A common question is just how much taxes can be saved by participating in a flexible spending account program. You contributions to an FSA plan are set aside pre-tax. "The amount of the benefit is subtracted from your gross wages before the federal income tax withholding is computed," said Cindy Hockenberry, EA from the National Association of Tax Professionals. In addition to reducing your income tax, FSA contributions also reduce your payroll or FICA taxes. "No employment or federal income taxes are deducted from your contribution," explains the IRS in Publication 969. This is the only way that I know of that you can actively reduce your payroll tax, short of taking a cut in pay.
FSAs come in two varieties: Medical FSAs to cover medical and dental expenses, and Dependent Care FSAs to cover day expenses for your children. Medical FSAs are particularly advantageous. Medical expenses are tax deductible only when your expenses exceed 7.5% of your adjusted gross income. And you must be able to itemize to claim the deduction. By contrast, medical FSAs reduce your taxable income right off the bat, and contributions in a medical FSA can be used to cover expenses that would not be tax deductible, such as over-the-counter medications.
Dependent care FSAs are used to set aside pre-tax dollars to pay for child care or adult day care services. Qualifying dependent care expenses allow you to work or to look for work and must be for the care of a qualifying person (usually a dependent).
A big drawback with FSAs: you must use all the money you have set-aside each year, or the contributions are forfeited. These "use it or lose it" rules were recently relaxed by the IRS. Kay Bell explains that the IRS will allow FSAs to pay out claims up to two and a half months after the end of the plan's benefit year. However, plan administrators are not required to do so. Employees should ask their human resources representative if any of their FSA money can be carried over to the following year.
More FSA resources:
- Some FSA money now can be carried over (Bankrate)
- What is a Flexible Spending Account? (About Financial Software)
- Manage Your FSA with Financial Software (About Financial Software)
- Maximize Your Employment Benefits (About Financial Planning)
- Flexible Spending Arrangements from Publication 969 (Internal Revenue Service)
- Medical and Dental Expenses, Publication 502 (IRS)
- Child and Dependent Care Expenses, Publication 503 (IRS)