Flexible Spending Accounts—Used Right They Can Save You Money

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November 2004

How would you like to reduce your taxable income while saving money that you can spend immediately to meet health care expenses not covered by your health insurance plan or day care expenses for your children under age thirteen? If your employer offers Flexible Spending Accounts (FSA) as part of the employee benefits, then you may have a good opportunity to do just that. Like most potentially good deals, however, you need to find out the facts and do a little homework to see if an FSA is right for you and your family.

What is a Flexible Spending Account?

Flexible Spending Accounts (which may also be called cafeteria plans, 125 plans, or 125 cafeteria plans) come in two varieties:

• Unreimbursed Health Care Expenses
• Dependent Care Expenses

The plans allow you to save, via payroll deduction, a set amount of your paycheck before taxes to help you pay for either expected health care costs not reimbursed by your health insurance or expected costs of caring for legal dependents who cannot care for themselves (such as a child under age thirteen or a disabled adult dependent). For many individuals, a properly designed FSA offers a way to save money by reducing taxable income and paying for all or a portion of out-of-pocket medical and/or dependent-care expenses with tax-free dollars.

Employers provide either or both FSAs as part of employee benefits. You may sign up for either plan or both, depending on your needs. You enroll on an annual basis, and unless you experience certain life-changing events as defined by the plan you can’t drop out during the year or join. The two plans are always treated separately (two separate accounts with two sign-ups and two payroll deductions). So let’s look at each type.

Health Care Flexible Spending Accounts

Even with a health insurance plan, you and your family will have expenses the plan doesn’t cover such as the deductibles, co-payments for doctor’s visits and prescriptions, over-the-counter medications, and uncovered services such as eyeglasses, dental care, chiropractic services (uncovered expenses of course vary from one insurance plan to another). By enrolling in a Health Care FSA, you can set aside a certain sum each month in the FSA to pay for these expenses. The employer determines the maximum amount you can set aside each year; within that maximum you determine a figure that comes closest to your expected expenses (that’s the most important place doing your homework comes in). That annual amount is divided by your number of pay periods, and that portion is deducted from your paycheck each period before taxes are withheld. When you incur one of those anticipated unreimbursed health care expenses, you submit the claim and receipt/required documentation to your employer to reclaim those tax-free dollars to reimburse yourself.

Benefits

• Lowers your taxable income by the amount you put in the FSA. Because you’d be paying those expenses anyway, the tax savings is like a discount on those expenses. For example, if you’re in the 28% tax bracket and you sock away in the FSA the $4000 maximum your employer allows and use it to cover $4000 of your $4300 out-of-pocket medical expenses, then you could realize tax savings of up to $600. This is just an example. You need to look carefully at your individual situation.
• The plan now covers over-the-counter drugs, a boon with all the prescription drugs that have moved to OTC.
• Deposit $300, for instance, in the account and your take home paycheck may drop only $275 because of the tax savings.
• If you itemize deductions on your tax return, but know that your typical medical expenses barely exceed the deductible percentage threshold of 7.5% of Adjusted Gross Income, then the FSA could offer greater tax savings than taking the deductions on schedule A. For example, if you and your spouse have a joint Adjusted Gross Income of $75,000, you could deduct on Schedule A only the amount over $5625. But if you have only $4300 unreimbursed medical expenses, the FSA would offer you greater savings.
• Typically, you can use the money you’ve agreed to place in the FSA before it’s all paid in. Let’s say in March, you fall down the back steps (ouch!), breaking your arm, your glasses and your pride, not to mention chipping a tooth. By the time you’re on the mend, you’ve spent $750 on deductibles and the glasses and dental work your health insurance doesn’t cover, but at $200 deducted per month you have only $600 in your FSA. Usually you can submit a claim for the whole $750, kind of an “advance” against the $2400 total you’ve agreed to deposit.

Potential Drawbacks

• Use it or lose it. At present, if you don’t spend all the funds within the year, you lose what you didn’t spend. There is no rollover. The average amount left in accounts is about $100. On the bright side, you only have to buy the drug or have the service by the end of the year, the IRS allows 90 days extra time for claim submission and money disbursement.
• Just like insurance, you have to submit your claim and documentation to get the reimbursement from your FSA. Different companies handle the reimbursement process differently. So make sure the process at your company is something you are willing to do faithfully. (More and more companies are turning to some sort of “account card” to make use easier by automating the reimbursement process.)
• Unless you carefully figure your estimated out-of-pocket expenses, you could put too much money in the account. So if you aren’t willing to take the time up front to really look at your health care costs and do the figuring, then you could leave more than your potential tax savings in the account. Many employers offering the plan provide worksheets to help make this task easier.

Dependent Care Flexible Spending Accounts

A Dependent Care FSA provides another option to help people who work provide physical care for small children or dependent adults who can’t care for themselves. Who's eligible? Single parents/caregivers or couples who both work (or one of whom is looking for work, going to school or disabled) can save a household maximum of $5000 annually to use for physical care expenses of certain dependents. Eligible dependents (you claim them as exemptions on your tax return) include children under age 13 and adult dependents who are physically or mentally unable to care for themselves. Typical services covered include child or elderly day care, day camp, and in home care. For specific details you must look carefully at the material provided by your employer.

Benefits

• Lowers your taxable income by the amount you put in the FSA. Because you’d be paying for dependent care any way, the tax savings can act like a discount on those expenses. You must determine, however, whether your savings is greater with an FSA or using the other dependent care tax credits available.
• Gives you an easy, dependable way to save for these necessary expenses.

Potential Drawbacks

• Use it or lose it. Like the Health Care FSA, if there’s money left over at the end of the year you lose it. However, most participants, particularly those who use the FSA for day care, report no problem using the maximum.
• Figuring out which will save you more money—a dependent care FSA or the various child/dependent care tax credits—can take some doing. You may wish or need to consult your tax preparer to get the best answers for your situation.
• You can’t easily withdraw mid-year, except in the event of certain life-changing events (as spelled out in your specific plan).

Deciding what’s best for you and your family

If you’re willing to take the time to find out about the FSA plans your employer offers and to do your homework to calculate what approach and what amount of savings is right for your individual situation, then I recommend that you drop by your HR or benefits department and pick up the information you need to get started.

Prepared for Corning Credit Union by Remar Sutton & Associates, November 2004. Reviewed March 2007. All rights reserved.