Wednesday, February 26, 2014

Try this weird tax trick that can pay off 3 ways

By saving more for retirement, some earners may qualify for tax breaks and bigger health-insurance subsidies

Young adults are signing up in greater numbers for the new state health insurance marketplaces created by the Affordable Care Act, although still not in numbers that proponents had hoped for. But here's another reason to act: With a bit of savvy, a younger worker—or for that matter, anyone with a relatively modest income—can boost retirement savings, cut federal and state income taxes, and save on premiums, all at once. If you’re not in that demographic but are close to someone who is, you can help.

Cut income, boost the subsidy

The trick is to reduce reported income. With the new exchanges, a premium subsidy kicks in for those with income 100 percent to 400 percent of the federal poverty level. For individuals in 2014, the ceiling for subsidies will be $45,960; for a family of four, $94,200. The subsidy is essentially a new kind of refundable tax credit. You can use it now to pay for coverage or apply it to your 2014 federal tax return, which you'll file in 2015.

With some exceptions, those who can afford coverage but don’t buy it must pay a fine when filing 2014 taxes; for individuals, it’s 1 percent of income or $95, whichever is higher. (The fine rises yearly to a maximum of 2.5 percent of income or $695 per person, whichever is higher, in 2016; after that it’s adjusted for inflation.)
To determine subsidy eligibility, the marketplaces consider an individual’s or household’s estimated 2014 modified adjusted gross income (MAGI). In this insurance calculation, MAGI is similar to adjusted gross income (AGI), but adds tax-exempt interest back in, as well as the income and housing cost of a citizen or resident living abroad, and the nontaxable portion of Social Security income that normally isn’t part of the AGI calculation.
You can deduct a number of items from MAGI, including college tuition, student-loan interest, pretax money put into health savings accounts and individual retirement accounts, and other expenses and deductions available to self-employed people. As you’ll see here, you can also reduce your MAGI with contributions to 401(k)s and other qualified retirement accounts.
Consider a 28-year-old single man in California with a MAGI of $23,000 a year, no employer-based coverage, and low expected use of medical services. In Covered California, that state’s marketplace, the lowest-priced “silver” policy with Anthem Blue Cross—considered middle-of-the- road coverage—would cost him $1,356 a year, with a subsidy of $1,836.
Contributing $2,000 to a traditional IRA would reduce his MAGI to $21,000. At that level, he’d pay $1,056 for coverage, saving $300 a year and gaining a higher subsidy for out-of-pocket costs. Assuming income-tax rates are stable between 2014 and 2013, he’d also save $300 in federal taxes and $71 in California state taxes. You could view the total $671 in savings as reducing his premium to $685.

Reap the Savers Credit

Lower- and middle-income workers who contribute to traditional IRAs, 401(k)s, and other qualified retirement accounts are also eligible for the federal savers credit. It’s 10 percent to 50 percent of the first $2,000 contributed. For tax-year 2013 it was available only to single workers with AGI of $29,500 or less, and couples with AGI of $59,000 or less (limits are slightly higher for 2014). In this example, the credit is $200. That brings his effective cost of insurance to $485 a year.
The savers credit applies to Roth accounts, too. Those after-tax contributions won’t lower MAGI or current taxes, or improve health insurance subsidy eligibility. But distributions are tax- and penalty-free after age 59 1⁄2, which could mean major benefits over traditional retirement accounts.
What if, instead of investing in an IRA, our worker contributed $2,000 to a 401(k) with an employer match? His savings would be the same as if he had contributed to an IRA. But a typical match of, say, dollar for dollar up to 6 percent of income would add $690 to his retirement savings. That’s not money directly in his pocket, but it effectively makes his insurance free.
Many at that salary range might not want to sacrifice 9 or 10 percent of income toward retirement savings. That’s where the help comes in, if you can afford it. If he agrees to contribute the $2,000, you offer to reimburse him all or some of that amount. Not only would you be helping him do the right thing for his health, you’d be improving his prospects for a healthy retirement.