When an HSA-First Strategy Makes Sense

Many--perhaps most--articles about health savings accounts suggest that employees with an HSA who participate in a 401(k) plan should first contribute to the 401(k) plan the percentage of their compensation that enables them to obtain the maximum plan sponsor match, such as 3% on the employee's first 6% of compensation. Employees should then max out their HSA account contributions through payroll deductions. Once that's done, they should go back to contributing any additional dollars to their 401(k) plans.

While this strategy is indeed attractive, an even better one would be to change the sequence of the contributions. That is, employees should first max out contributions to their HSAs no matter their tax bracket, and once that's done, contribute to their 401(k) plans.

Break out that trusty old HP 12C and calculate any contribution, time horizon, and interest-rate combination. Then reduce that number by, say, 25% for tax to come up with the 401(k) balance. (An HSA demonstrates even greater superiority over an employer match in a 401(k) plan when withdrawals are made at a tax bracket higher than 28%, thereby illustrating the power of tax-free withdrawals in retirement. That is, the higher an employee's tax bracket, the larger the employer's 401(k) match must be to in order beat contributing to an HSA first.) 

A 401(k) plan will beat an HSA if left to retirement. However, reality intrudes when withdrawals are made from the 401(k) to pay for things like medical expenses and a participant in a 401(k) is slammed with taxes and penalties. This is why it makes the most sense to first max out HSA contributions and thereafter get the maximum company match from the 401(k).

Do the same for an HSA but then factor in a 7.65% (FICA) discount up-front and no tax deduction at the back end. In most calculations, the HSA-first strategy is ahead by one third. Then, add in a typical employer match of 3% on the first 6% in employee compensation and take the balance out at a 35% tax bracket. The result: HSA tax savings even beat the employer's match. And don't forget, 80% of employers that offer an HSA contribute $500-1,500 to an employee's HSA.

Once these two no-brainers are accomplished--max out HSA contributions first and then obtain a full company match for the 401(k) plan--only at that point should employees begin their retirement needs planning for the year and so on into the future.

For those who are uncomfortable with this strategy for whatever reason, perhaps they would prefer contributing simultaneously to both the HSA and the 401(k) account on a regular periodic basis throughout the year.

Apart from the issue of the sequence of contributions to an HSA and a 401(k) plan is the issue of the difference in the amount of contributions. For example, Employee A saves and invests $5,000 (a nice round number used even though it slightly exceeds what an individual 55 or older can currently contribute annually to an HSA) annually for 30 years in an HSA. Employee B also saves and invests $5,000 annually for 30 years in a 401(k) account. Employee A in the HSA will amass $611,729 while Employee B in the 401(k) plan will amass $423,699.

The differential in favor of the HSA of nearly $200,000 is due to avoiding payment of the (up-front) 7.65% FICA tax (or more in certain other states and localities) for 30 years of contributions. (Assumptions for the foregoing terminal amounts include a 25% income tax bracket, an 8% return, an HSA that's in the payroll deduction scenario to avoid paying 7.65% in FICA taxes and HSA assets are used for qualified medical expenses. Also, a 25% income tax bracket was applied for withdrawal of 401(k) money.)

Tax-Deferred Accumulation of Earnings and Interest on Contributions
Any earnings and interest generated on contributions to an HSA accumulate tax-deferred over time. When these accumulations are used to pay for qualified medical expenses or to reimburse an HSA holder for previous qualified medical expenses, they become tax-free distributions.

Tax-Free Distributions to Pay for Qualified Medical Expenses
In essence, HSA assets can be used to pay for anything tax-free. Suppose that HSA holders are able to max out contributions to their HSAs and pay for qualified medical expenses out-of-pocket through some or all of their careers. If the holders have kept their medical expense receipts over time, they can get reimbursed later for those expenses from their HSAs.

There's not even a need to have a current qualified medical expense; the HSA holder merely needs to have a receipt from any time in the past to get reimbursed. Qualified medical expenses, then, can arise from any year--not just the current one. This proactive strategy allows an HSA holder to augment retirement income tax-free rather than first pulling money from, say, its taxable 401(k) plan account. This could be helpful in cases where withdrawals from a 401(k) account could bump the holder into a higher tax bracket which could also result in higher Medicare premiums

Other instances of the versatility and flexibility of the HSA abound. For example, the fact that an HSA holder can contribute to an HSA until April 15 for the previous tax year (like an IRA) allows for a post-calendar year tax avoidance strategy. Suppose that a 56-year old self-employed worker had $4,000 in medical expenses and paid for them with (after-tax) out-of-pocket money because the worker didn't know that he or she was eligible for an HSA. A savvy investment advisor informed the worker about eligibility.

