With the passing of the Tax Cuts and Jobs Act (TCJA) many taxpayers found themselves in a difficult position this past year. In high cost of living/heavy tax areas like New York, this may have resulted in an unexpected tax burden, or perhaps the confusion around the release of the tax cut resulted in missed tax savings. No matter the result, the root problem comes from being unprepared and uninformed.
Even given all the massive changes in the tax code as a result of the TCJA, one of the best tools taxpayers have assisting in reducing their tax burden for the year and increase their savings is with the use of tax-deferred accounts. A tax-deferred account, broadly speaking, is an account that is usually funded using “pretax” dollars (by a function of reducing your taxable income now) and allows for growth of the investment tax-free. The tradeoff for this will be that generally when the investment is withdrawn, it is then taxed. By avoiding tax currently and in the growth period, taxpayers will see better returns which are compounded in the tax-deferred account.
Qualified Retirement Plan (QRP)
A Qualified Retirement Plan is the most popular type of tax-deferred account. These plans allow taxpayers to put money aside for retirement and grow tax-free. When looking at the plans, some of the benefits are more focused on the individual, wage-earning taxpayers while other plans are designed for business owners whose compensation is generally in the form of pass-through income. The plans are not completely mutually exclusive (for example, a passthrough S Corporation owner also will draw a salary that can see tax savings via a 401(k) plan).
For individual taxpayers, Qualified Retirement Plans cover the typical retirement savings vehicles such as a 401K or an IRA. In 2019 you will be able to save up to $19,000 in pretax earnings in your 401K account. Additionally, those of you who are over the age of 50 can contribute an added $6,000 per year. As for IRA’s, there are different types you can consider:
- Traditional IRA
- Roth IRA
- SIMPLE IRA
Traditional and Roth IRAs have the same contribution limits, the smaller of $6,000 per year ($7,000 for those 50 and older) or earned income for the year. There are also certain other limitations, such as other Qualified Retirement Plan coverage for you or your spouse in connection with employment and income limitations. The primary difference between a Traditional and Roth IRA has to do with the deduction for contribution; a traditional IRA is deductible now and therefore reduces taxable income, but a Roth IRA is nondeductible, does not reduce taxable income but also does not incur income tax when withdrawn. In a perfectly theoretical vacuum, if a taxpayer were to invest the savings from a traditional IRA over the same period a month is held in a Roth IRA, both accounts will leave the owner in the same place after taxes, not making one better than the other. An analysis of the current and future facts and circumstances can help determine which is best. Unlike with a 401k or SIMPLE IRA, a taxpayer can set up an IRA outside of their employment.
A SIMPLE IRA is a form of retirement account that is designed for the employees of small business taxpayers and works in function very similar to a 401(k) plan. An employee can elect to contribute up to $13,000 of his or her pay ($16,000 if over the age of 50) per year to a SIMPLE IRA in 2019. This can then be either matched dollar for dollar by the employer, up to 3% of the employee’s compensation, or the employer’s contribution can be a flat 2% of the employee’s compensation.
For business owners, many of the above strategies can work, but there are additional wrinkles to consider in how much the business may want to contribute to the plan. For 401(k) and SIMPLE IRAs, the company can make certain elective or nonelective contributions on behalf of the employees, allowing for a current deduction and increasing the amount that is deferred by the company. Smaller pass-through entities also have the option of a Simplified Employee Pension (SEP), which is an employer only contribution to a retirement account. This amount is generally 25% of eligible compensation up to an annual IRS limit. For 2019, the limit is $56,000 of contributions or $224,000 in compensation.
Many of these plans have “more than one way to skin the cat” allowing for picking and choosing of features that can be combined in order to best maximize contributions and benefitting owners.
If you have children, a 529 plan is another way to pursue an additional tax deferral. Contributions to 529 plans can now be used to pay up to $10,000 per year of K-12 education, as compared to the previous tax law that limited its use to post-secondary education expenses. The earnings in these plans are also tax-free if they are used to pay for tuition for kindergarten through college. The contributions are not deductible on your federal tax return, but most states allow the deduction if you utilize a state-approved plan. The benefit on these plans is the tax-deferred growth rather than the immediate tax savings.
Health Savings Account
Health Savings Account, or HSA, is a financial account established by an individual or family to pay for qualified medical expenses tax-free. Health Savings Accounts can be opened by an individual or offered by an employer alongside a high-deductible health insurance plan.
Health Savings Accounts combine the benefits of both traditional and Roth 401(k)s and IRAs for medical expenses. Taxpayers receive a 100% income tax deduction on annual contributions to the HSA, they may withdraw HSA funds tax-free to reimburse themselves for qualified medical expenses, and they may defer taking such reimbursements indefinitely without penalties.
HSAs are unique and come with triple the tax advantages:
- Tax-deductible contributions,
- Tax-free accumulation of interest and dividends, and
- Tax-free distributions for qualified medical expenses.
Unused HSA balances will convert to a qualified retirement plan upon separation from the employer of a change in plan. The purpose of tax planning is to ensure tax efficiency.
Through tax planning, all elements of the financial plan work together in the most tax-efficient manner possible. People are inclined to make careful plans when they consider making a home purchase, accepting a new job, or taking a dream vacation. However, when it comes to taxes, they often leave matters to chance, perhaps not realizing the tax savings that can result! The tax-deferred vehicles outlined above give you a few of the ways to save money for your future and on your taxes. Even so, comprehensive tax planning before any major changes, from divorce to downsizing your home, can have immediate and long-lasting results. At Cerini and Associates, we are prepared with advice and planning for any situation, large or small, which can have an immediate effect on your financial wellbeing.
To learn more about this topic, please contact:
Edward McWilliams, CPA
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.