be carried over and used throughout the entire year.

It's a good idea to check with your benefits department to see if these special rules apply to your FSA account.

Daycare FSA

It's not uncommon for an individual or a married couple to place one or more of their children in daycare. Individuals can pay for this expense or part of it through a daycare FSA account on a pre-tax basis. Babysitters and camps may also have similar coverage.

Dependent children or adults that need looking after qualify as long as they don't require medical care. The caveat is that the plan participant and their spouse, if applicable, must be employed. In other words, an employed husband with a stay-at-home wife cannot send the kids to day camp and get the benefit of paying that expense with pre-tax money.

For most plan years, individuals or married couples filing jointly can set aside up to $5,000 each year for daycare FSAs while married individuals filing separately can set aside $2,500. However, the 2021 dependent care FSA contribution limit was increased by the American Rescue Plan Act to $10,500 for single filers and couples filing jointly (up from $5,000 in 2020) and $5,250 for married couples filing separately (up from $2,500 in 2020).

The total tax savings are similar to savings experienced by those using medical FSA plans. If your employer does make contributions on your behalf, the combined total cannot exceed the annual limit.

Park Your Money

With the ever-changing price of gas, how do you bring commuting costs into focus? Try a commuter savings account. Whether you take a bus, train, van, ferry, or drive and park, this type of savings account can help.

Estimate what you spend each month in parking and set aside that money on a pre-tax basis in a commuter parking savings account. You can set aside a maximum monthly limit of $270. According to Wageworks.com's Commuter Savings Calculator, a person who spends $200 a month on parking and is in the 24% tax bracket can potentially save $48 a month, or more than $576 a year.

If you don't drive and park, you can estimate the monthly cost of a ticket for your mode of transportation. You can then save that money every month in the commuter account and pay for those expenses using pre-tax dollars. Potential cost savings can be similar to the parking account plan mentioned above.

The commuter account is another 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 health care 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.