So before tax-time in April, the worker establishes an HSA and contributes $4,000, thereby avoiding payment of federal and state income taxes. (But not FICA taxes because the self-employed cannot establish an IRS section 125 cafeteria plan. However, LLC or LLP members might be able to establish a 125 plan if they have elected to be taxed as a Subchapter C Corporation; competent professional counsel should be consulted in such cases.) The worker then took out $4,000 from his or her HSA to reimburse himself/herself.

The result: a wash that saves a lot in taxes. This post-calendar year tax avoidance strategy demonstrates again that having a receipt for qualified medical expenses that were paid even far in the past allows an HSA holder to get reimbursed--assuming, of course, that the holder has been able to pay for its medical expenses out-of-pocket along the way.

Additional Advantages of HSAs
The Tax Cuts and Jobs Act passed by Congress last year failed to further expand the advantages of HSAs. However, it's thought that there will be a Medicaid/Medicare HSA provision as well as one to increase HSA contribution limits included in the 2018 Budget Reconciliation Act. In the meantime, here are some additional advantages of an HSA.

Full Vesting. Any contributions made to an employee's HSA by either the employee or its employer are immediately vested in the employee.

Portability. An HSA can be opened by a worker anywhere. For example, if employees don't like their employer-sponsored HSAs, say, because it's pricey and/or the investments are suboptimal (which is often the case), they can pull the assets from it and invest them elsewhere in an optimal HSA (within 60 days but without the rigmarole of a rollover). The downside to this non-payroll deduction scenario, of course, is that employees cannot take the 7.65% (or more) deduction for FICA taxes. Even if employees are currently ineligible to make contributions to their HSAs, the HSA always stays with them not their employers.

Flexibility. HSA holders can withdraw HSA assets or change them at any time while letting the HSA accounts accumulate, regardless of their current employer or current eligibility. In addition, there are no required minimum distribution rules or requirements to begin taking withdrawals at a certain age.

Sources of Contributions. Those other than HSA holders can contribute to a holder's HSA including a family member and, as noted, their employers.

Coverage for Family. HSA holders can use assets from their own HSAs to pay for qualified medical expenses incurred by spouses and their tax dependents even if they aren't eligible to establish their own HSAs or even if they have health insurance different than the holder.

At Death. At an employee's death, the HSA can be rolled over to a spouse tax-free, plus that spouse can continue to save and invest in the HSA. But if the HSA is rolled over to a nonspouse, the HSA balance is fully taxable like the balance in a 401(k) plan.

Medicare/Retirement. The Medicare Part B monthly premium (for visits to the doctor) is deducted from a recipient's monthly Social Security check. In such cases, however, an HSA holder can get reimbursed from HSA assets for these premiums as well as Part D monthly premiums (for drug prescriptions).

Source: http://news.morningstar.com/articlenet/article.aspx?id=842764

IRS simplifies procedure to request relief for late portability elections

Estate tax rules can be tricky for executors, especially when dealing with provisions they may have to face only once in a lifetime. A case in point is the portability of the deceased spousal unused exclusion (DSUE) amount, which, if elected, allows the estate exclusion amount ($5.49 million in 2017) to pass from a deceased spouse to the survivingspouse.

To make the exclusion portable, the executor must timely file an election. What happens if the executor, unaware of the necessity of the election, misses the filing? Fortunately, there may be relief. The rules for applying for this relief have changed again under Rev. Proc. 2017-34.

A brief history of the estate tax exclusion

Few taxes have caused as much debate as the estate tax. For years it has served as a lightning rod for tax reform, with those objecting to it calling it a form of double taxation, while defenders point to the tax revenue it generates and the oversized fortunes that pass from generation to generation.

In an attempt to lessen the blow of the estate tax, Congress long ago added an exclusion, allowing anything below that exclusion amount to be passed down to the next generation tax-free. This compromise has generally worked as long as both sides of the political spectrum were content with the size of the exclusion amount.

