Flexible spending accounts let you pay for eligible out-of-pocket health care before federal, state, and Social Security taxes are deducted from your paycheck. Taking advantage of them is a great idea.
Admit it: you probably spend more time comparison shopping online than reviewing your annual benefits enrollment materials. That's a big mistake, because the money you could save by choosing the right employee benefits package probably far exceeds any savings you could get on a big-screen TV.
For example, many people don't sign up for an extremely valuable benefit – flexible spending accounts (FSAs). If your employer offers them, FSAs let you pay for eligible out-of-pocket health care and/or dependent care expenses on a pre-tax basis – that is, before federal, state, and Social Security taxes are deducted from your paycheck. Using an FSA to cover expenses you would have paid for anyway reduces your taxable income by that amount, which in turn lowers your taxes.
Here's how it works: Say you earn $40,000 a year and are in a 25 percent tax bracket. If you contribute $1,000 to the health care FSA and $3,000 for dependent care, your taxable income would be $36,000 – about a $1,000 reduction in federal taxes alone, depending on your marital status, withholding deductions and other factors. (Use this calculator to evaluate your situation.)
Health Care FSAs let you pay for IRS-allowed medical expenses not covered by medical, dental, or vision insurance, including deductibles, copayments, orthodontia, glasses and contact lenses, prescriptions, chiropractic, and smoking cessation programs. Check IRS Publication 502 for a list of allowable expenses. Dependent Care FSAs let you use pre-tax dollars to pay for expenses related to care for your children, disabled spouse, parent, or other dependent incapable of self-care, including:
- Licensed day care or adult care facility fees
- Services provided in or outside your home (including babysitter, nursery school, or summer day camp) so that you and your spouse can work, look for work, or attend school full-time.
- Before- and after-school programs for dependents under age 13.
- Babysitting by relatives over age 19 who aren't your dependents.
For some lower-income families, using the federal income tax dependent care tax credit is more advantageous than an FSA. So crunch the numbers or ask a tax expert which alternative is better for you. Just be aware that you cannot claim the same expenses under both tax breaks.
Your FSA contributions are deducted from paychecks throughout the year. As you incur eligible expenses, you submit receipts to the plan administrator for reimbursement. Also, many employers now offer prepaid health care cards, that let you draw on your account at the point of service to pay for qualified medical expenses, thereby eliminating the need to pay cash up front and submit reimbursement forms.
Keep in mind these FSA restrictions:
- Maximum contribution amounts vary by employer, but commonly are $2,000 to $5,000 a year for health care and $5,000 for dependent care FSAs.
- Health care and dependent care account contributions are not interchangeable.
- Estimate planned expenses carefully because you must forfeit unused account balances. Some employers offer a grace period of up to 2 ½ months after the end of the plan year to incur expenses, but that's not mandatory, so review your enrollment materials.
- You must re-enroll in FSAs each year – amounts don't carry over from year to year.