Dear Dollar Stretcher,
I have recently taken a job that allows an employee to open a flexible spending account. The flexible spending account is pseudo-savings account that allows the employee to put money aside each pay period for health insurance premiums, childcare expenses, and medical expenses. What do you know about such plans? Are they really beneficial to the employee? How do you determine your tax savings? I have tried to figure this all out myself but the worksheets are confusing!
Can you help?
RJ is a fortunate employee. The flexible spending account is a wonderful way to save on taxes. And, although there are some risks involved with the plan, they're usually quite manageable for most people. We'll begin by explaining what the plan is. Then we'll walk through what you would do to join your plan and finally, we'll show RJ a quick way to calculate tax saving.
The flexible spending account or FSA is a program that allows you to pay for certain expenses (for instance medical care) with pre-tax income. The key to the program is to remember that if you lower your taxable income, you'll lower the amount of taxes that you pay. Money that you put into the FSA is not counted in your taxable income.
Here's how it works. First, your employer must decide to offer a FSA plan. Once a year an "open enrollment period" will be held. That's the time when you elect to participate in the plan and decide how much money to contribute to the FSA. You'll repeat this process every year.
You'll enroll by completing an election form. That will authorize your employer to deduct a portion of your wages and contribute them to the plan. Whatever amount that you decide to contribute will not be counted as taxable wages. You can think of your contribution as money going to a savings account.
OK, now let's get to the meat of the issue. How much should you contribute? That will depend on your family situation. You'll need to look at the list of eligible expenses and decide how much you expect to spend on them in the coming year. The most popular eligible expenses are pre-school daycare and uninsured medical expenses. Your employer will provide you with a list that specifies what's covered. For instance co-payments, dentures, dentist exams and eye exams are covered. Health club memberships, over-the-counter drugs and weight loss treatments are not.
So, how do you know how much you'll spend on those items next year? The best way is to look at the previous year to see how much you have been spending. Make adjustments for changes in your family's circumstances. For instance, if Junior's entering kindergarten this year you can expect your childcare expenses to decrease.
This is one case where you'll want to estimate your expenses on the low side. That's because FSA's have a 'use it or lose it' provision. This is the biggest risk you need to know about. Suppose you set aside $1,200 for medical expenses during the year. And you only spend $900 in eligible expenses. You would lose the remaining $300. So it's important not to contribute too much.
There's also one important escape hatch that's available to employees. If you have a "family status change" you can change the amount that's being contributed. A family status change includes a change in marital status, number of dependents, employment status or work schedule. Typically, these are the kinds of events that would be most likely to significantly effect your spending on eligible expenses.
Once you incur an eligible bill you'll need to put it in for repayment. It's a little like submitting an insurance claim form. Submit them as they occur. You can expect to be allowed to submit expenses for a short period of time after the plan year ends.
Now let's see if we can't help RJ figure out how much tax saving is available. We'll need to make some assumptions to illustrate our example. We'll say that RJ is looking at putting $1,000 into the FSA and is in the 15% tax bracket. We'll also assume that RJ does have enough expenses during the year to spend his $1,000. How much will RJ save? That's fairly easy.
Remember that the savings comes from reducing your taxable income. In this case by $1,000. How much tax would RJ pay on that extra income? Well, we said his tax rate was 15%. But, there's also a 7.65% contribution to Social Security. Depending on where RJ lives, there might also be a state income tax to consider. So, taxes would consume 22.65% (15% + 7.65%) of the $1,000 or $226.50. That's what RJ will save.
It's really that simple. Add your Federal tax rate, social security tax and state income tax rates. Multiply that total rate by the amount that you intend to put into the FSA. That's your savings.
OK, so what's the catch? There are a couple things to consider before signing up for an FSA. First, the 'use it or lose it' provision. A cautious estimate of expenses and use of the family status change should provide reasonable protection.
The other risks are a little less obvious. Because you're reducing your taxable income you could be reducing pension, life insurance, disability insurance, unemployment, workers' compensation or Social Security payments. Suppose you have employer paid life insurance equal to your annual salary. If you reduce your salary by $1,000 and happen to die, you'll have that much less insurance coverage.
Another consideration is that you'll need to be able to pay the bill first and then wait for the repayment to be approved. Remember, you've already had the money deducted from your paycheck. So for a period of a few weeks it's as if you had to pay the bill twice and wait for reimbursement.
Barring unusual circumstances, these are not the kind of concerns that should keep you from taking a close look at flexible spending accounts. After all, it's not often that someone offers to help pay 22% of your medical bills.
One final thought. If your employer doesn't offer the FSA, ask them to talk with their accountant. The employer saves money with them, too. Thanks to RJ for asking an interesting question.
Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report and he's a regular contributor to US News Money and CreditCards.com. You can follow Gary on Twitter or visit Gary Foreman on Google+.
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