Many employers offer pre-tax benefits like flexible spending accounts. However, sometimes it can be tough to understand how these benefits actually save you money. Get the know-how you need to make the most of your pre-tax deductions.
Many employers offer pre-tax benefits to their employees. But you may be wondering: how do these benefit plans actually help you out?
Well, the general idea is that these plans allow you to set aside part of your income before it’s taxed to cover some necessary expenses in the present, and also help you set aside money for the future. But understanding how these plans are set up is important, because there can be a few potential drawbacks.
Let’s look at a few examples, starting with flexible spending accounts. Employers often offer flexible spending plans so you can set aside part of your pre-tax income for expenses like commuting and healthcare. These accounts can be useful – especially if you know ahead of time how much you spend on these expenses. But in some cases, you can lose money you set aside if you don’t use it by the end of the year.
A transportation spending account plan, or TSA, is pretty straightforward: with this type of plan, you set aside some of your pre-tax income – up to certain limits – for eligible expenses associated with getting to work. This could be things like a monthly transit pass or a parking pass. When you set up the plan, you decide how much of your pre-tax income will go into the TSA.
So, if you have a $100 monthly transit pass, you can set up your plan to deduct $100 from your monthly pre-tax income.
So, how much money would you save on a plan like this? Well, say you have a $40,000 salary and an effective tax rate of 15%. With a TSA, that $100 will be deducted from your salary before you pay taxes on it each month. Over one year, that transit pass will amount to [$100*12] $1,200. Now let’s subtract that from your salary. That’s [$40,000-$1,200] $38,800. So that’s what you’ll be taxed on.
With a 15% tax rate, that’s [$38,800*.15] $5,820 that you’ll pay in income tax for the year.
If you didn’t set up a TSA, you’d be paying [40,000*.15] $6,000 in taxes every year. So you’re saving $180 dollars.
A health flexible spending account, or “health FSA,” can be a little more complex. A health FSA allows you to set aside money ahead of time for eligible medical expenses that aren’t covered by your insurance – things like prescriptions, doctor’s office co-pays, and eye exams and glasses.
But unlike a TSA, it can be more difficult to predict how much – or how little – of this money you’ll need over the course of a year. Except for a few limited circumstances, the amount of money you choose to put into a health FSA per month can’t be changed after the beginning of the year. And if you don’t end up using the money you set aside by the end of the year, you might lose all or most of it.
Let’s say you estimate that you’ll spend $1,500 on eligible medical expenses over the course of the year, and want to put that much into your health FSA.
Let’s look at what you save in taxes by using the same calculations we did with the TSA. With $1,500 in your health FSA, on your $40,000 you’ll only pay [40,000-1,500=$38,500*.15] $5,775 in taxes, instead of $6,000. So you’re saving $225.
[Show tax calculations for both options side by side, highlight $225 saved with health FSA]
But – that’s only if you use that $1,500. What if you end up only using $100 of that $1,500?
Some health FSAs give you an additional grace period in which you can use the money you have left over before you lose it. Others allow you to carry over a portion of what’s left to the following year, and some plans don’t allow any money to be carried over at all.
So, if you’ve got $1,400 in the health FSA at the end of December, you could lose it- or a large portion of it.
Every company will have their own set of rules for these plans, so if you set up a health FSA, talk to your employer about the details of your plan because
[See math, with $1,400 vanishing]
saving $225 in taxes won’t matter much if you’re losing $1400.
But, if you have regular medical expenses and have a good idea of what you’ll be spending on them, a health FSA could be a great benefit.
Now let’s look at another type of benefit that has some tax advantages: a 401(k).
A 401(k) can be one of the biggest potential benefits your workplace offers. This plan allows you to contribute part of your income to a 401(k) investment account.
But it’s important to note that unlike a flexible spending account, this isn’t an un-taxed benefit. A 401(k) is usually referred to as a “tax-deferred” account. This means you won’t pay income taxes on the money you contribute now, and the money you contribute can grow un-taxed up until the moment you take the money out of the account. At that time, you will have to pay taxes on both your initial contributions, and any earnings you may have made on your investments.
Now you may be wondering, why should I invest in a 401(k)? Well, for one thing, when you set aside money for a 401(k), that money is subtracted from your current income. If you are in a higher income bracket and the amount of money you set aside is enough to move you into a lower income bracket – you could end up paying a lower percentage of your income in taxes.
In addition, the same amount of income invested in a tax-deferred account will be greater than the amount of income you’d be left with to invest in a non-tax-deferred investment account.
Over time, if these investments increase in value and are re-invested continually, you could potentially have a larger amount of retirement savings to draw from later in a 401(k) than in an after-tax investment account. Although the total retirement savings you eventually receive will depend on a lot of factors, one of them being your future tax rate at the time of withdrawal. If your tax rate is lower when you reach retirement than when you make your contributions, you could end up saving some more money.
Another big advantage of 401(k)s is that some employers offer matching contributions. Depending on what you contribute to your 401(k) each year, your employer might also contribute a matching percentage. There are certain rules to when and how they contribute matching funds, so make sure you learn all the details of your employer’s plan.
And while a 401(k) can be a great benefit to help you build a healthy investment account for the future, there are some risks and restrictions as well. With any investment account, you can earn or lose money depending on how well your investments perform over time. And, unlike a deposit account at a bank, an investment account is not FDIC insured and is not bank guaranteed. With most 401(k)s, there are also fees associated with the account. Some of the fees are built into the management of individual funds, but there can also be additional fees for the administration of the account and other fees as well. These fees can have a substantial impact on your returns – so make sure you understand exactly how your plan is set up. And if you need to withdraw money from the account early – before you’re age 59 and a half – you may incur an additional early withdrawal tax, on top of the income tax that you will owe.
So while pre-tax benefits can help you save when setting aside money for expenses and retirement investments, there are risks involved. When you review the pre-tax options offered by your employer, take time to consider your own expenses and needs to help make sure your money’s working to your benefit.
Merrill Edge is available through Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), and consists of the Merrill Edge Advisory Center (investment guidance) and self-directed online investing.
MLPF&S is a registered broker-dealer, member SIPC and a wholly owned subsidiary of Bank of America Corporation.
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