Reposted By Request: Flexible Spending Accounts

Below is an educational post I wrote in 2006 about Flexible Spending Accounts. Is it really almost that time again? I received a request to address the subject, so I am re-posting. Just a note that the new health care legislation will slash the health care FSA to $2,500 from amount employers normally allow, $5,000 although there is federal technically no limit.

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. [As of 2011, non-prescription, over-the-counter medicine and items like band aids will no longer qualify for reimbursement].

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 record keeping. 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 [or organizational skills] 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(!). [Regardless of your decision of whether or not you should use an FSA, your childcare provider should be paid legally].

Question: Is camp a qualified DCFSA expense? What about yeshiva tuition?
Answer: Day camp for a child 13 and under is a qualified 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 and estimate upcoming and new expenses [to come to a reasonable prediction of] 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. [As of 2011, even if you are using 2010 funds within the grace period, you will no longer be able to buy over-the-counter drugs or a lifetime supply of band aids].

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. FSAs are an excellent and legal way to make your income stretch further.