Got Orthonomics in your Email Box?

Tuesday, December 05, 2006

Flexible Spending Accounts

The end of the calendar year is quickly approaching, and many employees are currently being asked if they want to fund a "Flexible Spending Account" (FSA). While the subject is relevant, I wanted to write a brief overview of these accounts, in addition to discussing their advantages and disadvantages.

In brief, the advantage of an FSA is the tax savings. The program allows an employee to put aside "pre-tax" money from earnings each pay period to help pay for two types of expenses:

1) Qualified Out-of-Pocket Health Care expenses and/or
2) Qualified Dependent Care expenses, i.e. childcare or adult dependent care expenses for qualified dependents that are necessary to allow you or your spouse to work, look for work (so long as you find a job and earn income), or attend school full-time.

An employee can put aside funds for one or both of these purposes, but funds must be designated separately for the entire calendar year. Both spouses can contribute the maximum amount allowed to their own Health Care FSA (HCFSA), however the amount allowed for the Dependent Care FSA (DCFSA) is limited per household.

Question: Just how much tax can you expect to save on your designated funds?
Answer: No less than 7.65% (FICA withholding that all employees are subject to) to upwards of 50%, although most will fall somewhere between 20 and 40%. To estimate your tax savings, add together your respective federal marginal tax bracket (ranges between zero and 35%), your respective state marginal tax (can range up to approx. 10%), and the 7.65% FICA withholdings.

Question: What Out-of-Pocket Health Care Costs qualify for coverage?
Answer: Basically all expenses except insurance premiums (e.g. dental and vision insurance) and items like over-the-counter vitamins. Of course, the list of allowable and unallowable expenses is a long and tedious read. But, before you go about designating your earnings, you should become familiar with it.

Question: What are the disadvantages?
Answer: The prime disadvantages are the following:
1) "Use it or Lose it" Whatever money is left in your account at the end of the Benefit Period (usually March of the following year, I believe) you forfeit for good. There are no refunds. This is a requirement of federal law.
2) If you are laid-off or leave your job without spending your account, it is gone forever.
3) The paperwork and recordkeeping. Proper documentation (receipts, bar codes on over the counter medications, etc) will need to be submitted with claims. Organization is key and those who lack time will suffer. Update: Many companies do have paperless reimbursement for certain expenses like co-pays.

Question: Can I still receive a tax credit for my childcare on my 1040 Tax Return if I am using a DCFSA?
Answer: No and Yes. You cannot receive the tax credit for the amount you designated in your DCFSA, but the incremental excess amount that you spent beyond your DCFSA designation can be claimed. (It is a bit complicated, but here is an example: A household with two children can claim a credit on a percentage of $6000 in childcare costs or $3000 per child. If the family only designates $4000 to their DCFSA, they can claim a credit on the excess $2000.)
Note: The same goes for trying to deduct health care expenses above 7.5% of your adjusted from income on your Schedule A (Itemized tax deductions).

Question: Is it better to use the tax credit or the DCFSA?
Answer: It depends. Because a greater dependent care tax credit is offered to those with lower household incomes, some will benefit more from using the tax credit.

Question: Does my childcare provider need to be paid "over the table?"
Answer: Yes, yes, yes. Don't make your designation unless you know your provider is filing their taxes. You will need the Tax ID or Social Security number for your daycare provider or babysitter. Without this vital information, you will not be reimbursed. You also might want to make sure that your provider understands why you are asking for this information(!).

Question: Is camp a qualified DCFSA expense? What about yeshiva tuition?
Answer: Day camp for a child 13 and under is a qualied expense. But, overnight camp is not, unless there is itemized billing for day services only! And, no tuition for an elementary school child does not qualify either. But, before and after-care services do if they are separately itemized.

Question: How much should I designate to my FSA?
Answer: Review your prior years expenses (I assume everyone has been tracking their budget now?)to determine your future expenses, but be careful not to overestimate what you will spend because of the "Use it or Lose it" clause. Also, be very careful you only include qualifying expenses. You don't want to end up buying ridiculous amounts of over-the-counter drugs because you stand to lose a significant amount of money otherwise.

Disclaimer: Please do your more research if you have questions and read your enrollment forms carefully. This is a primer on the subject and is in no way a complete overview. Goodluck.

23 comments:

Ezzie said...

7.65 x 2 if you work on a 1099, correct?

I *believe* that most places cap how much you can put in an FSA.

I should probably know this, but... an HSA is the most common FSA? Or is that something slightly different?

SephardiLady said...