That "just right" exclusion amount has been a moving target. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, P.L. 107-16, put the exemption on a continuing growth chart from 2001 through 2010, when the exclusion amount in effect became unlimited. Then, in 2011, the exclusion was scheduled to drop to $1 million after EGTRRA's sunset.

Neither side of the political spectrum was happy with this cliff, so Congress addressed the issue in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (Tax Relief Act) of 2010, P.L. 111-312. The exclusion amount was set at $5 million plus annual inflation adjustments (after 2011), with the hope that this would prevent future fighting over the exclusion amount.

To make the $5 million exclusion even more palatable to those opposed to the estate tax, Congress temporarily passed, then later made permanent, a provision allowing any unused exclusion of a decedent to pass to a surviving spouse. This portability of the DSUE amount effectively allows a couple to pass up to $10 million (plus inflation) to their heirs tax-free.

Electing portability

Rules regulating exclusion portability to the surviving spouse are found in Sec. 2010(c)(5)(A), which states:

Election required. A deceased spousal unused exclusion amount may not be taken into account by the surviving spouse . . . unless the executor of the estate of the deceased spouse files an estate tax return on which such amount is computed and makes an election on such return.

In other words, for DSUE portability to be claimed, the executor must elect portability on the deceased spouse's estate taxreturn.

The IRS, thankfully, has made electing portability easy. If the executor timely files the decedent's Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, which generally is due nine months after the decedent's date of death, portability is automatically elected. If a return is timely filed, to decline to make or not be considered to have made a portability election, the executor must make an affirmative statement to that effect on the return or an attachment, which few executors will choose to do.

Extension of the portability election

Executors are most likely to run into problems if Form 706 is not timely filed. Under Regs. Sec. 20.2010-2(a)(1), estates electing portability are considered to be required to file Form 706 under Sec. 6018(a), with a due date of nine months after the decedent's death or the last day of any period covered by an extension obtained under Regs. Secs. 20.6075-1 and 20.6081-1.

The rules for missed elections go down two possible paths. Path A is followed by those who are required to file Form 706 under Sec. 6018(a) without regard to Regs. Sec. 20.2010-2(a)(1). In this situation, no further extension is available under Regs. Sec. 301.9100-3. In other words, if the executor was required to file a Form 706 under Sec. 6018(a) without regard to portability within nine months of the decedent's death (plus any period covered by an extension other than under Regs. Sec. 301.9100-3) but failed to do so, a portability election is not allowed.

Executors who did not timely file a Form 706 and the portability election who were not required to file Form 706 under Sec. 6018(a) may go down Path B, which allows extension relief.

Rev. Proc. 2014-18, issued in February 2014, provided a simplified method for executors on Path B to extend the filing period for portability under Regs. Sec. 301.9100-3 for estates of decedents who died between Dec. 31, 2010, and Dec. 31, 2013, which was available until Dec. 31, 2014. After that, executors seeking relief had to use the letter ruling process. Consequently, the IRS was flooded with private letter ruling requests for portability extension relief, most of which came from executors who did not discover the need to file for the portability election until the surviving spouse passed away. Due to the large influx of letter ruling requests, the IRS again decided to allow a simplified method of extending the election and did so in Rev. Proc. 2017-34, issued in June 2017.

Extensions under the new simplified method

Under Rev. Proc. 2017-34, if an executor missed the original election date and was not required to file Form 706 under Sec. 6018(a) without regard to the portability election, for decedents dying after Dec. 31, 2010, the executor may file a complete and properly prepared Form 706, by Jan. 2, 2018, or the second anniversary of the decedent's death, whichever is later, to obtain an extension of time to elect portability. The return must include a note at the top stating that it is "filed pursuant to Rev. Proc. 2017-34 to elect portability under Sec. 2010(c)(5)(a)." No user fee is required.

Rev. Proc. 2017-34 also notes that this portability extension relief does not extend the period available to the surviving spouse or surviving spouse's estate to claim a credit or refund for the overpayment of taxes under Sec. 6511(a). It also does not extend the time the surviving spouse's estate has to file a Form 706 upon the surviving spouse's death. However, if the claim for credit or refund on the surviving spouse's return is filed within the time required by Sec. 6511(a) in anticipation of the decedent spouse's executor's making a late portability election, it will be considered a protective claim for credit or refund of tax.

If, subsequent to the grant of relief under the simplified method, it is determined that, based on the value of the gross estate and taking into account any taxable gifts, an executor of an estate was required to file an estate tax return for the estate under Sec. 6018(a), the grant of an extension under the simplified method is deemed null and void ab initio.

