Flexible Spending Accounts

Flexible Spending Accounts (FSAs), also known as reimbursement accounts, are optional benefits plans offered by many U.S. employers that allow employees to set aside money from their paychecks on a pretax basis to pay for eligible out-of-pocket medical and dependent care expenses.

There are two types of FSAs - one is for health care-related expenses and the other is for dependent care-related expenses. These two accounts are separate. You may sign up for either or both of them during the open enrollment period, but it's important to note that money set aside in one account cannot be used to pay for expenses from the other.

You can enroll in an FSA only during your company's open enrollment period unless you have a qualified "family status change" during the year such as marriage, birth or adoption, divorce, or loss of a spouse's insurance coverage. The contribution amount(s) you designate for the year will be deducted from your paycheck each month (or each pay period - check your employer's plan for details).

You must actively re-enroll in FSAs each year - contribution amounts don't carry over from year to year. Also note that FSAs are not portable from one employer to another. You must enroll in your new employer's plan if you change companies.

How Pretax Contributions Work

The IRS allows participants to contribute to their FSA account(s) through payroll deductions taken out on a pre-tax basis. This means the money is deducted from your pay before federal and state income taxes and Social Security have been withheld. Thus, your taxable income is lowered, which in turn reduces the amount of taxes you must pay.

By contributing to an FSA to cover expenses you would have paid for anyway, you reduce your gross taxable income by that amount, which in turn lowers your tax bill. For example, say you earn $35,000 a year and are in the 25 percent marginal tax rate. You decide to put $1,000 in the Health Care FSA and $3,000 in the Dependent Care FSA. This would lower your gross income by $4,000 and in turn reduce your taxes by $1,000. That's $1,000 that stays in your pocket instead of going to Uncle Sam.

The more you contribute to FSAs, the greater your potential tax savings. Just be sure that you calculate your expected expenses carefully, because according to IRS rules, any funds in your account not used during that plan year must be forfeited (see Tax Rules that Govern FSAs below).

While almost all employees benefit from the tax savings provided by FSAs, you should be aware that making pretax contributions to FSAs may slightly reduce your Social Security benefits at retirement. However, the value of current year tax savings usually more than offsets any such slight reduction in Social Security benefits.

Tax Rules That Govern FSAs

There are several IRS rules that govern the use of FSAs:

• Any healthcare expense for which you are reimbursed by your Health Care FSA cannot be taken as a deduction from your federal income tax in any tax year, even though it may qualify as a tax-deductible expense - you must either declare the expense on your tax form or get reimbursed through your FSA - never both.
• You cannot be reimbursed from your FSA for any healthcare insurance premiums, although plan deductibles and co-payments are allowable reimbursed expenses.
• The alternative to using a Dependent Care FSA is to take a dependent care tax credit when you file your federal income taxes. The two alternatives have different pros and cons: See the discussion in "How Dependent Care FSAs work" below.
• It is important that you estimate your expenses carefully, because you must use all the funds in your FSA account during the plan year or forfeit the remaining amount. This is known as the "use it or lose it" rule.
• In 2005, Congress passed a law allowing employers to grant an optional 2 ½ month grace period that would extend the deadline. Thus if your plan is on the calendar year, the deadline for eligible expenses to be incurred may be extended from December 31 until March 15 of the following year. Important Note: This grace period is voluntary, not mandatory, so be sure your employer offers a grace period before factoring one into your plans - otherwise, you would need to incur expenses within the plan year.
• However, even though you must incur an expense within the plan year (or within the grace period, if offered), your employer typically will provide a specified period after the plan year ends during which you may submit a claim for an incurred expense (usually 90 days beyond the plan year, but check with your employer for the exact date).
• The IRS defines "incurred" as when the service was provided, not when you were billed. For example, if your child's day care provider bills you at the beginning of each month, you can be reimbursed by your Dependent Care FSA only after you have received all day care services for that month, not when you paid the month's bill.