How to get the most out of a Flexible Spending Account

For many employers the fall is time for “open enrollment” for various employee benefits, including dependent care and health care “flexible spending accounts” (FSA). If your employer offers an FSA you should consider participating you can realize substantial tax savings from such a plan.

Participants in an employer-sponsored dependent care and health care FSA can set aside a specific dollar amount of their salary each year to pay for qualifying child-care or medical expenses during the year. The maximum amount that can be set aside for a dependent care plan is $5,000. There is no statutory maximum for a medical expense FSA, but most employers will limit employee contributions.

Monies set aside in a flexible spending account are considered “pre-tax” for both federal income tax and FICA (Social Security and Medicare) tax purposes. If your annual salary is $50,000 and you set aside, and spend, $5,000 in an FSA, the federal wages reported in Box 1 on your Form W-2, as well as the Social Security and Medicare wages, will be $45,000. If you are in the 25% bracket, this $5,000 will save you $1,633 in federal income and FICA taxes.

A pre-tax contribution to a dependent care FSA will generally provide a greater tax benefit than claiming the Child and Dependent Care Credit especially for those in the 25% and higher brackets. The maximum credit allowed for such a taxpayer is $600 for one qualifying child or $1,200 for more than one qualifying child.

Medical expenses are deductible as an Itemized Deduction on Schedule A only to the extent that they exceed 71/2% of AGI. Medical expenses paid through a pre-tax health care FSA are fully deductible from gross income.

The savings does not end there. Employee contributions to an FSA will reduce Adjusted Gross Income and may therefore increase deductions and credits that are affected by AGI (such as medical and miscellaneous expenses on Schedule A). Plus many states also treat FSA contributions as “pre-tax”, so you may save state income tax as well. Unfortunately, New Jersey does not treat contributions to either type of FSA as being “pre-tax”.

An FSA is a “use it or lose it” plan. If the amount of qualifying child-care or medical expenses paid by an employee-participant during the year is less than the amount that has been set aside in the plan the employee loses the excess. For example, if Mary Mom has set aside $5,000 of her salary in her employer’s dependent care FSA for 2007, but pays only $4,000 in qualifying child care expenses during the year, she loses $1,000 in wages! The $1,000 cannot be carried forward to the next plan year. So if you are a participant in a dependent care FSA and you currently have an unspent balance in your “account” make sure you spend that balance before year-end so you do not have to forfeit any of your salary.

There is an exception for a medical expense FSA. If the plan allows, participating employees have until March 15th of the next year to submit expenses to the plan. If the above example was for a medical FSA instead of a dependent care FSA Mary would have until March 15, 2008 to incur and submit up to $1,000.00 of medical expenses, which would be applied against the $5,000 set aside for 2007.

Only medical expenses that are deductible on Schedule A can be paid or reimbursed by a health care FSA, with the one exception of non-prescription “over-the-counter” medicine and drugs. They are not deductible on your tax return, but can be paid “pre-tax” through an FSA.

If (1) you are married, (2) both you and your spouse are eligible to participate in an employer-sponsored FSA, and (3) only one of you will earn wages that exceed the Social Security wage base ($102,000 for 2008), the spouse with the salary that is less than the Social Security wage base should claim as much of the couple’s combined FSA contribution as possible.

John Q Taxpayer will earn $110,000 in 2008 and wife Jane Q will earn $40,000. Both are eligible to participate in an FSA. They decide to set aside $5,000 for medical expenses for tax year 2008.

If Jane has the entire $5,000 taken from her salary, the couple will save an additional $310 in total taxes ($5,000 x 6.2% Social Security portion of FICA tax). Because John’s salary, even after the deducting the possible $5,000 FSA contribution, exceeds the $102,000 Social Security wage base, he will not realize any Social Security tax savings by contributing to his employer’s medical FSA.