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Tax optimization: employee benefits edition

I know -- it's not very catchy. But it's much more precise than "how do I pay less in taxes?", which could mean many different things. And while not catchy, optimizing your taxes is right up there with cash flow management, income allocation and asset allocation in terms of putting money in your pocket!

Of course, tax optimization can't fit into a single blog article. (If it could, Michael Kitces would have done it already!) But what I can do is point you to several of the biggest knobs you're likely to have available as a tech professional: your employee benefits!

The Big One: qualified retirement plans

Of course, when it comes to tax dollars saved, often the best employee benefits of all are qualified retirement plans: 401(k)'s, 403(b)'s, etc. As of 2020, you can shelter up to $19,500 of your pay per year -- $26,000 if you're over 50! -- and that's not even including your employer match! (And don't even get me started on "mega backdoor Roth IRA's"...) That said, I know there are a couple questions that often come up when you go to enroll.

Question #1: "What fund(s) do I invest in?" While this is a potential opportunity for serious optimization, don't let the perfect be the enemy of the good. If you don't already have an asset allocation and/or investment policy statement in place, you can almost always simply choose a target date retirement fund: a portfolio designed to go from aggressive to conservative over time as you approach the given target date. Is it perfectly optimal? Often, no. Is it well-diversified? Yes. Is it likely to fit your risk tolerance and risk capacity? Also yes. And these days, they're often made up of low-cost index funds, to boot! So consider starting with a target date retirement fund and optimizing later. (You know how premature optimization is a cardinal sin in programming? Same goes for financial planning.)

Question #2: "Do I make Traditional or Roth contributions to my 401(k)?" This is also an opportunity for optimization, but if you don't have access to an in-depth, long-term tax analysis of the alternatives, consider leaning towards a Roth. Roth funds have a couple of advantages in the flexibility department that can make a serious difference both before and after retirement!

And yes, while it's not strictly tax-related: strongly consider taking advantage of your employer match if humanly possible. You likely won't use the money right away, but it's still free money!

HSA's, FSA's, and other TLA's

But QRP's are only the start; there are a host of other tax-related employee benefits out there. For example, many employers are starting to offer pre-tax commuter benefits -- tax-sheltering some of your income to pay for e.g. mass transit tickets and parking passes.

Now, hopefully your commute isn't a huge percentage of your income...but if you've got young kids, child care probably takes a hefty bite. This is where dependent care flexible spending accounts (sometimes abbreviated to DFSA's) come into play: you set aside a certain amount of your pay during open enrollment to pay for child care, and apply for reimbursement as those expenses are incurred. The amount you set aside is pre-tax, i.e. tax-sheltered.

A few things to be aware of with regards to DFSA's.

  • You can't change the amount outside of open enrollment, so be absolutely sure you'll spend that amount! (That said, the max is low enough that most parents I know don't have an issue on that front.)

  • The above is especially relevant because DFSA's are generally "use-it-or-lose-it"; if you don't incur qualified expenses during the year, you lose your DFSA contributions.

  • They can't be used for children 13 or older.

  • DFSA's are subject to nondiscrimination testing, which means that if non-"highly compensated employees" aren't making enough use of them, the contributions of highly compensated employees may be reduced, often partway through the year and without warning! (This is worth noting if both you and your partner have access to a DFSA; all thing being equal, consider using the DFSA of the partner less likely to run afoul of this issue.)

In addition to DFSA's, there are savings accounts related to healthcare, in the form of HFSA's (healthcare flexible savings accounts) and HSA's (health savings accounts). What's the difference? In short, an HFSA is like a DFSA, but for healthcare. An HSA, though, is (a) only accessible if you have a high-deductible healthcare plan (HDHP, and yes, welcome to acronym land), and (b) not use-it-or-lose-it. In fact, once it's hit a certain balance, you can invest it as if it were a retirement plan!

If this sounds like an amazing opportunity, it is -- in fact, it's worth its own in-depth article.

Employer stock

Speaking of employer benefits that are worth their own article: employer stock is another opportunity for tax optimization.

Sometimes, there's less opportunity than you might think. Consider restricted stock units (RSU's): they're taxed as ordinary income as soon as they vest, and their cost basis is equal to their price on that day. In other words, there's no tax benefit for selling them immediately versus holding why not sell them immediately, invest the proceeds in your portfolio, and be done with it?

Other times, though, the tax rules can be pretty arcane. The tax law around employee stock purchase plans (ESPP's) reads like someone tried to riff off of incentive stock options (ISO's), but didn't fully think through the consequences. While treating them like RSU's and selling them immediately upon purchase is rarely a foolish decision, consider indulging your morbid curiosity and reading up on ESPP tax treatment.

(Side note: if you're not making full use of your ESPP, please, do so. Figure out how to make the cash flow work, if that's what's stopping you. Assuming you sell your shares immediately upon purchase, it's free money -- don't leave it on the table!)

If you've already got vested or purchased employer stock sitting in an account accumulating capital gains, you may be wondering how to divest these "legacy" shares in a tax-optimal manner. There are a few options for minimizing taxes on stock sales, but bear in mind: at the end of the day, the only thing worse than paying taxes on gains is having no gains to pay taxes on. In other words: don't or give away money you wouldn't anyway, just to reduce taxes!

"But I'm an insider, so I've only got a handful of days out of the year to sell my stock!" Then get in touch with HR/Legal and request information on setting up a 10b5-1 plan. Seriously, don't play games with this stuff; if the options are between optimizing your taxes and having a huge portion of your portfolio sitting in a single stock, strongly consider taking the tax hit now, rather than waiting for your company to pull an Enron!

Go forth, and optimize!

You've got your tasks for your next weekly money time: maximize your usage of your employer benefits, especially your 401(k) match, ESPP's, and FSA's/HSA's, and create a plan for handling employer stock in a tax- and diversification-optimized manner. And if you've got questions, I've got answers.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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