Hi Ezzie. HSA and FSA accounts are a new subject to me. I haven't done a lot of research on HSA accounts because it doesn't apply to our household. But, if we have a high number of self-employed people that are interested, I'm happy to do the research.

I studied accounting years before this legislation was enacted by Pres. Bush. These accounts are highly beneficial and I am always trying to keep my knowledge current.

An HSA is for those not covered by other health insurances or covered by a high deductible health plan. I believe that these accounts are generally for self-employed people or contractors, in which case I believe you would be correct about the 7.65% *2, since both parts of the employment tax burden are carried by the contractor.

Here is the Treasury site with info:
http://www.ustreas.gov/offices/public-affairs/hsa/faq.shtml

Ezzie said...

They're not just for self-employed - we have them in our office, for example. My father (financial planner/insurance) is a huge fan, and basically told me to max out the HSA (as had our accounting professor who is the MP of his own accounting firm) - unless you have almost no expenses, you probably want it to be a bit less than your deductible, if your deductible isn't *too* high. If you can estimate your expenses for the upcoming year, that's obviously better. This way, in a year where you're hitting your deductible, the deductible you're paying completely pre-tax, and everything above it is covered by insurance. If you have a healthy year, and only use (say) 2/3 of $1,500 you put in a HSA, even though you lose the $500 you saved almost that much if not that much in taxes, depending on your bracket. In the long run, you're better off using the HSA.

(To clarify, I think it's better to slightly overestimate than substantially underestimate with the HSA. But it's probably about the same either way.)

I think an HSA must be an FSA. They seem to be the same.

SephardiLady said...

Hi Ezzie, my father has actually lobbied his congressmen for many years HSA legislation.

I think you are confusing the terminology. An HSA and FSA help the user reach the same goals. However, an HSA seems to be controlled by the user, an FSA by the employer.

From Wikipedia (http://en.wikipedia.org/wiki/Flexible_spending_account):

"A flexible spending account (FSA) is a tax-advantaged savings account set up through an employer in the United States. An FSA allows an employee to set aside a portion of his or her earnings to pay for qualified medical or dependent care expenses. Money deducted from an employee's pay into an FSA is not subject to payroll taxes, resulting in a substantial payroll tax savings. An FSA is similar to a Health Savings Account (HSA), which is available to self-employed persons or some small businesses."
------------------------
From Wikepedia (http://en.wikipedia.org/wiki/Health_savings_account):

A Health Savings Account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States. HSAs were established as part of the Medicare Prescription Drug, Improvement, and Modernization Act which was signed into law by President Bush on December 8, 2003. These accounts are a component of Consumer Driven Health Plans.

A Health Savings Account is an alternative to traditional health insurance; it is a savings product that offers a different way for consumers to pay for their health care. HSAs enable you to pay for current health expenses and save for future qualified medical and retiree health expenses on a tax-free basis.

You must be covered by a High Deductible Health Plan (HDHP) to be able to take advantage of HSAs. An HDHP generally costs less than what traditional health care coverage costs, so the money that you save on insurance can therefore be put into the Health Savings Account.

You own and you control the money in your HSA. Decisions on how to spend the money are made by you without relying on a third party or a health insurer. You will also decide what types of investments to make with the money in the account in order to make it grow.

SephardiLady said...

And speaking of estimating, the tax savings are significant enough that overestimating isn't particularly problematic.

The more data a family has, the better their estimation should be. We did an FSA for the first time this year (2006). Even with the new baby, we only underestimately by about $100. . . most of which can be attributed to an unexpected dental expense for my husband.

We had solid data on our expense patterns from 2004 and 2005 which I attribute to our ability to estimate properly.

RaggedyMom said...

Great overview of this subject, SephardiLady. Time for me to submit more of my medical receipts! (I'm waiting for a couple of big bills to lighten how much paperwork I need to send in!)

Anonymous said...

Vitamins I believe are only covered if they are directly prescribed by your doctor. Taking Centrum would not qualify. You can go to www.drugstore.com and they have a FSA store (there's a link in the top menu). Everything you buy there is covered. Very useful at the end of the year and you have some unused funds that you need to spend. Other drugstore sites may have something similar.

RWM

SephardiLady said...

RWM-You are correct. Over the counter vitamins don't count. All prescriptions do, including vitamins such as pre-natals.

Anonymous said...

2) If you are laid-off or leave your job without spending your account, it is gone forever.

I don't think this is true. Whatever you have contributed thus far is able to be used by you, because most companies have an outside firm that administers the plan. Once the money is taken out of your check and put in your account, it is yours to spend on medical care for the entire calendar year. The only thing is, if you leave the company before you are paid up, you can't expect the full amount to be in your account.