The takeaway

If the decedent passed away on or after Jan. 1, 2011, and the executor missed electing portability of the DSUE due to not being otherwise required to file a Form 706, extension relief is available under Rev. Proc. 2017-34. However, this relief will soon disappear for estates of decedents who died before Jan. 2, 2016, leaving the private letter ruling process as the only recourse for their executors.

Source: https://www.thetaxadviser.com/

A Detailed Look at Tax Reform: Changes to Deductions and Credits

Tax reform cleared its first major hurdle in Congress on November 16 when the House passed its version of the bill by a 227-to-205 vote mainly along party lines. (No Democrats voted for it.) But the legislation, which would generally be effective for tax years beginning after 2017, still has a long way to go around the track before it hits the finish line.

The bill approved by the House contains many of the measures proposed during the past year by the Trump administration and GOP lawmakers. The following provisions may be of particular interest to your clients.

Individual Tax Provisions

Tax rates: The current tax rate structure of seven brackets would be replaced by just four brackets of 12%, 25%, 35% and 39.6%. (Note that the top rate will remain at 39.6%.)  In addition, a “bubble tax” of 6% would apply to a portion of adjusted gross income (AGI) above $1 million.

Standard deduction: The bill essentially doubles the standard deduction from $6,350 to $12,200 for single filers and from $12,700 to $24,400 for joint filers. Combined with other proposed tax law changes, many more taxpayers will be claiming the standard deduction in lieu of itemizing deductions.

Personal exemptions: Currently, a taxpayer is entitled to claim a personal exemption of $4,050 for himself or herself, a spouse and each qualified dependent. The bill eliminates all personal exemptions.

Itemized deductions: The bill repeals most itemized deductions while preserving tax breaks for charitable donations and disaster-area casualty losses. The deduction for mortgage interest would be reduced to cover $500,000 of acquisition debt, down from $1 million, but interest deductions for existing loans would be grandfathered. The state and local tax deduction, a lightening rod for controversy in high-tax states, would be limited to property taxes of up to $10,000.

Child tax credit: The child tax credit for children under age 17, which is currently $1,000, would be increased to $1,600, subject to certain restrictions. However, the extra $600 would not be refundable, unlike the $1,000 base credit.

Alternative minimum tax: The alternative minimum tax (AMT), which was designed to affect only the wealthiest taxpayers but has been a thorn in the side of millions of others, would be completely repealed.

Family tax credit: The new legislation would create a new $300 nonrefundable tax credit for each taxpayer as well as any non-child dependent such as an older child or an elderly relative. However, the credit would have a short shelf life and would expire after five years.

Recharacterizations: Although most retirement plan rules would remain intact, the House bill repeals the rule allowing a taxpayer to recharacterize a Roth IRA back into a traditional IRA. Typically, recharacterizations are used when the value of the taxpayer’s account drops. 

Business Tax Provisions

Corporate tax rates: One of the main tent poles in the new legislation is a reduction in the top corporate tax rate from 35% to 20%. After much debate, lawmakers made the corporate tax rate permanent.

Repatriation tax: Under the House-approved bill, a one-time tax of 14% would apply to existing foreign profits being held in offshore accounts. In addition, foreign profits invested in non-cash assets offshore would be taxed at the rate of 7%. The law gives companies up to eight years to pay up.

Pass-through entities: Currently, profits funneled through pass-through entities like S corporations and partnerships are taxed at individual tax rates as high as 39.6%. The new bill would limit the top tax rate on these earnings to 25%. It would also provide a lower rate of 9% for businesses earning less than $75,000.

Business deductions and credits: The new bill would add several key tax benefits for businesses while removing certain deductions and credits. For instance, it would effectively allow 100% Section 179 expensing of business property for a five-year period, but repeal the Section 199 manufacturing deduction and Work Opportunity Tax Credit (WOTC).

Finally, the new law would repeal the federal estate tax, a long-time target of GOP legislators, but not in one shot. The repeal would not completely take effect until 2024 and would be combined with a doubling of the estate tax exemption. Under current law, the exemption is $5 million (indexed to $5.49 million in 2017).

It’s still too early for your clients to take action based on these provisions, but the proceedings should continue to be monitored closely. Keep your clients informed about any significant developments.

Source: http://www.cpapracticeadvisor.com/