A lot of people focus a lot of time and effort on giving as little money as possible to the Federal government. I can understand why, but much of this time and effort appears to be expended on things with very little gain for the average individual. Now that we’re in November, chances are you’re in an open-enrollment period for your company benefits. MarketWatch recently delved into three options that may be available that may reduce your tax burden, but without discussing the drawbacks.
It seems one thing that people often forget to discuss is that everything in life is a tradeoff on something else. Buying something means taking on more debt or having less money. The same with taxes. Taxes are always going to be a financial catch-22, because reducing your tax burden almost always requires you taking on a major expense or reducing your take-home pay – i.e. the only realistic and legal means of reducing your tax burden involves you giving up money.
With that, let’s get into MarketWatch’s three options.
Health care flexible spending account (FSA)
Under the law you can set aside up to $2,500 of your pre-tax salary or wage into a designated tax-free account to be used for certain health care expenses, such as deductibles and other out-of-pocket expenses. This reduction means you also reduce your tax burden to the Federal government.
Here’s the catch: what you don’t spend you lose. So to avoid really losing out on this deal, you’d better be pretty good at approximating what you’ll be spending, unless your employer allows for a rollover of whatever is left or a grace period that extends into the new year, both which should still be accounted.
Where the FSA really shines is for the routine out-of-pocket expenses that you can reasonably expect. As an example, my wife goes to the eye doctor every year and wears contacts. The out of pocket expenses and cost of her contacts could be covered through an FSA. Instead I opted to bring her under a better vision plan that’ll reduce our out-of-pocket expenses without a significant reduction in my paycheck – i.e. she’s on the vision plan I get through work.
In short, her next vision appointment will have a reduced out-of-pocket expense attached to it without having to take a reduced income to offset it.
So the health care FSA is better than merely having an account into which you periodically put money to save up for known upcoming expenses because of the tax exempt status. Now only if they’d have something similar for veterinary expenses.
Dependent care flexible spending account
The only drawback of this option is just the "use it or lose it rule". But otherwise, this one seems to be virtually all gain if you have kids and pay for child care. You reduce your tax burden without increasing your out-of-pocket expenses, right?
Well, technically, you don’t increase your out-of-pocket expenses, but you may not be decreasing them either. Most dependent care FSAs requires you to seek reimbursement for what you spend. This basically means that you’re still using after-tax dollars to pay for care, then seeking reimbursement for what you’ve already spent out of your pre-tax dollars. The alternative to the dependent care FSA is the dependent care tax credit.
Many health care FSAs provide a card similar to a debit card that allows you to spend your health care FSA money when you need to without having to seek reimbursement later. So far such an option for dependent care FSAs is not wide spread, and may not even be an accepted form of payment. For example if you hire your neighbor to watch your under 13 child while you and your spouse go out for the night, you may not be able to pay him or her with your FSA debit card and will likely, instead, have to pay with cash or a check and seek reimbursement.
That’s provided you have enough in your FSA at the time you file for reimbursement to be reimbursed. Most dependent care FSAs are not "front loaded", meaning, like a bank account, you can only receive as much as is currently sitting in your FSA and no more. Many health care FSAs are "front loaded", meaning you can spend as much as you need when you need it, so long as you don’t go over your annual allotment.
Apparently there are flexible spending accounts for transportation expenses. Interesting. But it only covers expenses related to public transportation, van pooling, and public parking. Damn.
So if I worked in downtown Kansas City and had to park at a parking garage, then I could set aside pre-tax dollars to cover those expenses. Wait, no. I’d have to pay cash or with a credit card at the garage exit, then seek reimbursement later. So if you drive yourself to work, you’re out of luck on this option unless you routinely park in a parking garage where you are charged for parking, but even then, unless you’re given a debit card for this, you still pay out of pocket and then seek reimbursement later.
Now you could switch to taking public transportation, but chances are that’s going to be something extremely inconvenient to you. I’ll use myself as an example. Currently it takes me about a half hour to get to work and to get home, about an hour out of my day. Mapping the same route through Google Maps to take the bus will take two hours each way, an additional three hours out of my day lost while I sit on the bus. No thanks.
If you’re already taking public transportation to get to and from work, then take advantage of this, but read your benefits package first to find out what is involved. Because what could be involved is a $130 maximum reduction each month in your gross pay, meaning a reduction in what you take home, while still paying the same price for public transportation (or more if fares have gone up), and having to live on less money until you seek reimbursement and are reimbursed for your transportation expenses. And if you’re already strapped for cash, it may be too costly to take advantage of this option depending on how long it takes to be reimbursed, with the reimbursements basically covering the next cycle of transportation costs.
The secret to reducing your tax burden: less money
The common denominator to these programs should be obvious: they reduce your income. Paying less in income taxes almost always requires you to reduce your take-home pay. Whether it is through 401(k) deductions, deductions for flexible spending accounts, or the like, they all require you to reduce your take-home pay. And that’s all pre-tax stuff. Even the after-tax allowable deductions require expenditures to go along with them.
So reducing your tax burden requires expending cash in certain directions or taking on payroll deductions that reduce your take-home pay. How many people actually actively realize this?
Reimbursement accounts – i.e. the FSA options that do not provide for a debit card – also still require you to spend out of pocket up front. This means that you are taking a reduced income without a congruent reduction in expenses, meaning your discretionary income is less until you get reimbursed, and how long that takes will depend on the benefits provider, and it’s additional time out of your day along with additional record keeping for the benefits provider. Now if you’re transitioning to a dependent care FSA where previously you took advantage of the dependent care tax credit, you should already have been doing some meticulous record keeping anyway, as you’d be needing it in case of an audit.
So in the end, rather than looking at these "tax breaks" and thinking you’re reducing your tax burden, you might be taking on even more. A reduced income, overhead and bureaucracy to take advantage of the option, no congruent reduction in out-of-pocket expenses. What are the gains and what are the trade-offs?
Do the math to determine how affordable it will be and what the best option will be. And this starts with knowing what the benefits plan provides and how to take advantage of it.