By Joyce Beebe, Ph.D.
Fellow in Public Finance
The end of the year and the start of a new one not only encourage us to reflect on the past and future, but they also bring many key deadlines with significant tax consequences. For workers, survey data show that the two most important employee benefits are health care and retirement benefits; employer programs that help pay off student loan debt are an increasingly popular benefit. The prevalence of these programs is consistent with the size of federal tax expenditures, or revenue losses attributable to exclusions, deductions, or exemptions in tax rules that are intended to encourage certain activities. According to the Joint Committee on Taxation (JCT), in 2019 the federal government excluded from taxes a whopping $164 billion in employer contributions for health care and health insurance premiums; it was the single largest tax expenditure item for the federal government. In comparison, defined contribution retirement plans such as the 401(k) cost $121 billion.
This article reviews certain elements of these three existing and emerging employee benefit programs and their tax implications, as well as the often-overlooked component of employer matching.
401(k)
A 401(k) plan is the most common retirement benefit offered by employers. Through 401(k) plans, employees can elect to contribute a certain portion of their wages through payroll deductions to the employees’ own accounts (“elective deferrals”). To encourage saving, many employers make matching contributions for employees who defer their wages. Employers can also simply contribute on their employees’ behalf, regardless of employee contributions.
The federal income taxes on employee contributions and associated capital gains attributed to the accounts are deferred until distribution. However, the contributions are still taxable for Social Security, Medicare and federal unemployment tax purposes; thus, employees still pay current Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes. For employers, their matching contributions (or contributions on their employees’ behalf) are deductible on the employers’ federal income tax returns. In other words, although there may be vesting requirements and employees cannot claim immediate ownership for the employer matching contribution, the matching essentially constitutes “additional compensation” or “guaranteed return” up to the plan’s designated limit, and it is how the federal government encourages employee retirement saving and employer matching.
Financially, even if taxpayers cannot contribute to the IRS-allowed limit ($19,000 in 2019 and additional $6,000 contribution for workers over 50; both amounts increase by $500 in 2020), they should always contribute to maximize their company match. For instance, if an employee is unable to make the full $19,000 contribution and her company matches 50% of each dollar she contributes up to 6% of her $60,000 salary, this means the maximum employer match will be $3,600, and she needs to contribute $7,200 to get that maximum match, which is the contribution she should aim for. All else being equal, if her employer is matching 100% of what she puts in, she only needs to contribute $3,600 to her 401(k) account to get her employer’s $3,600 match.
Health Savings Accounts
As the year comes to a close, there has been increased media interest in an underutilized but rapidly growing health benefit: the Health Savings Account (HSA). Taxpayers who enroll in high deductible health plans in 2019 can contribute $3,500 as an individual or $7,000 for an individual with family coverage (the amounts increases by $50 and $100, respectively in 2020). An additional $1,000 is applicable for people 55 and older. The funds in the HSA can be devoted to investment accounts instead of sitting in brokerage or savings accounts, which permits faster asset accumulation. In addition, once contributed, the funds in the HSA can carry forward without an amount or duration limit. In 2017, IRS data show that close to 2 million taxpayers are contributing approximately $5.4 billion to such accounts.
Although the HSA represents a contractual relationship between a taxpayer and a qualified HSA trustee (e.g., bank, insurance company, or other IRS-approved nonbank organization) and does not have to be offered by employers, both employees and employers can contribute to the HSA, and employers can match its employees’ contributions. The matches or contributions made by employers on behalf of eligible employees are not considered employee income and are not subject to federal income tax, Social Security, Medicare, and federal unemployment tax. Employer matches or contributions are deductible as business expenses for income tax purposes.
