We are about a month away from the tax-filing deadline – usually April 15, but this year extended to April 18 – and hopefully you have gotten a start on your 2016 taxes. Whether you have or not, there are still some strategies you can bring to bear and get a tax benefit before the deadline.
Not all of these strategies apply universally. Make sure you check your eligibility with your CPA or tax preparer.
Open and fund a Health Savings Account
I am a big fan of Health Savings Accounts (HSAs), which allow you to set aside money for qualified health care expenses on a tax-free basis. You and/or your employer make contributions into the HSA, and those funds can be used for a long list of medical expenses.
The reason I like HSAs so much is that they offer a dollar-for-dollar offset against income, and there is no phaseout for high-earners. The HSA is an adjustment to income taken on the front page of your 1040 return, reducing both your adjusted gross income and your overall tax liability, regardless of whether you itemize deductions or take the standard deduction.
Eligiblity for an HSA requires having a high-deductible health plan (HDHP). For 2016, the minimum deductible on a health plan to be HSA-eligible was $1,300 for an individual plan and $2,600 for a family plan. The maximum out of pocket (OOP) amounts were $6,550 for an individual plan and $13,100 for a family plan. That’s the trade-off with an HSA-eligible health plan: you are responsible upfront for more dollars out of pocket before the plan kicks in. Your health insurance provider can tell you if your plan is HSA-eligible.
Even if you deposit funds into an HSA and withdraw them immediately to cover health costs, the tax benefit may still be worth it, particularly for those in the upper brackets. For 2016, you can contribute up to $3,350 if you have an individual HDHP or $6,750 if you have a family plan. If you are 55 or older, you can contribute an additional $1,000 to your HSA (maxing out at $4,350 or $7,750 for individual and family plans, respectively). Any employer contribution made to an HSA on your behalf counts toward the annual maximum.
If you turned 65 and enrolled in Medicare during 2016, you can still make a partial contribution to an HSA for the months of the year in which you were not enrolled in Medicare. For those who have December health insurance renewals and switched to an HSA-eligible HDHP in December 2016, you can make a full year’s contribution to an HSA for 2016 even though you only had the HDHP for one month of the year!
There are a number of reputable HSA providers out there; you don’t have to go with the provider suggested by, or affiliated with, your insurance carrier. You have until the tax-filing deadline to open and fund an HSA for 2016 tax purposes.
Make a contribution to a traditional or Roth IRA
Another adjustment to income is the deductible contribution to an IRA. If eligible, you (and possibly your spouse) can make deductible contributions to IRAs for 2016 by the tax-filing deadline. The maximum contribution amount for 2016 is $5,500, plus an additional $1,000 “catch-up” contribution if age 50 or older.
Eligibility for deductible IRA contributions is somewhat complicated. The first criteria is that you must have “earned income” in order to make any IRA contribution. Assuming the answer is yes, and you are under age 70 1/2, your ability to deduct an IRA contribution depends on your filing status (single, married filing jointly, etc.), your modified adjusted gross income (“MAGI” – usually close to if not equal to adjust gross income, or AGI), and whether you or your spouse participate in an employer retirement plan.
You can find a very handy flowchart for determining 2016 IRA deductibility here (courtesy of the Confident Returns blog).
For our working younger clients, we encourage contributions to Roth IRAs – the reason being, for many workers in their 20s and 30s, the tax benefit of a deductible IRA contribution is less impactful, and their income is usually below the phaseout for Roth IRA contributions.
Roth IRAs are an excellent vehicle for building up a bucket of tax-free dollars at an early age, particularly because at some point income will exceed the eligibility for future Roth contributions. In some cases, parents assist their young-adult children in funding the Roth IRA. As with deductible IRAs, Roth IRAs can be opened and funded for 2016 by the tax-filing deadline.
Make a contribution to a non-deductible IRA (and convert to a Roth)
If your income does not allow you to make a deductible IRA contribution, consider making a non-deductible IRA contribution by the tax-filing deadline. While you will not get a deduction for the contribution, any earnings in the account grow tax-deferred until distributed.
An effective strategy with non-deductible IRA contributions is to initiate a Roth conversion using the non-deductible IRA. You will pay tax on the earnings in the account at the time of the conversion, but there will be no tax due on the initial contribution amount.
Ever since income limits on Roth conversions were lifted in 2010, this strategy has been used by high-income earners as a way to accumulate Roth IRA assets. There are pitfalls, especially if you have existing traditional IRA assets. Be sure to check with your CPA/tax preparer so that you avoid the common mistakes of these so-called “back-door” Roth conversions.
Open and fund a SEP-IRA if you have business income
For the self-employed and others who report business income on Schedule C of the tax return, one way to reduce your tax liability is to open and fund one of several retirement plans available to small business owners, the most popular being the SEP-IRA (“Simplified Employee Pension” IRA). You can contribute up to 25% of your compensation, to a limit of $53,000 in 2016, into a SEP-IRA. There is a special computation used to determine your maximum allowable contribution when self-employed, but it effectively works out to 20% of net earnings.
With a SEP-IRA, you can make a prior-year contribution as late as September 15 if your tax return goes on extension. Even if business income is not significant, it may still be worthwhile to consider a SEP-IRA to help lower your overall tax liability.
We may not yet be able to travel back in time, but we can take advantage of these strategies in 2017 to impact our tax picture for 2016.
Questions or comments? Contact me on Twitter @juanros or LinkedIn.