I have a lot of fond memories of Januaries in Nebraska. Snow storms (it’s actually snowing as I’m writing this), a Nebraska football bowl game (OK, maybe not every year), watching the Packers in the playoffs (I was born in Wisconsin so don’t judge), and receiving a bunch of tax statements, hoping I don’t have to pay in this year. I’m sure you can relate, right?
OK, most people probably aren’t thinking much about their taxes quite yet, but tax season will soon be in full swing, and we’ll all be experiencing one of the two certainties in life. For the most part, what’s done is done – meaning, there’s not a whole lot you can do to change your tax bill for 2019. After all, 2019 is in the past. However, there are exceptions.
Traditional IRA Contributions
There are two common ways people can manage their previous year tax bill. The first is making an IRA contribution. You have up until the tax filing deadline to make contributions to an IRA from the previous year. Contributions to a Traditional IRA (as opposed to a Roth IRA) can lower your taxable income if you’re under certain income limits. You also get the benefits of tax-deferred growth, which means that unlike a non-retirement accounts, you don’t have to pay taxes on any growth within the account until you take money out of the account – which, hopefully, isn’t until after you retire, because otherwise, you’ll have to pay some penalties. There are some other limitations on what you can put in the account. For example, you have to be earning income to be able to contribute. Again, there are also income limitations on the tax deductibility, but for many people, contributing to an IRA can be an effective tax management strategy that also helps your retirement picture.
If you’re eligible to contribute to a Traditional IRA, and you’re able to deduct the contribution and lower your tax bill, should you always do it? Before you do, consider contributing to a Roth IRA instead. Roth IRA contributions don’t benefit you now from a tax-savings standpoint, but the earnings grow tax-free (not just tax-deferred like a Traditional IRA). If you’re in a low tax bracket now and a higher tax bracket later on, it might be more beneficial to contribute to a Roth IRA instead. For more detail on that decision, check out this blog article.
Health Savings Account (HSA) Contributions
Another common tax management strategy that you might still be able to use is contributing to a health savings account (HSA). Contributions to an HSA have a similar effect on your current taxes as Traditional IRA contributions. You have up until the tax filing deadline to contribute to the account if you want to classify the contribution for the previous year. HSAs have some unique tax advantages. They have what we call “triple tax savings”. Your contributions to the account lower your taxable income, the growth is tax-free, and if you take the money out of the account to pay for qualified medical expenses, the distribution is tax-free. In that regard, they’re pretty unique.
There are some unique characteristics of contributing to an HSA with which you need to be familiar. First, you need to be enrolled in a high deductible health insurance plan to be eligible to contribute to an HSA. If you’re not, you can’t contribute to the account. But that also means you have a low deductible in your insurance plan, so that’s something to be thankful for.
Second, many employees contribute to an HSA through payroll, and some employers even contribute to their employees’ HSAs. Other employees contribute directly to the account after they get paid; their contributions don’t go through payroll. There are different paper trails for those different contribution methods, and they show up differently on your tax documents. But at the end of the day, they have the same effect on your tax bill. Why do you need to know there are differences? You need to be sure you’re not contributing more than the IRS limitations, so you need to add up those employee and employer contributions that were made in 2019 to see if you have any room to contribute any more money to the account in 2020 for tax year 2019.
Other Financial Planning Opportunities
January isn’t just a time to watch football while it’s snowing outside, or sip hot chocolate while reading tax statements by the fireplace wondering how much you’ll owe in taxes. It’s also a time to reconsider your savings, spending and giving strategies for the year. Many workers get a pay raise in January, so be intentional about how you want to use that extra money. If you got a raise prior to January but never thought about how you’d use the money, now is a good time for you to strategize, too. How much of that extra income do you actually need to pay for your basic expenses? Can you afford to save a little more of that income (in an IRA, HSA, or any other savings account for that matter) each month? Could you afford to give a little extra to your favorite charities? What you want to avoid is lifestyle creep – that tendency to spend extra income in little increments over time without realizing it. Lifestyle creep makes it difficult to cut back on spending, so avoiding it is the easiest way to combat it.
Implementing Your Plan
When you’re considering contributing to an IRA or HSA for the previous year, it’s important to run things by a qualified tax professional like an accountant. Accountants can look at all of the rules and restrictions to help you determine whether you can even contribute in the first place, and if you can, help you understand how much (if anything) you’d actually be able to save in taxes by doing so. They might also identify other tax-savings opportunities.
I’d also recommend talking to a fee-only financial planner, like the planners here at Flagstone, to see how these decisions affect the big picture. Even if you have the ability to do take advantage of these opportunities, it doesn’t necessarily mean it’s in your best interest to do so. As fiduciaries, we try to figure out if these strategies are, indeed, in your best interest. That said, don’t let analysis paralysis get in your way of making a decision. Not making a decision is effectively a decision to do nothing. Doing nothing is great way to spend a snow day in Nebraska, but when it comes to your finances, be intentional about your decisions.