How to put thousands into your employees' pockets for next to nothing
- Claire Baker
- Jul 17, 2023
- 8 min read
If you think that benefits that benefits that help employees save on their taxes aren't sexy, you probably aren’t aware of how much money such programs can really save. In this post, we’ll discuss the types of employee benefits that offer tax savings and explore a few examples of how they can put thousands of dollars back in your team's pockets.
By the end, maybe you’ll be a convert to how exciting tax-sheltered benefits can be, and eager to share your enthusiasm with your team.
Types of Tax-Sheltered Employee Benefits:
We'll discuss four types of tax-sheltered benefits in this article, including:
Here's summary of the features of each of these types of accounts:
| Annual Limit | Rollover? | Interest-bearing? | Growth taxed? | Early withdrawal penalty? | Catch-up contributions? |
(Health) FSA | $3,050 | $610/year | No | n/a | No | No |
Dependent Care FSA | $2,500 individual, $5,000 familiy | No | No | n/a | No | No |
HSA | $3,850 individual / $7,750 family | Employee keeps all funds | Yes | No | No | $1000 for employees over 55 |
Commuter | $300/month | Balance remains for as long as you're with the company | No | n/a | No | No |
Traditional 401(k) | $22,500 employee only / $66,000 employee + employer | Employee owns balance | Yes | Yes | Yes (10% + income tax rate) | Employees over 50 can contribute an extra $7,500 per year above the limit. |
ROTH 401(k) | $22,500 employee only / $66,000 employee + employer | Employee owns balance | Yes | No, but funds deposited after tax | Yes (10%) | Employees over 50 can contribute an extra $7,500 per year above the limit. |
Flexible Spending Accounts
TL;DR: Use your FSA to set aside money for 1-year of qualified expenses to save up to ~$900/year in taxes, and make each dollar go 1.4x farther.
Flexible Spending Accounts allow employees to set aside pre-tax dollars to pay for eligible medical expenses in the same calendar year. Employers also have the option to fund an employee’s FSA account, making it a helpful tool for lowering the overall cost of employee health plans without paying exorbitant premiums.
The annual FSA contribution limit is $3,050 in 2023. Up to $610 of unused funds roll over at the end of the plan-year, and any other unused funds go back to the employer. When an employee leaves the company, they generally forfeit any unused FSA balance remaining after the run-out period back to the company (unless the company has a policy of refunding unused balances).
💡 Do right by your team: Although not required by law, employers may return unused FSA balances to the employee (after withholding taxes). I advocate for establishing a policy that unused employee-contributed funds that aren’t rolled over be returned to the employee. Nevertheless, companies are within their rights to keep unused employee-funded balances if they wish to do so.
There are 3 types of FSA plans:
Healthcare FSA (HCFSA) - Can be used for eligible expenses from the list of eligible expenses in the IRS’s Publication 502. These expenses include most medical bills, equipment, prescriptions, out-of-network healthcare bills, dental bills, vision expenses, and some over-the-counter healthcare products. Healthcare FSAs don’t cover insurance premiums. If not otherwise specified, most FSAs refer to healthcare FSAs.
Limited Expense FSA (LEXFSA) - Since HSAs and FSAs overlap in many use cases, participants with HSA accounts are ineligible for standard healthcare FSAs. Limited Expense FSAs (LEXFSA) allow those who are ineligible for a standard FSA to set aside money for vision and dental expenses only.
Dependent Care FSA (DCFSA) - These accounts allow participants to set aside money for childcare of a child under 13, or an adult family member who is unable to care for themselves because of mental or physical impairment. Funds can be used for preschool, summer camp, adult day programs, or babysitting and nanny expenses. Dependent care annual contribution limits are set at $2,500 for a single parent and $5,000 for families, and aren’t adjusted annually for inflation like healthcare FSAs. Any leftover unused funds from a DCFSA do not roll over.
Health Savings Account (HSA)
TL;DR If you have few medical expenses each year, an HSA allows you to save pre-tax money for future medical expenses. HSAs are similar to 401(k)s in that the employee owns the account after leaving the company, and interest gains aren't taxed.
Similar to FSAs, Health Savings Accounts allow employees to set aside pre-tax dollars for qualified medical expenses. The difference between FSAs and HSAs is that HSA funds are stored in an interest-bearing account owned by the employee, so funds do not “expire” as they do with an FSA, and the employee keeps the balance once they leave the company. Employers can contribute to employees’ HSA accounts.
