What Is A Flexible Spending Account?
A flexible spending account (FSA) is a special account you put money into via payroll deductions that can be used to pay for qualifying medical or dependent care expenses. The benefit is that you don't pay taxes on money put into these accounts. So if you earn $3,000 a month and put $200 total a month into these plans, you only pay income tax on $2,800 of income. Why is this good? Apart from the obvious answer of "paying less taxes is good," a medical FSA allows you to deduct more medical expenses than you otherwise could. (Although FSA contributions are not "deductions" you take on your income tax return, they allow you to pay for medical expenses with pre-tax dollars, which in effect, is what a deduction does.)If you were to itemize your taxes and claim deductions for medical expenses on your income tax return, you would not be able to deduct medical expenses less than 7.5% of your total income. By using a FSA account, you can start saving taxes on the very first dollar of medical expenses. Let's look at our above example where you earn $3,000 a month. That's $36,000 per year. Without a flex spending account, if you decide to deduct your medical expenses on your income tax, you would only be able to deduct expenses over 7.5% of your income. In this case, that would be $2,700. A single person making $36,000 has an effective income tax rate of about 11.5% (using 2015 tax rates). Because that first $2,700 of medical expenses is not deductible, you pay tax on that money - which amounts to $310.50.
But if you used a medical FSA and put $2,700 into it, ALL of that money is tax free. So just by using a FSA, you've saved yourself $310.50. That's the benefit of FSAs.
There is also a flexible sending account that can be used for dependent care expenses and it provides the same tax benefits for child care expenses.
Note that these are two separate types of accounts. You cannot use funds from your medical FSA to pay for dependent care expenses and vice versa.
What Are The Drawnbacks?
Use It Or Lose It
The problem with these accounts is that they are "use it or lose it" accounts. When you set up your contributions during open enrollment, whatever amount you choose to contribute is unchangeable for the entire year and, if you do not use all the money you put into these accounts, you lose that money. (Some plans allow you the option to roll over unused funds to the next year's plan or let you use unused funds for the first couple weeks of the next year.)So you have to be good at estimating your future expenses. For regular, recurring costs, like monthly child care payments, this can be fair easy to do. For things like medical costs, it can be a bit trickier. How do you know how many times you are going to see the doctor next year?
Contribution Limits
There is also a limit as to how much you can put into these accounts each year. For 2016, the contribution limits for a medical FSA are a minimum of $120 and a maximum of $2,550. The limits for dependent care contributions vary, depending on if you are single or married. Single filers can contribute up to $5,000. Married filers can contribute $2,500 per spouse. As with anything tax related, there are all sorts of other limitations and conditions, so check with your employer's HR department or your tax advisor for full details.Limits On Use
What you can use the money for is also limited, You can't use funds from your dependent care account to pay for a baby sitter when you and your spouse go out to dinner. You can use it, however, to pay for a babysitter while you go to work. For medical expenses, most over the counter medicines are not eligible, but all prescription medicines are. Co-pays for doctor visits are, as are any insurance deductible payments. Costs for contact lenses, eyeglass lenses and frames, and diabetic supplies are also eligible.Potentially Lots Of Paperwork
So How Do You Choose How Much To Put Into These Accounts?
For a dependent care account, this process is usually easy. You likely pay a monthly fee for before or after school care (or daycare if you child is not yet old enough for school). Just multiply that by 12 to get your annual contribution amount. If your child is in school, don't forget the summer months. Your costs may be more for those times they aren't in school and need care all day long. Also, keep in mind the school year and calendar year do not sync up. This bit me this year. My daughter was in fifth grade last year and I planned my FSA contributions based on her attending after school care for an entire year. But when she entered sixth grade in August, she starting riding her bike home after school and didn't need after school care. Because FSA contributions are fixed for the year, I could not change it and so I lost five months of contributions because I had no child care expenses to claim for August through December. D'oh!Medical FSA contributions are a bit more challenging. First if you are taking any medicine regularly, at the very least contribute the amount your prescriptions cost for an entire year. Next, I figure at least 2 doctor visits per person per year, so add in co-pay amounts for those. Finally, if you wear contacts or glasses, consider if you want or need to get new ones in the coming year. Costs for eye exams, contacts, and eyeglass lenses and frames are eligible expenses. These can run into the hundreds of dollars, so if you know you're going to need some, add that to your contribution amount. Again, because of the use it or lose it nature of the accounts, if anything, it's best to under estimate rather than over estimate your future medical expenses.
If you use any kind of budgeting or expense tracking tool, such as Mint.com, it might be really easy for you to look at how much you've spent on each type of expense over the past year and use that as a guide to selecting your contribution amount for the next year.
