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Tax Planning Opportunities for W2 Employees

Tax Planning Opportunities for W2 Employees

April 17, 2024

In order to truly kick off the first ‘financially focused’ article of 2024, my goal is to educate folks on the opportunities they have for some tax planning as W2 employees. 

While it could be argued that W2 employees have less flexibility with tax planning strategies when compared to self-employed individuals or small business owners, this does not mean there is no action that can be taken to maximize one’s tax bracket today while also having an eye on potential taxes down the road.  Always consult with a qualified tax professional prior to making any decisions.

With that said, read along for 3 tax planning movies one could consider:

  1. Contribute to your Employer-Sponsored Retirement Plan (401k, 403b, etc.)

For the most part, W2 employees have access to a 401k or 403b plan through their employer.  These types of savings vehicles allow you to put good size dollar amounts away for one’s eventual retirement, and many employers do offer their employees a match on their contributions.  For example, a fairly common one is if an employer contributes 3% of your salary into their 401k, the employer will match their 3% match.  That is 100% return on your money just by contributing!

With these contributions, you also may have the choice of contributing pre-tax (Traditional), or ROTH (post-tax) to this vehicle.  The current contribution limit in 2024 for 401k contributions is $23,000 (if you are under age 50), and those over age 50 can contribute an extra $7,500 as an ‘catch-up’ contribution for a total of $30,500 in 2024.

I typically educate clients on having a balance between ROTH and pre-tax contributions to create choice and flexibility down the line.  However, if an individual or couple are in their highest earnings years, they may consider contributions of all pre-tax to receive a tax break today, while understanding that 100% of their withdrawals will be taxable at their income tax rate down the road.  This is especially relevant if you believe you will be in a lower tax bracket during your withdrawal years.

With the above in mind, in my personal opinion, not all of your money should be geared towards your retirement accounts, but it does typically make sense to allocate funds to these types of accounts for retirement planning purposes, receiving the employer match, and of course for current and future tax planning.  As always, please consult with your tax advisor prior to making any decisions.

  1. Health Savings Account (HSA) – Triple Tax Advantage If Used Properly!!

This additional pre-tax option can provide for choice outside of simply saving for retirement.  Your eligibility to contribute to this type of account does depend on which healthcare plan you currently have – if you have a high deductible health insurance plan you should be eligible to contribute to an HAS – number wise you need a minimum annual deductible of $1,600 (single plan), $3,200 (family plan) and a maximum deductible and out-of-pocket expenses of $8,050 (single plan), $16,100 (family plan).

To summarize, an HSA is an account that lets you set aside monies on a pre-tax basis to pay for current or future qualified medical expenses.  By doing so, you also receive a reduction in your taxable income by making this contribution.  The current contribution limit in 2024 for a family plan is $8,300 and $4,150 for individuals.  Moreover, for most plans, as long as you leave a few thousand dollars (depends on the specific plan rules) in the cash portion of the account, the remaining monies can be invested in the mutual fund options offered – very similar to your 401k or 403b plan investment options. 

At this point I often have the conversation with my clients to determine if you withdraw these funds to pay for medical expenses today, or if you pay out of pocket and allow the invest portion to grow.  Additionally, the monies built up in the account can be used to pay for Medicare premiums at age 65 – more specially Medicare Part B, Part D, Medicare Advantage Premium, deductibles, copays, and coinsurance!  In some cases, you can also use these funds to pay for individual long term care insurance premiums up to a certain amount each year (amount varies depending on your age).

I personally think HSAs are often overlooked as a savings vehicle, so I typically encourage clients to at least understand the underlying pros and cons prior to make a decision.  Aside from an HSA being triple tax advantaged - meaning that the money is contributed pre-tax (reduces taxable income), the monies that are invested grow tax-deferred, and the withdrawal of these funds are all tax-free as long as they are utilized for qualifying medical expenses. 

Once you turn age 65 you can actually utilize this vehicle as a normal pre-tax retirement account - just like your Traditional IRA or 401k – however, the only thing to be aware of here is that the withdrawals are taxable if they are for general retirements purposes.  Lastly, let’s say your HSA has been open for 10 years and you paid out of pocket for a medical procedure 5 years ago.  Under current rules, you can go into your HSA and reimburse yourself for this expense tax-free (as long as you have your receipt to back this up)!  As a note, you must have had your HSA open at the time of this procedure.  Pretty cool.

  1. ROTH Conversions

I often receive many questions surrounding ROTH conversions.  As a general statement, ROTH conversions involve a process of withdrawing money from your pre-tax retirement account, paying the appropriate tax, and depositing the funds into a ROTH IRA.  From there, the funds invested in the ROTH will grow tax-deferred and the entire conversion amount can be withdrawn tax-free as long as 5 years have gone by.  As a note, one can always withdraw the conversion amount prior to the 5 years (without penalty or tax) as this amount has already been taxed - the earnings will be tax-free once the 5 years have passed.  Additionally, each ROTH conversion has its own 5-year clock. 

Typically, I look at these strategies for clients when anticipate experiencing lower income years, or if they have just retired and we have enough cash or taxable investments to find their lifestyle while we facilitate a few years work of ROTH conversions.  If an individual does consider doing a ROTH conversion while still working, they need to keep in mind that the amount they convert will be tacked onto their overall income – which could bump them up to a higher marginal tax bracket, and in turn, have them pay more taxes than if they waited until their income dropped.  In my opinion, the key here is to maximize the tax efficiency by understanding what marginal tax bracket you are in today and using some assumptions to estimate your bracket down the line to determine the proper timing.  To me, you are designing a strategy to reduce your lifetime taxes, rather than in one specific year

Furthermore, one rule I have is that the client should have the money set aside in cash to pay the tax on the conversion – by doing so the entire conversion amount gets deposited into the ROTH IRA.  For example, if a client wants to convert $100,000, we would convert $100,000 from pre-tax to ROTH and pay the tax out of cash so the full $100,000 is converted.  Rather than only truly converting $80,000 out of the $100,000 if $20,000 will go to the IRS as a result of 20% federal tax in this example.  Always consult with your tax professional before making any decisions.

Some may ask…. why would one consider a ROTH conversion?  Typically, it is an opportunity to move pre-tax monies to post-tax monies in anticipation of being in a higher tax bracket down the road.  Moreover, if this strategy is started early enough, this could be a way for a client to reduce their projected Required Minimum Distribution (RMD) amount and also pull this money out at a lower tax bracket compared to the projected bracket at their RMD age.  As a reminder, an RMD is the required minimum amount the IRS requires you to withdraw at a specific age.  Considering recent changes from Secure 2.0 Act, if you were born between 1951-1959 your RMD age is 73, however if you are born after 1959 your RMD age is 75. 

So, if we do some planning around what you may be required to take out at your RMD age, assuming your tax bracket based on current tax laws, we could review some ROTH conversion scenarios that aim to withdraw these funds at a lower tax rate than you are projected to at your RMD age.  Simple example, but a lot more planning needs to happen before this decision can be made.

Please let me know if you have any questions or need clarification on the above.  More on this topic in the weeks ahead. - used for HSA deductible and out of pocket expense figures. 

For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.