Flexible Spending Accounts (FSA): Tax-advantage spending


Flexible Spending Accounts (FSA)

Simply stated, a Flexible Spending Account (FSA) is a tax-advantaged financial account to pay for qualified medical expenses. Money is deducted straight from an employee’s paycheck before any income taxes are taken out, and that money is directly transferred into a bank account. These funds can then be used on qualified health care expenses throughout the year, including deductibles, coinsurance, copays, dental expenses, vision expenses, etc. Click here for a full listing of qualified expenses.

In other words, using an FSA allows you to completely avoid income taxes (legally!) on earnings used for medical expenses. This is an automatic savings of anywhere between 10% and 35%, depending on your income tax rate. Here is a simple example showing the immediate savings of using an FSA based on $1,000 of income:


As you can see, this person, who is in the 25% income tax bracket, is saving 25% by using an FSA due to the fact that no income taxes were taken out. The annual maximum for an FSA in 2013 is $2,500.

FSAs are typically not available for high deductible health plans (HDHPs). However, HSAs are available and are also great tax-saving tools.

How it works

When an employer offers an FSA, typically you just need to enroll and decide how much money you would like to contribute for the year. Contributions will be made from each paycheck in equal amounts. So if you decide to put $2,000 into the FSA and are paid bi-weekly, $76.92 will be deducted directly from your paycheck ($2,000 / 26 paychecks). The cool part about this is that the $2,000 becomes available at the beginning of the calendar year, so you can use $2,000 on February 1st even though you have only contributed about $150.

  1. Enroll in your employer’s plan before the enrollment deadline
    1. Select how much you would like to contribute for the year in the FSA
  2. Receive the debit card from the financial account administrator (the bank)
  3. Use the debit card to pay for all medical expenses until all the money is used
  4. Keep the receipts, as you can be audited when filing your taxes

Use It or Lose It

Because FSA elections can only be made once for the entire year, the amount you contribute is an important decision. If you don’t put enough in the FSA, tax savings will be lost. If you put too much in and don’t use it, the amount does not carry over to the next year and will be lost when the next year begins. For example, if you only use $500 of the $2,000 contributed, you won’t ever see the remainder.

This leaves a difficult decision to be made. To some extent, you’ll have an idea of medical expenses that should arise in the year. If you have normal prescription medications, a planned surgery, or are just completely healthy, you’ll have some direction. Obviously, events needing medical attention can arise without much warning. This is the tough part.

A good starting point is to look at your out-of-pocket maximum for the year, since this is the max you could spend on medical expenses (not including dental and vision). If you have a low out-of-pocket max, say $500, and also have a spouse and a few kids, it’d be worth putting $500 in the FSA for your medical expenses, since the chances of reaching this $500 out-of-pocket max is high. To estimate above and beyond this, take a look at possible vision and dental expenses.

If your out-of-pocket max is $5,000, the choice becomes less clear. There is no exact right or wrong answer to this. Depending on the type of year, you may be happy you had contributed $3,000, saving $750 from the tax-advantaged account. Or you may have only spent $1,000 on medical bills for the year and left $2,000 to evaporate into thin air.

Seeing this example, it may be worth staying on the conservative side and contributing an amount on the lower end of possible expenses. After all, the possible tax savings on using the FSA is somewhere between 10-35%, whereas the unused FSA is losing the remainder after tax savings (between 65-90%. This is because you had a tax savings of 10-35%). This is all personal choice, but I would not be willing to put this much risk into a smaller reward, unless I was pretty sure that these dollars would be spent.

FSAs are very different from HSAs and HRAs. Be sure to understand the terminology and save yourself a hastle!

Image courtesy of cooldesign / FreeDigitalPhotos.net

About Trent

I started Frugal Purpose to share my love of personal finance to assist your pursuit of a more fulfilling life. I am a financial analyst by trade, traveler at heart, and want to share with you the beauty of this world.


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