Editor’s note: The Hustle is a new bimonthly column in which artist and Enrolled Agent Hannah Cole discusses taxes and finance management for artists. She is the founder of Sunlight Tax. In this week’s column Cole examines tax shelters such as Flexible Spending Accounts and Healthcare Savings Accounts.
What is a tax shelter?
The term “tax shelter” may conjure offshore accounts and shell companies, but in fact it is just a way of reducing your taxable income. Abusive tax shelters are illegal, but there are many legal ones that are actually set up by the US government to encourage Americans to set aside money for important things, like health care, child care, college, and retirement. I want to discuss a subset of these tax shelters, the Flexible Spending Accounts (FSAs) and the Healthcare Savings Accounts (HSAs) which came up in my previous piece on artist taxes. These accounts allow you to set aside up to a certain dollar amount tax-free to pay for qualified expenses. What you set aside gets subtracted from your taxable income, reducing your overall tax liability. Many of these programs have open enrollment periods in November, so just in time, here is a primer on this group of tax shelters for the working artist.
Tax shelters for employees
If you or your spouse is employed, you can take advantage of employer-sponsored Flexible Spending Accounts (FSA) for health care, child and dependant care, and transit, if your employer offers them in its benefits package. Not all employers do. The rules vary from account to account.
For a healthcare FSA, which is the most common shelter offered, you can set aside up to $2550 per year per employee (regardless of family status). The money is not subject to payroll tax or income tax, which means that you shelter the money from your income tax rate plus the 7.65% payroll tax. You can use the money to pay for qualified healthcare expenses including dental, vision, mental health, deductibles, copays, and prescriptions. But money you set aside must be used that year. Some employers may allow a 2.5 month grace period, or a rollover of $500, but they aren’t required to. So it’s important to anticipate your next year’s expenses as accurately as you can. For those who aren’t in the habit of evaluating your healthcare expenses, take heart. You can base it on what you spent last year, or you can do a rough sketch of what you expect in the upcoming year: say, a new pair of glasses, copay for one physical, two dental cleanings, a flu shot and 12 months of birth control pills. You need to submit your itemized receipts with your claims forms, and the process can be a hassle.
FSAs for dependent care are a little different. While most people use these accounts for childcare, they are also good for an elderly parent, disabled spouse, or other person that you can claim as a dependent on your tax return who is incapable of caring for themselves. The money can even cover day camp or babysitters as long as it enables you to work, look for work, or attend school full-time (it’s not for date nights). Both spouses must earn income to qualify, unless they are disabled or a full-time student. The 2016 contribution limit is $5,000 for an individual or married couple, or $2,500 for someone married filing separately.
Transit benefit FSAs are less common, but allow an employee to set aside pre-tax dollars for commuting or parking expenses, or for public transit expenses, up to $255 per month.
So let’s say you are lucky enough to have access to all three of these FSAs, and your spouse also has his own health care FSA and transit FSA, (since the limits on those are per employee), and you decide to max them all out for the best possible tax savings. Let’s say you make a combined $100,000 per year. And you save a further $195/year each from the payroll tax exemption on your health care FSA. So your taxable income is now $83,390.
$100,000 combined salaries
– $2550 healthcare FSA spouse #1
– $2550 healthcare FSA spouse #2
– $5000 childcare FSA
– $3060 [12 x $255] transit FSA spouse #1
-$3060 [12 x $255] transit FSA spouse #2
– $390 [2 spouses x $195] 7.65% payroll tax savings
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$83,390 taxable income
You have lowered your taxable income by $16,610. If your tax rate is 25%, then you save $4152.50 in taxes.
$100,000 x .25 = $25,000 tax if you sheltered nothing
-$83,390 x .25= $20,847.5 tax on your lower amount of income
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$4,152.50 = tax savings for one year
And you not only pay tax on a smaller amount of income, you may be able to bump your taxable income into a lower tax bracket, meaning you actually pay a lower tax rate as well.
Tax Shelters for Freelancers
Freelancers without a working spouse can’t access the FSAs. But if (and only if) you have a High Deductible Healthcare Plan (HDHP), you can use the stealth-ninja of savings plans, the Healthcare Savings Account (HSA). These accounts are meant to help you save money for your high deductibles and unforeseen medical expenses, but they have some interesting flexibility. You are allowed to invest the money in low cost index funds to optimize growth. You can take money out tax-free when you have a qualified medical expense. But unlike a healthcare FSA, the money is yours, whether or not you use it up in a given year. And once you turn 65, it essentially functions as a retirement account – any withdrawals for qualified medical expenses are tax-free, but you can take out money for other purposes and pay income tax on it (as you would with a Traditional IRA). So the growth potential and the fact that you own the money forever make the HSA a more powerful savings vehicle than a healthcare FSA. The 2016 contribution limit is $3,350 for an individual and $6,750 for a family.
And one last note on health insurance. If you have Marketplace health coverage under the Affordable Care Act (ACA): it’s important to report changes in income as soon as you can. For freelancers, estimating your income is often tricky—but if your income increases, say, you get a year-end bonus, or land a big client, you may have to pay back part or all of your subsidy.
DISCLAIMER: True tax advice is a two-way conversation, and your accountant needs to hear your full situation to apply the rules correctly in your case. This post is meant for general information only. Don’t act on this alone.
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