How Flexible Spending Accounts Work

The cost of healthcare is overwhelming nowadays. Even with insurance, individuals and families can find themselves spending a significant amount of money in medical costs. The average family of four will likely pay $24,671 in healthcare expenses in 2015 – 27% more than in 2011. By contrast, salary increases over the same time period haven’t reached even half of that level.

Flexible spending accounts (FSAs), which are offered through your place of work or business, help to offset the high price of healthcare by giving consumers the opportunity to pay for some medical expenses with pretax dollars. That means, you’re receiving a roughly 30% discount on your allowable healthcare costs, depending on your tax bracket.

For example, a family making $50,000 and contributing $1,500 to an FSA will save $459.75 on healthcare costs. If they were to max out their contributions at $2,550, the savings would jump to $766.25. They can also contribute up to $5,000 for dependent care expenses such as day care, babysitters and care for an elderly dependent, saving up to an additional $1,532.50 (if they contributed the maximum). For more details on those expenses, see Benefits Of A Dependent Care Flexible Spending Account.

And you also cut your tax bill. Let’s say you earned $1,000 on your last paycheck and your employer deducts $50 for your FSA contribution. That means that you in effect made $950 – and your employer then calculates and withholds your taxes based on that amount. If you’re in the 28% tax bracket, for example, you paid about $15 less in taxes on that paycheck alone. Pretty good deal, isn’t it?

You can sign up for an FSA during your company’s open enrollment period, normally in November or December. It’s as simple as providing some basic information and deciding how much you want to contribute for the year. Contributions are deducted from each paycheck. Because deductions come from pre-tax dollars, the money is deducted from your gross pay.

There are some conditions, though.

• First, since they are offered through your workplace, obviously you can’t get an FSA unless your employer provides one.
• Self-employed people aren’t eligible.
• Once you elect a certain contribution amount for the year, you can’t change it.
• There’s a maximum amount you can contribute each year. In 2015, the limit is $2,550.
• You can only use the money on approved items. The IRS lays these out in its Publication 502. Generally speaking, if your doctor prescribes a test, medication or medical equipment, you can probably pay for it from FSA funds. You can also pay for dental appointments, chiropractors, eyeglasses and contacts, hearing aids, addiction treatments, modifications to your car or home if you or a loved one have a disability, ambulance services, and books and magazines printed in braille. You can even pay for some transportation costs related to healthcare treatments and for the training and care of a guide dog.
• You cannot pay health insurance premiums or be reimbursed for over-the-counter medications, as well as other cost limitations. So, before making a large medical purchase, make sure it’s allowable to use FSA funds.

FSAs are a "use it or lose it" type of plan. You have roughly one year to use the total sum you contributed for the plan or it becomes your employer’s money. But all may not be lost. There are two exceptions: The IRS now allows employers to carry over up to $500 into the next year; employers can also offer employees a grace period of up to 2½ months to use the leftover money. Bear in mind, however, that a company doesn't have to offer either of these options, and it's not allowed to offer both. So, check ahead of time about your employer's particular rules regarding excess funds.

Because of the “use it or lose it” rule, you might be tempted to be super-conservative in how much to contribute. But Kevin Haney of A.S.K. Benefit Solutions says to think differently. “A person electing to contribute $1,000 would reduce their tax bill by $376. If this person left 20% of their contribution unspent, they still would save $176.” In other words, you would have to overestimate by a lot to not come out ahead, even if you don’t use your entire amount. And there are always ways to spend the money: Load up on spare pairs of contact lenses. Treat yourself to some quality sunglasses with complete UVA/UVB protection.

Haney also advises scheduling elective procedures at the beginning of the year, if you want to use FSA funds to pay for them. Since you haven’t yet paid the money into the fund, you’re essentially taking a loan from your employer.

“Employers must immediately fund any qualified expense, regardless of when it occurs during the plan year. Employees can schedule planned medical procedures at the very beginning of the plan year (major dental work, braces, infertility treatments, etc.). They then have 52 weeks to repay the loan using pretax dollars.”

He continues, “Employees enjoy a better than zero-percent interest rate because they repay the loan with pretax, rather than after-tax, money. A person paying 5% state income tax, 7.65% FICA and 25% federal income tax would need to earn $1,603 in gross income in order to have $1,000 in after tax dollars. That equates to a minus 60% interest rate.”

If you’re leaving your company, try to use your FSA funds before you go because you don’t have to pay the company back for the difference between what you spent and what you paid in, says Erik O. Klumpp, CFP®, founder and president of Chessie Advisors, LLC. “If an employee gets reimbursed for their maximum contribution early in the year and then ends up moving and leaving their employer, they essentially get a huge discount on their reimbursed healthcare services. If the employee suddenly finds that they will be leaving their employer, they should utilize as much of the FSA account as they can before they leave.”

“When employees forfeit excess money in their accounts at the end of the year, that money stays with the employer," he adds. "That forfeited money also covers employees who have been reimbursed, but leave the employer prior to making the full year's contribution.”

An FSA is similar to a Health Savings Account (HSA). Both plans allow you to contribute pre-tax dollars, have annual contribution limits and can only be used for  approved health-related expenses. But an HSA doesn't have a "use it or lose it" rule, you don’t have to be employed by somebody to get one, and the contribution limits are higher – $3,350 or $6,650 for a family in 2015.

However, you can only have an HSA in combination with a high-deductible health plan, which might or might not the insurance choice you prefer.  For more on the pros and cons of each account, see Comparing Health Savings And Flexible Spending Accounts. 

Because accounts like these are more complicated than basic checking or savings accounts, some consumers may be leery of contributing to an FSA. But, by not participating, they’re throwing away a roughly 30% discount on healthcare costs and a reduction in their income tax, too. (For details, see Healthcare FSAs Increase Your Personal Savings.) It's a win-win proposition, all around.