To be eligible to contribute to an HSA, the employee must be enrolled in a qualified high-deductible/high-premium (HDHP) health plan. In 2023, HDHP plans must have an in-network deductible of at least $1,500 for an individual, or at least $3,000 for a family to qualify the participant for an HSA. The annual HSA contribution limit is $3,850 for an individual under 55, $4,850 for an individual over 55, and $7,750 for a family in 2023.
Although an employee can only contribute to an HSA when enrolled in a HDHP plan, they can use the funds for qualified expenses at any time, including during the same year as the account was created, once they have moved on to a different health plan, or many years later when their healthcare expenses are higher. Since HSAs are interest-bearing investment accounts whose growth and withdrawals are untaxed, the longer the funds stay in the account the more value they will have.
401(k) Plans
TL;DR - 401(k) plans allow employees to lower their annual taxable income now or in retirement, potentially netting participants many times their initial investment by the time they retire. Interest revenue on 401(k) plans aren't subject to capital gains tax.
401(k) plans allow employees to contribute to a retirement account whose growth is not subject to capital gains tax. The participant can also choose whether income tax is applied before deposit or at withdrawal by selecting either a traditional or ROTH plan.
Traditional 401(k)s defer income taxes until the money is withdrawn at retirement, resulting in larger contributions with each paycheck for a larger interest-generating principle. Under normal economic circumstances, traditional 401(k)s are a better choice for older workers whose accounts will have less time to accrue interest.
ROTH 401(k) contributions are made after taxes have been withheld, allowing participants to withdraw funds tax-free after retirement. ROTH plans are generally a better choice for younger workers, for whom accrued interest can exceed principal over time.
The annual 401(k) contribution limits are $22,500 for an employee under 50, and $30,000 for an employee over 50. If an employer contributes to the 401(k) it can drive the maximum contribution even higher, to a combined $66,000 for an employee under 50 and $73,500 for an employee over 50.
The graphs below show how maxing out your 401(k) contribution for a single year can yield significant gains over time with compound interest. Remember that although the balances for ROTH accounts are lower than an equal amount in a traditional 401(k), ROTH withdrawals are not taxed while withdrawals from traditional accounts are taxed at your regular tax rate.
There are additional fairness requirements for the company’s 401(k) plan as a whole to make sure that lower-income workers are able to take advantage of the program at a similar rate to their higher-paid colleagues. For more information about the compliance requirements for your 401(k) plan as a whole, click here.
Commuter Benefits
TL;DR - Commuter benefits let employees set aside up to $300/month for commuting expenses, lowering their tax burden by up to $1000 per year and increasing the purchasing power of each dollar by 142%. Some areas require employers to offer a commuter benefit.
Commuter benefits allow employees to set aside pre-tax dollars to pay for eligible commuting expenses, such as public transit or parking. Commuter benefits are required for businesses located in New Jersey and certain large metropolitan areas such as New York City, San Francisco, and Washington, DC. Even if not required by law, commuter benefit programs can offset any employee's commuting expenses.
The limit for commuter benefit contributions is $300 per month, and funds remain available for as long as the employee works at the company. Employers can also contribute to commuter benefit accounts, provided that the combined employee + employer contributions don’t exceed the $300/mo limit.
Impact of tax savings
To understand how much money an employee can save by taking advantage of these tax-sheltered programs, consider the following examples of two employees:
👩 Rose & 👩🏾 Trudy are is 50 years old
👨👦 Ross is a 25-year-old single father
🧔🏽♂️ Tad is a 25-year-old single person with no dependents
For the purposes of this example, let's assume they are all in the 24% income tax bracket and live in Nevada where there is no state income tax. All examples also assume a 7% annual interest rate, and that they will be in the same tax bracket in retirement as they are today.
🚌 Commuter
By contributing $300/month to their commuter accounts, each team member reduces their total annual taxes by $864.
Without a commuter program, they would have had to earn $394.74 to net $300 post-tax for their commuting budget, effectively saving them an additional $94.74/month or $736.84 annual savings on commuting expenses.
Total annual savings: $1,600.84
🧧 FSA
By contributing $3050 to a healthcare FSA or LEXFSA, a participant can lower their annual tax burden by $734.
By using pre-tax dollars, an FSA enables an extra $963.16 purchasing power for eligible expenses.
Total annual savings: $1697.16
👨👦Ross can contribute an additional $2500 to a DCFSA, lowering his annual tax burden by an additional $600. Using pre-tax funds to pay for childcare expenses saves an additional $789.47.
