Tax questions answered
Today, I have three excellent questions about reducing taxes and saving money.
Kari says, “Love your podcast! Can you clarify whether investing in a Roth IRA and I bonds helps your taxes by reducing your taxable income–or are pre-tax retirement assets, such as a 401k, the only way to bring your taxable income down?
Jennie says, “I love your podcast. My fiance and I both qualify to contribute to our Roth IRAs. Once we get married, can we still contribute to them if we file taxes separately, or do we have to file jointly?”
Lisa, F. from Houston, Texas, says, “Love, love, love your podcasts! Thanks so much for being a wonderful, informative resource for everyone, but especially for women! I’m about to be a retired school teacher and must stretch my pennies. Once I spend all my flexible spending account (FSA) funds, what medical expenses can I deduct on my tax return?”
Thanks for your question, Kari, Jennie, and Lisa! I’ll answer them so you have more clarity on terrific ways to reduce your taxes and keep more of your hard-earned money.
Which investments help reduce your taxes?
At the heart of Kari’s question, she’s asking which investments or accounts help reduce your taxes. So, let’s review how several tax-advantaged accounts work to cut your tax liability.
Contributions to traditional retirement accounts, like a traditional 401(k), 403(b), or IRA, are made on a pre-tax basis and reduce your taxable income in the current year. For instance, if you earn $60,000 and contribute $7,000 to a traditional IRA, it reduces your taxable income to $53,000.
However, suppose you or a spouse contribute to a traditional workplace retirement plan and a traditional IRA in the same year. In that case, some or all of your IRA contributions may not be tax-deductible, depending on your income.
Laura reviews six rules you should know to take advantage of multiple retirement accounts and avoid pitfalls. Listen to that episode in the player below.
With a traditional retirement account, your contributions and investment earnings get taxed as ordinary income when you take withdrawals. Making withdrawals before 59.5 means you’re subject to income tax plus an additional 10% penalty.
So, you don’t escape taxes with a traditional retirement account but defer them to a later date. You must take annual required minimum distributions from traditional retirement accounts starting at age 72 or 73, based on your life expectancy and account balance.
The other primary type of tax-advantaged retirement account is a Roth. With a Roth 401(k), 403(b), or IRA, your contributions are made on an after-tax basis, which means they are nondeductible. For instance, if you earn $60,000 and contribute $7,000 to a Roth IRA, your taxable income is $60,000.
While Roth contributions don’t reduce your taxable income, their investment growth is never taxed after age 59.5. That means your Roth withdrawals are entirely tax-free–plus, they have no required minimum distributions. Skipping taxes on Roth investment earnings could save you a bundle! However, the Roth IRA has an annual income limit, which I’ll review in a moment.
However, like a traditional account, early withdrawals of untaxed earnings from a Roth before 59.5 would be subject to income tax plus a 10% penalty. But your original contributions can be withdrawn tax and penalty-free from a Roth IRA at any time.
In addition to retirement accounts, other tax-advantaged accounts reduce your taxes.
For example, contributions to a health savings account (HSA) are tax-deductible, reducing taxes. Withdrawals from an HSA to pay qualified medical expenses are tax-free.
However, you must be enrolled in an HSA-eligible health plan to contribute to an HSA. You could purchase the policy through an employer or as an individual. In addition to a retirement plan, your employer may offer other benefits that reduce your taxable income, such as a flexible spending account (FSA).
Kari also asked about I bonds, a US Treasury bond designed to protect investments from inflation with an interest rate that adjusts every six months. Your earnings are exempt from state and local taxes but not federal income taxes. However, you can defer taxation and report the earnings when you redeem or cash out a bond.
You can purchase up to $10,000 of electronic I bonds per year and may be able to buy an additional $5,000 using a tax refund. I bonds may pay higher interest rates than savings accounts or CDs, but they come with a penalty if you cash them out early.
Another type of bond, a municipal bond, can be free of federal, state, and local income taxes, depending on where you live and if you hold them until maturity. They can be subject to state and local taxes under certain circumstances.
READ ALSO: Am I investing too much for retirement?
How do married couples qualify for a Roth IRA?
Jennie asked what will happen to her and her fiance’s ability to make Roth IRA contributions after they get married. For 2024, the contribution limit for a Roth or traditional IRA equals your (or your spouse’s) earned income up to $7,000 or $8,000 if you’re over 50.
