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Tax Planning for Young Professionals

My last post was about the technical side of a tax return - outlining many of the deductions you can take and the restrictions around each. If there is something in this blog that you do not fully understand, it can probably be found there. This blog relates to the application and potentially some planning you can do to fall into some of those deduction categories.


You shouldn’t be going out of your way to make purchases or spend extra money just to get a tax deduction - as I mentioned in my previous post, a $1 deduction does not equal $1 less of tax. But if you plan on spending the money anyway, timing the payment may bring you a better financial outcome. And most importantly, make sure you are reporting what you did on your tax return so that you can receive the benefits.


Not all of these options are available to everybody, but consider your current situation and if any of these relate specifically to you.


Contributions to Tax Advantaged Savings Accounts


Health Savings Account - These are accounts that can be used if you have a high deductible health plan. You can either contribute directly to the account, or instruct your employer to contribute through payroll. The account gives you a tax deduction upon contribution (Fed and most states), grows tax deferred and can be withdrawn for qualified medical expenses tax free. If you contribute through payroll you may be able to avoid FICA taxes as well (7.65% if you have less than $137,700 in wages). You have until April 15, 2021 to fund the account for 2020.


Roth IRA - You can contribute to a Roth IRA up until April 15, 2021 for tax year 2020. There is no upfront tax deduction, but the account grows tax deferred and can be distributed tax free if you follow the rules.


You can also consider a Roth conversion if your income is lower than normal in 2020. This is when you take a pre-tax retirement account and transfer it into a Roth retirement account; you can do the full account or a partial amount. Upon conversion, you will have to pay ordinary income taxes on the amount converted (assuming there is no basis), which should be paid from a non-retirement account. The point of this is to pay the income tax now while your rates are lower, so in the future you can distribute the money tax free (when your tax rates are potentially higher).


Finally, there is also the strategy of Backdoor Roth - this is utilized when you are hitting the maximum funding limits of qualified retirement accounts and are not able to make a deductible contribution to a traditional IRA. It is a little beyond the scope of this blog but I am happy to discuss further in regards to your personal situation.


Traditional IRA - Similar to a Roth IRA, this can be funded up until April 15, 2021 for tax year 2020. You get an upfront tax deduction for the contributions, the money grows tax deferred, but in the future any money you distribute will be taxed at ordinary income tax rates. Typically states recognize the same rules as the IRS, but there are states that do not (looking at you, NJ).


Company Sponsored Retirement Plan - This may include 401(k), 403(b), or another qualified retirement account. Your employee contributions can be set as either “traditional” or “Roth” and you can change this amount as often as you want (assuming HR makes the changes). This account needs to be funded prior to year-end and can only be funded via payroll. Make sure you know how much the company matches to ensure that you are getting the full amount.


Coronavirus Related Relief - On the flip side, it may be beneficial to consider taking a distribution from a retirement account prior to year-end. If you were impacted physically or financially from the virus, you may be able to take a distribution of up to $100,000 without paying the 10% early withdrawal penalty. You have the option of recognizing the income tax ratably over three years, and can pay the full amount back within three years to avoid the taxes. If you foresee your finances being impacted going into 2021, this may be a great option to take advantage of while we wait for a vaccine to be distributed. You can take a distribution, hold it in cash as an emergency fund, and then pay it back by 2022 if you realize you never needed the money. Or, use it as needed and pay income taxes on the distribution spread out over the next few years.


Contributions to Tax Advantaged Accounts


Note in this category I do not label them “savings” accounts because these accounts are “use it or lose it”. Additionally, these are decided for the year ahead - so no changes can be made to these accounts (unless a qualifying event) for the rest of 2020. These are elected during open enrollment.


Flexible Spending Account (FSA) - This works the same as an HSA, except the account cannot rollover year over year. This is an account controlled by the employer, so make sure you understand what happens if you leave the company in the middle of the year, if you don’t use the full balance, or how you can add to the account if there is a qualifying event throughout the year. You can not contribute to this account if you are contributing to an HSA, and you typically contribute to this account if you cannot contribute to an HSA (based on health insurance plan). For tax year 2020, the planning item would be to make sure you are using all the funds you contributed into the account prior to year-end (unless there is a grace period into 2021 to consider).


Limited Purpose FSA - This is typically used if you have high medical costs (above your insurance deductible) or high dental or vision costs. It works the same as an FSA, but because it is “limited purpose”, it can be combined with an HSA. I see this account as a way to use tax-advantaged funds for high medical costs, without having to use funds from your HSA so it can continue to be invested and grow year over year, tax free.