Total annual savings of DCFSA: $1,389.47
💰 HSA
Since children often have frequent and unexpected medical expenses, an HSA is not a good choice for Ross, but his 25-year-old coworker Tad could enjoy $924 in tax savings by maxing out his HSA, assuming his medical expenses remain low.
Since Rose is 50, she is eligible to make larger catch-up contributions that would earn her $1,164 savings on her annual taxes.
Assuming that both Tad and Rose remain healthy and their contributions remain in the account earning 7% interest per year the balance on their 65th birthday will be:
Tad (40 years' accrual): $57,651.66 = $53,801.66 interest income!
Rose (15 years' accrual): $13,381.30 = $8,531.30 interest income!
🏦 401K
For comparison, let's assume that both Ross and Rose choose the ROTH plan, and Tad and Trudy each choose the Traditional plan. Since Rose and Trudy are over 50, they are eligible for catch-up contributions.
By selecting the ROTH option, Ross and Rose do not lower their annual tax burden but spare themselves from income tax when they retire.
By selecting the Traditional option, Tad (who is under 50) can save $5,400 on taxes. Trudy (who is over 50) can save $7,200 on her annual tax return.
By each employee's 65th birthday, they can expect the following approximate savings:
Ross: With 40 years to grow, Ross's original post-tax contribution of $15,828.75 will have grown to $237,026.25 that he can enjoy tax-free. His approximate profit is $221,197.50. His estimated lifetime tax savings is approximately $53,087.40.
Tad: With 40 years to grow, Tad's original pre-tax contribution of $22,500 will have grown to $336,925.30, which he will pay income taxes as he withdraws. Assuming Tad's tax rate stays the same, his approximate profit is $233,563.22 by the time he's 65. His estimated lifetime tax savings is approximately $5,400.
Rose: Assuming that Rose began contributing when she was 50, her $21,105 post-tax contribution will grow to $58,229.36 by her 65th birthday that she can enjoy tax-free. Her approximate profit is $37,124.36. Her estimated lifetime tax savings is approximately $8,909.85.
Trudy: With 15 years to grow, Trudy's original pre-tax contribution of $30,000 will have grown to $82,770.95 by the time she's 65. She will pay income taxes on withdrawals. Assuming Trudy's tax rate stays the same, her approximate profit is $62,905.92. Her estimated lifetime tax savings is $7,200.
Putting it all together
Now that we've looked at some examples, let's consider how much savings and interest income each of these individuals could expect if they maximized their savings through these tax-preferred programs:
| Commuter | HSA | FSA or LXFSA | DCFSA | 401(k) | Total free money |
Ross in 2023 | 1,600.84 | | 1697.16 | 1,389.47 | | $4,687.47 |
Ross @ 65 yrs | | | | | $221,197.50 | $221,197.50 |
Rose in 2023 | 1,600.84 | 1,164 | 1697.16 | | | $4,462 |
Rose @ 65 yrs | | 8,531.30 | | | $37,124.36 | $45,655.56 |
Tad in 2023 | 1,600.84 | 964 | 1697.16 | | 5,400 | $9,662 |
Tad @ 65 | | $53,801.66 | | | 233,563.22 | $287,364.88 |
Trudy in 2023 | 1,600.84 | | 1697.16 | | 7,200 | $10,498 |
Trudy @ 65 yrs | | | | | 62,905.92 | $62,905.92 |
Thus, with no employer funds whatsoever, our team saved between about $4,500 and $10,500 in 2023 on income taxes. Our older workers earned an additional $20-25,000 in interest by their 65th birthday, and our youngest workers netted more than $200K in interest from a single year’s 401(k) and HSA contributions.
Employers can further sweeten the deal by partially funding any of these tax-preferred programs through a match or a direct contribution. Since businesses can write off contributions to employees’ accounts, this approach lowers the company’s total tax burden while in effect giving the employee additional tax-free compensation.
In short, both employers and employees get 1.5x the value of every dollar compensated through a tax-sheltered program that they do through straight cash compensation. When those savings can earn compound interest, the benefits of the savings grow exponentially over time.
Want to learn more about getting the most out of your benefits package? Check out these related articles:
How 401(k)s help small teams stretch their compensation budget
(Coming soon!) How to message your employee benefits for maximum impact
(Coming soon!) Is your benefits package as inclusive as you think it is?
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