Ariella said...

good, clear explanation. We tend to put not so much in my husband's medical FSA b/c of the lose it possibility. So we had quite a shortfall when it came to paying for my daughter's glasses.

SephardiLady said...

Anon 1:03PM-I was provided this info by someone else who is in a related field to me. I was told a company can loose if you leave early and they paid a claim in excess of the amount in your account, or an employee can loose if they leave without spending their plan. I guess things are supposed to even out for businesses this way, which makes them willing to take the risks involved.

I know that at certain points in time, we have been paid for more than our account was funded. In fact, this is one of the time. There is one more pay period, yet my husband's workplace has paid out our entire allotment.

A friend of ours who was laid off, ended up finding creative ways to quickly spend the account since it wasn't going with him.

If you have a regulation to show I am incorrect, please provide it. I am more than happy to make a correction.

Ezzie said...

Thanks - my bad.

My only question is exactly how the HSA works - do I submit receipts to the HSA, or does it somehow automatically deduct from there? I never quite got that.

SR said...

I do use the FSA and basically send in receipts for co-pays, prescriptions and other medical charges not covered by insurance.

Do you know where the deal with the use it or lose it came from? It really is a bit of a scam.

I say that anything you don't use should be appropriately taxed like the rest of your salary and then given to you.

SephardiLady said...

(An example from a friend who is in the know):
Use-it-or-lose-it might seem like a scam. But companies can also lose a significant amount of money.

Let's say a person sets aside $3000 in an FSA. In February the employee has $500 in their account, submits a receipt for reimbursement for Lasik ($1500). The company reimburses all $1500, leaving a deficit in the account of $1000. Come Mar 1, the employee turns in their notice. Now the company is out $1000.

However, some employees will neglect to spend all of their FSA money and hopefully the company won't lose in the aggregate.

elisheva said...

My company won't reimburse more than what you have put in the FSA to date. If you ask for more, they just keep paying you back as the money comes in.

If direct deposit is available, it makes this very simple! We even have our set up so we don't have to submit any paperwork at all since it all goes through Aetna. (That's through my husband's company.)

By the way, I thought HSA's let you save the money that you don't use. Sometimes the company will even put some money into your account.

SephardiLady said...

Interesting info Elisheva. Goes to sow how unique each company is.

We also have paperless reimburement for all expenses through the health insurance (prescriptions and co-pays). However, we still have to track over the counters, dental, and vision.

One note: an HSA and an FSA are different. I have yet to research HSA's. (Ezzie had a good question on the HSA's).

Mike S said...

The "Use it or lose it" is required by the tax code, although you are allowed to modify your initial elections under certain conditions (e.g you had another baby, etc)

Your child care provider should be paid above the table even if you don't use an FSA.

The description of medical expenses allowed in the initial post is not wuite right. Preventative care is covered, provided it is prescribed (not merely recommended) by your doctor--e.g. your prescription blood pressure medication is allowed. So are prescription eye-glasses.

SephardiLady said...

Mike-I agree with you 100% that employees should be paid over the table. Unfortunately, not everyone is in our boat.

I understand how preventative care can be misconstrued. I think I will edit that part out fpr clarity. I was referring to things like over the counter vitamins, not prescription eyeglasses or blood pressure meds.

Thanks!

Ari Kinsberg said...

unrelated to this post, but mazal tov

tzvinoach said...

Useful and relevant post!

One comment, though --
You say that "tuition for an elementary school child does not qualify" for DCFSA. People should be aware, however, that pre-school tuition does qualify. This includes nursery, kindergarten, and arguably Pre-1A as well.

Anonymous said...

I know that at certain points in time, we have been paid for more than our account was funded. In fact, this is one of the time. There is one more pay period, yet my husband's workplace has paid out our entire allotment.

It could be because your husband's workplace, like mine, has you put in all of your contributions during the first part of the year and none during the last part.

I did actually have a question about what happens if you have taken out $1000 but only funded $500 and then leave the firm. I wonder if your company can ask for the money back. I haven't been in that situation, but I have been in the situation where I submitted claims in the later part of the year after I was already not working but had paid up. The claims were all paid. I don't think the federal government would let your employer keep money you earned and put into your flex spending account. Seems illegal.

SephardiLady said...

Anon. . . The federal regulations specify use-it-or-lose-it.

Ahuva said...

The company cannot ask for the money back if you have used all of your FSA but leave before the end of the year. I was just in this situation and asked. :)

You can continue to file claims after you have separated from the company. (I have until March 1, I think.) I'm not sure if the purchases have to have been made before your last day or not.