07 February 2006

Use Tax-Deferred Accounts

This part two in a weekly series focusing on lowering tax bills and making the process of filing slightly easier. Today, I’ll focus on the easiest way to lower your tax bill using money you’re already spending.

Use Tax-Deferred Accounts

This past year, I used my Dependent Care and Health Care Spending Accounts, my 401(k), and my wife’s pension in order to shelter about $10,000 from Federal taxation. Assuming a 25% tax rate, those alone saved $2,500 in taxes this past year. Missouri follows the Federal tax treatment of these items, so throw in another $600 saved in state taxes. I’ve saved $3,100 in taxes without really going out of my way.

I figure that I’m young enough that Social Security will no longer exist by the time I get to retire. Therefore, I have to save for retirement anyway. My wife has to contribute to her pension for the same reason. In both cases, we’re getting an automatic 25% return by being allowed to use tax-deferred money to fund these expenditures. In addition, my employer matches 3% of my salary, which is another automatic return on my contributions.

We fully fund the Dependent Care account since we pay more than $5,000 in child care during the year. This allows us to save $1,250 in taxes alone. Again, we’re essentially saving 25% on our child care just by using the Dependent Care account. We use the Health Care Spending Account to fund our anticipated expenses for the year. Since the rules regarding the use of the HCSA were liberalized to include over the counter drugs in 2003, it is much easier to guarantee that there will not be any money left over at the end of the year (which is forfeited).

There are other ways to achieve the same result. An IRA could be used, but the deductions are limited to $3,000 and are severely limited if you are covered under an employer sponsored pension plan. Additionally, a deduction is available for child care expenses if a Dependent Care Flexible Spending account is not utilized (Form 2441).

However, I believe the easiest way to achieve these savings is simply to invest in a 401(k) and use the Flexible Spending Accounts so that the money is available throughout the year rather than simply after you file your tax return.

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