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| The Basics | Salary reduction plans adds cash to your wallet
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If you have child care or medical expenses, salary reductions plans are a great way for you and your employer to save on taxes and put cash in your pocket.
By Jeff Schnepper
The name isnt very appealing: Salary reduction plans. So lets give it a new name: "Increase your income" plans. Now are you interested?
A salary reduction plan allows you to convert potentially non-deductible expenditures into deductible expenses. Its a great idea, but it only helps if your employer offers it.
In its simplest form, a salary reduction plan is an agreement between you and your employer to reduce your salary by a given amount, based on the assumption that youre going to use that money sometime during the year to pay for specific types of expenses. In effect, your employer sets up an account for you from which you can get reimbursed tax free.
Its a great deal for you and your employer, so long as you really have to pay the expenses, but well get to that in a minute after we see how this works for you and your taxes.
Lets assume youre single, making $68,800 a year. Youre in the 25% bracket for 2005 and 2006. You and your employer agree to reduce your salary by $7,000 for the year. Whats the result?
You and your employer just saved $535.50 each in Social Security and Medicare payments that neither of you has to make. In addition, your employer doesn't have to pay any state disability, worker's compensation or other payroll taxes on the $7,000 in salary that youre not getting paid.
Over the year, you'll have access to the $7,000 that you conceded in salary for expense reimbursements. In the beginning of each year, you tell your employer how much you want withheld from your salary and for what purpose. Thats why these plans are sometimes referred to as cafeteria plans or flexible spending accounts. You pick and choose which expenses you want reimbursed.
You can set up salary reduction plans to handle these expenses:
- Group life insurance payments
- Health-care payments
- Disability premiums
- Dependent care assistance programs (including child care)
The reduction amount you choose is withheld equally from each paycheck. By making these reimbursements tax-free, the salary reduction plan converts all of these expenditures that you would normally incur into deductible expenses -- whether or not they normally would be allowed as a deduction.
Lets look at dependent-care benefits. While not deductible, under certain circumstances up to a maximum of $6,000 for two children (or $3,000 for one child), they qualify for a credit.
A credit is a dollar-for-dollar reduction in your tax; a deduction reduces your tax by the amount of the deduction multiplied by your marginal tax rate. That credit ranges from a maximum of 35% to a minimum of 20% depending on your income.
Income is defined as your total adjusted gross income on your return. For someone with income of more than $43,000, the credit is 20% or a maximum of $1,200 ($6,000 x .20).
Let's change the example slightly. Now, you're in the 28% bracket for 2005. Rather than a maximum of $6,000 in qualifying payments for your two children, the salary reduction plan allows as much as $5,000 to go into dependent-care expenses. This saves you $1,400 in taxes ($5,000 x .28), or $200 more than the maximum $1,200 allowed under the credit.
Do the math. If youre in the 15% bracket, the credit may be preferable. You can get a credit of as much as 30% if your income is less than $10,000. Alternatively, most taxpayers would be better off taking the deduction. Compare your marginal tax bracket to your credit amount (See IRS Form 2441 for credit amount breakdowns). Take the one that gives you the biggest bang for your buck.
Insurance and medical expense reimbursements are where the real tax savings can be found. Normally, medical insurance and medical expenses are not deductible except for amounts that exceed 7.5% of your adjusted gross income. So, for example, if your adjusted gross income is $100,000, the first $7,500 in medical expenses, including medical insurance, is not deductible.
However, under a salary reduction plan, if you know your medical insurance premiums are going to be $500 a month, you can reduce your salary by $500 a month. That $6,000 expense is reimbursed to you tax-free. In the 28% bracket, that saves you $1,680 in taxes.
In addition to the insurance payments you know you will be paying, project your other medical expenses (e.g. co-payments on doctor visits, dental expenses, expenses for medical equipment, glasses, hearing aids, etc.) and reduce your salary for those payments as well.
Life-insurance payments are not deductible. But you can make them deductible by including group term life premiums as part of your salary reduction plan.
Heres the catch: Dont take out more money than you know youre going to spend in a year. Any amounts you place in the plan that arent spent by March 15 in the year following are forfeited. So, if you have $1,000 left in a spending plan on Dec. 31 in 2005, you have until March 15, 2006 to use it. That's a new rule, but the principle is the same -- use the money by the expiration date or lose it.
Moreover, once you've made your allocation, you cant transfer excess amounts from one type of expenditure, such as dependent-care benefits, to another, such as medical reimbursements.
In addition, once the plan year begins, you cant change the amount you have committed to the salary reduction plan unless there is a change in your family status, such as your marriage or the birth of a child.
Dont let these restrictions discourage you from participating in a salary reduction plan. They merely require you to be careful in calculating the amount you want withheld from your salary.
In many cases, you have the option of accelerating or deferring medical expenses. Orthodontia payments and elective non-cosmetic surgery are good examples. (Purely cosmetic surgery no longer qualifies as a deductible medical expense and therefore doesnt qualify for salary reduction reimbursement.) They allow you to be more flexible in your plan participation.
Without a doubt, your planned insurance payments (health, accident, and group term life) should be included. They are fixed payments and you know in advance how much youre going to pay. By including them, you guarantee their deductibility.
There is very little downside to establishing a salary reduction plan. Any administrative costs to your employer should be more than offset by payroll tax savings. Its a win-win for all sides -- except for the IRS.
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