Taxation Without Representation workshop recap 💸

Navigating the 2020 tax season and tax-advantaged accounts as a 20-something

“The hardest thing in the world to understand is the income tax.”
— Albert Einstein

Given the extension of this year’s tax day to July 15th, I’m sharing a recap of LifeClub’s first online workshop that my friend, Dave Metalf, CPA and I hosted in March. LifeClub is built on the idea of having intellectual and meaningful conversations around daunting adulting topics that we feel like we should be more knowledgeable about. With the 2020 tax season in full swing and the implications of COVID-19 on tax filings emerging, what better place to start than filing taxes?

For most of us, TurboTax is synonymous with filing our taxes. We rely on the software to tell us how much we owe to our state and to the federal government. When TurboTax tallies up how much we owe or will receive back, we might go through the form to confirm we’ve entered in the right figures then hit submit. Every year, I debate if I should consider moving from TurboTax to hiring an accountant, but then procrastinate until March or April and begrudgingly set aside an afternoon over the weekend to get my taxes in order on my own.

Modern day income tax came into existence when Congress passed the 16th amendment in 1909, allowing the federal government to collect tax from Americans’ wages. The lack of “representation” today (signified in the title of the workshop) is the lack of understanding that young professionals have about the US tax system, blindly filing their taxes once they graduate into the real world. But, we can demystify some of the challenges around tax management if we just sit down and actually talk about it versus waiting to think about it once a year. For more on the history of taxes, Stuff You Should Know has an interesting podcast on How Income Taxes Work.

Over the course of the workshop, Dave shared a series of anecdotes that we often hear as young professionals and contextualized why the decisions we make today will have a ripple effect on our long-term wealth. Below are the highlights from our conversation.

Taxes impact our daily lives far more than we realize.

In every paycheck, we see a chunk of our income taken out for local income, state income, federal income, and payroll taxes.

From a local and state income perspective, I always wondered why friends who worked across different state lines had more complicated tax filings. It all makes sense when you think about the infrastructure you use on a day-to-day basis. If you work in another state during the week, you’re driving on their roads or taking their public transportation, using their stop lights, depending on their fire station and hospitals to be functional, etc. Ultimately, the local and state income tax ensures that you can go about your daily life outside your apartment in whatever city you work and work in.

For federal income and payroll taxes, we often hear politicians debate the tax rate and the economic impact it has on the government spending, but did you know that our individual federal income taxes make up >50% of the tax revenue that the federal government collects? The rest of the federal government is funded by payroll taxes (e.g., Social Security, Medicare), corporate income tax, and other taxes/fees. All of our federal tax money goes towards funding federal programs including the military (the largest portion of the budget), interstate highways, the CDC, education, housing, etc. If we paid our federal income tax as a single payment, it would likely be the largest single expense every year.

Maximize your tax-advantaged account options before opening a brokerage account.

For 20-somethings, common tax-advantaged plans include 401(k), Roth IRA, and health savings accounts (HSA)/flexible spending accounts (FSA). Dave equates using tax deductible investment vehicles to taking advantage of a 30% discount on every investment you make. When you consider the taxes you pay on the money you invest in a typical non-retirement (or non-HSA or -FSA) brokerage account, that money is essentially getting taxed twice — first as income and then as investment income.

Your 401(k), Roth IRA, and HSA/FSA are a different story. The “tax-advantage” kicks in because we’re only taxed on the income piece, but not the investment income. Most of us are encouraged to take advantage of our employer’s 401(k) match right out of undergrad so we focused our conversation on Roth IRA and HSA/FSA.

Roth IRA: a retirement account that allows you to withdraw your contributions tax-free at any time for any reason

Beyond the traditional 401(k) that is offered by employers, Roth IRAs are individual retirement accounts that we set up on our own to save for retirement. Roth IRAs require the extra step of opening an account outside our 401(k) so it often goes unopened until we learn about the benefits a few years out of school. It’s a significant benefit particularly since there’s an income limit on who can max out on Roth IRA. Read on for income limits on maximizing out below.

The skinny on Roth IRAs:
1️⃣ Grows tax-free. You pay taxes on the money you put into your Roth IRA upfront and your earnings grow tax-free.

2️⃣ No tax or penalties on withdrawing your contributions. Unlike your 401(k), you can withdraw your contributions (not investment gains) at any point without being taxed or penalized. See Charles Schwab’s overview to Roth IRA rules.

3️⃣ Max out your 2020 Roth IRA up to $6,000. In 2020, for anyone who makes <$124,000, the maximum contribution you can make is $6,000; however, the contribution max is reduced if you make between $124,000-$139,000 and no contribution allowed for anyone who makes >$139,000. Calculate your 2020 contribution limit using Charles Schwabs’ calculator.

4️⃣ Rollover your 401(k) from your last employer to your Roth IRA. When you move companies, you have the option to roll your 401(k) over to a Roth IRA. See Investopedia’s guide to thinking through any tax implications if you consider rolling over.

HSA & FSA: triple tax benefits for qualified tax expenses

Under current law, 20-somethings have the option to stay on their parents’ health plan until their 26th birthday. This often leads to a scramble during the window in which they need to opt into their own health insurance plan. The biggest differences between HSAs and FSAs are that we control HSAs and funds can roll over each year while FSAs are owned by your employer and only $500 in funds roll over into the next year.

The skinny on HSA/FSA:
1️⃣ By funding a HSA or FSA, you see triple the tax advantage. The money you allocate to your HSA/FSA 1) goes into the account tax-free, 2) grows tax-free, and 3) can be withdrawn tax-free as long as you use them for qualified medical expenses.

2️⃣ Pay for your medical expenses tax free. Qualified medical expenses vary from acupuncture to birth control to eye exams to therapy and many things in between. See the IRS’ list of qualified expense deductions.

3️⃣ In 2020, you can max out a HSA up to $3,550 and a FSA up to $2,750.

It’s time to consider saying goodbye to TurboTax and working with a tax accountant when life starts getting complicated.

Every year, I wonder if I should consider working with an accountant to file my taxes. Dave’s perspective is that it makes sense to work with an accountant when you start experiencing complicating life factors that TurboTax might not be equipped to fully advise you on. Examples include getting married, launching a side business, buying a house, inheriting property, going through a divorce, etc.

Next steps?

✅ File your 2019 taxes before July 15th.
As it relates to COVID-19, if your income has not materially changed between 2018 and 2019, the general recommendation is to file your 2019 tax return and not delay filing just because of the extension, particularly if you expect to receive a refund this year.

✅ If you haven’t already, open your Roth IRA and contribute up to $6,000 (depending on your income).
If you haven’t funded your 2019 Roth IRA, it’s not too late. You have until the tax deadline (July 15th) to contribute for 2019. NerdWallet covers how and where to open an IRA and you can calculate your contribution limit using Charles Schwabs’ calculator.

✅ Ensure that in addition to contributing to your HSA/FSA, you’re also investing a portion of the money rather than just leaving it in the savings account.
Typically, there’s a minimum balance you need to have in your account before you can invest it (~$1,000).

💫 Special thanks to Dave for hosting an engaging conversation on a notoriously dry topic and arming us with the tools and motivation we all needed to get our tax-advantaged plans fully funded!

Disclaimer: All investment decisions are made at your own risk. Personal situations may vary significantly. Any tax advice included is not intended or written to be used, and cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.