Dependent Care FSA - Used for dependent care expenses of a child that you are the custodial parent. There is also a federal tax credit available, but typically the DCFSA account has a better tax advantage than using the dependent care expense credit; the benefit depends on your tax rate, total dependent care costs and your income, so make sure you understand your specific situation to choose which is more beneficial. You elect the total amount over the full year and it will be taken evenly throughout the year in each paycheck. The considerations are similar to the standard FSA, which are to understand the employer rules around the account and make sure to use the full amount prior to year-end (and avoid forfeiting any money).


Transportation account (train, parking, etc.) - This is also a payroll deduction you can use to pay for qualified transportation expenses in a tax friendly manner. I used to live in Media, PA and would take the train into Philly everyday. My monthly train cost was about $160/mo - I elected this benefit and avoided taxes on about $2,000 throughout the full year, which saved me about $700 between Federal, State, City and FICA taxes. Make sure your contributions are qualified and under the monthly maximum for this benefit.


Above-the-line deductions


2020 Charitable contributions - As I mentioned in my previous post, 2020 will allow for a $300 above-the-line deduction for charitable contributions. If you give to charity but typically do not get the benefit of itemized deductions, this year you will get the benefit for up to $300.


Student Loan Interest Deduction - If you started, or continue to pay student loan debt in 2020, the interest you pay will be reported to you in a 1098-E from your loan servicer, and you should make sure you report it for the tax deduction. No tax planning here, just calling it out to make sure you report it.


Also pointing out that “above-the-line” is where you would report any HSA contributions or deductible Traditional IRA contributions, which were talked about above.


Itemized Deductions


Although individuals may have less control (or no benefit) over when they pay property taxes, state income taxes and mortgage payments, you can at least control your charitable giving to an extent.


You can “bunch” your charitable contributions if you think you might lose the ability to itemize deductions, or it will help you get an added benefit in a certain year (typically due to higher income). This is when you make a larger contribution in a year you would get a larger benefit, and forgo giving the next few years. This same strategy can be applied on a smaller scale to the $300 above-the-line deduction for 2020.


Take this example: John Doe lives in CA and decides he wants to live in AZ. He owns his house in CA, but doesn’t want to sell it, so he will rent it to another family while he is gone. He will rent a home for himself when he gets to AZ.


John was itemizing deductions, but he will lose a lot of the deductions (property tax & mortgage interest) by shifting his primary home into a rental (expenses move to Schedule E instead of Schedule A), and therefore will start taking the standard deduction in future years. John typically gives $1,000 to his favorite charity every year, but since he will not be itemizing deductions next year, he will not get the tax benefit. Instead, this year he gives an upfront gift of $5,000 to the charity, gets the tax benefit on Schedule A for the full $5,000 prior to moving to AZ, and does not give for the next few years.


Tax Credits


I have amended tax returns in the past based on missed education tax credits, so I feel it necessary to mention. If you paid tuition to a qualified university in a tax year, and also paid for books, supplies, etc. then these expenses can be used to claim either the American Opportunity Tax Credit or the Lifetime Learning Credit. Keep track of your expenses and get the full benefit that these credits allow; college is expensive!


Some other credits to mention (but not all credits available) are the dependent care tax credit (mentioned above), Savers Credit (based on your income and how much saved into a retirement account), Healthcare Coverage Tax Credit (for low income families), and Residential Energy Efficient Property Credit; if any of these applied to you over the tax year, make sure that you are claiming the expenses and getting the credit.


State Tax Planning


Your state may allow certain deductions or credits for expenses paid. These are less talked about because state income taxes are typically a fraction of federal taxes. One I can talk about is Arizona - they have charitable credits for Qualifying Charitable Organizations (QCO), Qualified Foster Care Charitable Organizations (QFCO), as well as public and private school tax credits. Credits are a dollar for dollar reduction (unlike deductions) and can be utilized up to your tax liability, also called nonrefundable tax credits. These credits give the unique opportunity to shift payments from the Arizona Department of Revenue to a qualified charity of your *limited* choice (limited to the list put out by AZ). In this instance, a $1 credit does equal $1 less of tax.


Note that the IRS has set out specific regulations around state tax credits - the general rule is if you take a state tax credit for charitable contributions, you cannot take the charitable deduction on your federal return - but you can add the amount of the credit as a “state and local tax paid” on Schedule A.


Final Thoughts


A lot of these accounts may sound confusing and can be a headache to understand how they all work, how they relate to each other, and making sure you follow all the rules to stay compliant. It may be easy to say you’ll learn all this later, or that you have a low savings capacity so this doesn’t really impact you - but what if planning around taxes is the way that you increase your savings capacity?


It is not just about how much money you make - it’s the money you keep. And taxes can be a big detractor from your savings ability. Planning around the different accounts and the ways that you save could potentially impact your financial health even more positively than increasing your income.


If you need help, look to get some. The savings you receive from utilizing the accounts available may just be worth the cost of a professional. Just make sure the professional is qualified and has your best interest at heart!