Unlike a traditional IRA, you can only contribute to a Roth IRA when you earn less than an annual threshold. The limit depends on your tax filing status and modified adjusted gross income (MAGI). Here are the 2024 income limits to qualify for a Roth IRA:
- Single taxpayers must have a MAGI of less than $161,000 but qualify for a reduced contribution from $146,000 to $160,000. You can make a full contribution with MAGI under $146,000.
- Married taxpayers filing jointly must have a MAGI of less than $240,000 but qualify for a reduced contribution from $230,000 to $239,000. You can both make full contributions with MAGI under $230,000.
- Married taxpayers filing separately must have a MAGI of less than $10,000 to qualify for a reduced contribution. However, you can use the single limits if you haven’t lived together in the past year.
Therefore, Jennie and her fiancé can use the limits for single taxpayers the first year they get married but must file jointly to get the most out of their Roth IRAs.
If you have a Roth IRA but become ineligible in the future, you can keep your account indefinitely and enjoy its tax-free growth. However, you can only make new contributions in years when your income is below the annual allowable limit.
READ ALSO: How to use a spousal IRA to boost your retirement
Which medical expenses are tax-deductible?
Lisa asked how to get the most tax benefit from her medical expenses after she drains her FSA. If you’re not familiar with FSAs, they’re medical savings accounts offered by some employers.
Eligible employees can make pre-tax contributions from their paychecks to an FSA to pay eligible healthcare and dependent care expenses. You decide how much to put in the account, up to an annual limit. For 2024, the FSA contribution limit is $3,200. You must spend FSA funds annually or forfeit them after a short grace period, known as the “use-it-or-lose-it” rule.
In most cases, you can’t contribute to an FSA and an HSA in the same year. However, for those who don’t have an FSA, using an HSA is an excellent way to pay for many healthcare expenses tax-free if you have a qualifying health plan.
If you use your FSA funds or choose not to use HSA funds to pay healthcare expenses, many can be claimed as a tax deduction on your tax return, reducing your taxable income if you itemize deductions on Schedule A.
For 2024, your eligible unreimbursed healthcare costs that exceed 10% of your adjusted gross income (AGI) are tax-deductible. If you or your spouse is 65 or older, you can deduct expenses that exceed 7.5% of your AGI through 2026.
Let’s say you’re 45 with an AGI of $100,000 and spend 5% or $5,000 on qualified healthcare expenses. No expenses are deductible because they don’t exceed 10% of your AGI. But if your total expenses were $12,000, you could deduct $2,000 ($12,000 – $10,000) of them.
To be considered tax-deductible, healthcare expenses must be necessary to prevent, diagnose, treat, or alleviate a medical condition. They can be for you, a spouse, and your dependents. You can deduct healthcare costs the year you pay them regardless of when you received the goods or services.
Examples of potentially deductible healthcare expenses include:
- Fees paid to doctors, chiropractors, dentists, psychologists, and psychiatrists
- Hospital or nursing home care
- Prescription drugs
- Eye care, including exams, eyeglasses, and contact lenses
- Hearing tests and aids
- Medical equipment like crutches and wheelchairs
- Transportation to receive medical care, including ambulance service
- Fees paid for acupuncture and Christian Scientist practitioners
- Treatment for alcohol or drug addiction, including transportation to local prevention meetings
- Fertility treatments like in vitro fertilization and pregnancy test kits
- Lactation supplies
- Vasectomy and abortion procedures
- Home modifications to accommodate a disability
- Owning a guide dog or other service animal
- Smoking cessation programs
- Health insurance premiums–unless already excluded from your gross income by an employer
That’s not a complete list. You can review hundreds of deductible healthcare expenses in IRS Publication 502, Medical and Dental Expensesopens PDF file .
Note that if an expense is a tax-free benefit, reimbursed, or paid for using a HSA or FSA, it doesn’t qualify as a deductible. Nor can you deduct expenses like cosmetic procedures unrelated to a medical condition, health club memberships, teeth whitening, or funeral expenses.
You can reduce your taxable income and taxes by carefully documenting your eligible healthcare expenses throughout the year. Remember to maximize contributions to a workplace retirement plan or individual retirement account. These are a few ways to cut taxes and keep more of your hard-earned income.
If you have tax questions, consult a tax professional for clarification and help filing your taxes. They can help you get every legitimate tax break you’re entitled to and save more money.
This is episode 840 which means there’s so much more Money Girl for you to explore in previous episodes! Make sure you’re following me on Instagram and the Money Girl Facebook page!