HSA v. 401(k)
Some practitioners tout the “triple tax advantage” the HSA offers: first, taxpayers make pre-tax contributions to the HSA; second, the amounts can grow tax-free in qualified investment accounts; and finally, if withdrawals are for qualified medical purposes, the distributions are tax-free. Because the HSA is essentially tax-exempt whereas the 401(k) accounts are tax-deferred, HSAs provide better returns than 401(k) accounts from a tax perspective. Specifically, although 401(k) accounts allow pre-tax contributions and the proceeds grow tax-free, distributions from the 401(k) accounts are taxable.
In addition, HSA alleviates concerns that some taxpayers may have about not having enough spare cash for medical emergencies if they set money aside in a 401(k); therefore, an HSA supplements the 401(k) and encourages retirement savings.
HSA v. FSA
From a value preserving perspective, the HSA is also superior to its close cousin, the Flexible Spending Arrangements or Flexible Spending Accounts (FSAs). Although one does not need to enroll in a high deductible health plan to utilize the FSA, the account suffers from an annual “use-it-or-lose it” restriction and, because of its short duration, the FSA does not have embedded investment features like the HSA. Finally, FSAs are employer-established benefit plans (rather than one that establishes a custodial relationship between an employee and a trustee); as such, employers have complete flexibility in designing the features. In 2019, employees could contribute up to $2,700 to their FSAs; this limit will be $2,750 in 2020.
The Qualification
Despite all of its attractive features — it is tax efficient, long-lasting, investable, immediately vested, and portable — the biggest hurdles for a taxpayer to utilize an HSA are probably that he needs to enroll in a qualified high deductible health plan (HDHP) and cannot be enrolled in Medicare. At the higher end, an HDHP’s minimum deductible is $1,350 for individual health coverage and $2,700 for family coverage. In some cases, the use of FSAs also disqualifies taxpayers from contributing to the HSAs because the IRS disallows double dipping of medical expense-related tax benefits.
Furthermore, if a taxpayer younger than 65 withdraws funds from the HSA for non-qualified expenses, the entire distribution is taxable, plus a 20% penalty. If the taxpayer is older than 65, the distribution will be treated like a 401(k) distribution: there is no penalty but it is considered taxable income.
Student Loan Repayment Assistance
The headline-grabbing $1.5 trillion student loan balance generated tremendous policy debates. From presidential candidates to congressional leaders, there is a wide range of proposals and discussions. For instance, Democratic presidential candidates proposed ideas including loan cancellation, cancellation based on income, or adjustments to payment amounts. Legislators also offered various solutions, such as excluding discharged student loan debt from taxable income (H.R. 2429 in 2015 and H.R. 5617 in 2016); implementing a cap on total payments (H.R. 4508 in 2017); and allowing employers to provide tax deductible student loan repayment assistance of up to $5,250 per year per employee (S. 796 in 2017; H.R. 1043 and S.460 in 2019). None of these proposals have advanced since their introduction in Congress.
In 2018, a private letter ruling (PLR) allows employer-offered student loan repayment assistance programs to be considered part of their retirement benefits. In the PLR, the employer implemented a program that allowed employees who make student loan payments of at least 2% of their salary to receive employer matched contributions to their 401(k) retirement accounts equal to 5% of their pay, regardless of their individual 401(k) contributions. Under this plan, employees who could not make both student loan repayments and retirement plan contributions now only need to make the loan repayments in order to receive an employer matched 401(k) contribution. A similar bill was introduced in 2018 but did not advance (S. 3771); this PLR offers an administrative solution to employers.
Although the PLR theoretically applies to only the requester and does not set a wider precedent for other companies, by clarifying the tax-free status of one employer’s student loan repayment assistance through retirement contribution matching, more employers may begin offering this type of program. The Department of Treasury’s 2019-2020 Priority Guidance Plan listed “guidance on student loan payments and qualified retirement plans” as a priority item that it plans further clarify in terms of its applicability. Certain employers allow workers to apply the value of unused days off for student loan repayments. The various types of employer assistance for student loan repayment, although still nascent in the workforce, allows workers to avoid postponing saving for retirement. Before the Congress reaches any consensus, this is a promising option for young workers.