November 20, 2013

Flexible spending accounts (FSAs), often called a flex plans, are not new, but they are improved.

Participants use them to set aside money pre-tax, to pay for out-of- pocket medical costs such as co-pays and other expenses not covered by insurance. Employers like FSAs because they don’t have to pay employment tax on the amounts employees use to fund their accounts. It’s a win/win, but despite the name, one thing these accounts have not always been is flexible. A few years ago the IRS added an optional “grace period” to make FSAs better, and now they’ve improved them again, by allowing a carryover.

For now, let’s start with the basics.

What is an FSA?

A flexible spending account is an employer-sponsored pre-tax (or “tax free”) account that you can use to set aside money to cover eligible health and/or dependent care expenses.

At the beginning of the plan year, January 1st, your employer will ask how much you’d like to contribute to the account. Total any expenses that you predict won’t be covered by your insurance, like the braces your child will need or on-going rehabilitation treatment. This amount is then taken out of your paycheck in equal installments each pay period, and put into a special account by your employer. Although there are limits to how much you can set aside, and up until now, any excess leftover after the plan year was forfeited, the benefits of having an FSA money are numerous.

Benefits of an FSA

An FSA is included in your employer’s benefits package for a reason–it reduces your income taxes. The contributions you make to your flex plan are deducted from your pay before any Federal, State, or Social Security taxes are calculated, and are never reported to the IRS. In other words, you’re reducing your taxable income while at the same time increasing your spendable income. Making the most of your FSA could save you hundreds of dollars in taxes per year.

A basic example of this would be if, say, you were in the 15% tax bracket. You know you’ll spend $1000 on eligible health care expenses, so you set it aside in a flex account for the year. Your “take home” pay is $1000. If you opt out of putting it into an FSA, but still spend that $1000, you’ll have paid $150 in taxes to the IRS. Your “take home” pay is then only $850.

Without an FSA, you’d still pay the amount not covered by your insurance, but you’d be using money from your paycheck after taxes have already been taken out. The chart below, from FSA Feds, gives a real example of the tax benefits of an FSA.

FSA Chart

“This example illustrates tax savings based on 25% Federal and 7.65% FICA taxes, resulting in a 32.65% discount on eligible expenses paid through an FSA. State and local taxes are not included. Actual savings will vary based on your individual tax situation, and on whether you are covered under Civil Service Retirement System (CSRS) or Federal Employees Retirement System (FERS). You may wish to consult a tax professional for more information on the tax implications of an FSA.” – FSAFeds.com

What Can Be Deducted

If it’s considered an eligible deductible expense, and isn’t reimbursed by your current insurance, it can be reimbursed through a Flexible Spending Account. Some deductible expenses for a health care FSA (HSA) include:

  • Fees in excess of reasonable and customary amounts allowed by your insurance
  • Non-elective cosmetic surgery
  • Stop-smoking programs and any prescribed drugs to help with nicotine withdrawal
  • Acupuncture treatments
  • Inpatient treatment at a center for alcohol or drug addiction
  • False teeth, hearing aids, crutches, wheelchairs, and guide dogs for the blind or deaf
  • Co-payments on covered expenses
  • Deductibles

With a dependent care FSA, you can save money for expenses used to care for dependents while you’re at work, like day care costs for children under the age of 13, or adult care programs for senior citizens that live with you. Also, some adoption costs can be included as expenses.

The IRS lists the ins and outs of the various FSAs and HSAs here, but take note: If you’re single and don’t expect to incur any health costs besides a few $25 copays, an FSA may not be worth it.

New FSA Rules for 2013

So, FSAs allow employees who participate to pay for medical costs with pre-tax savings. Employees decide how much to put into the accounts through payroll deductions. As they incur an eligible expenses, they are reimbursed from the funds in their FSAs. The maximum a participant can put into an account is $2,500, although employers can set lower limits.

There has been one potential drawback with FSAs. Originally, they were inflexible, as in, use-it-or-lose-it. Any funds left in an individual’s account at year end were forfeited.

This restriction caused some problems.

  • Many employees were leery of participating, for fear of losing their hard earned money.
  • Some participated, but underfunded their FSAs to avoid forfeiting money if they failed to spend it.
  • Or if they got to the end of the year with an unspent balance, they would go out and make purchases they wouldn’t ordinarily make, like an extra pair of prescription sunglasses, just to use up the money.

The “Grace Period”

A few years ago, a grace period was added to FSAs to encourage greater participation. The grace period is 2 and ½ months, after the end of the year during which employees could spend out the balance of their FSA funds. A grace period is not automatic, and must be elected by the employer. This feature improved FSAs, but the newest addition should prove even better.

The Carryover

Now FSA participants who do not spend out their fund balances by the end of the year, may carry over up to $500 into the following year. So an employee who ends the year with $400 in his or her FSA and has chosen to set aside $2,000 into the new year’s plan will have $2,400 to spend in the new year.

Again, the carryover is not automatic. An employer must make the election to allow the carryover. The upper limit to carryover is $500, but employers may choose to allow a smaller carryover.

Note: A plan cannot allow both the carryover and the grace period. Employers must choose one or the other. So, if you have a plan in place which currently allows a grace period, you must elect to end the grace period in order to choose the carryover.

When does this kick in? It can begin now for employers who amend their plans to allow it. Normally such an election would have to be made before a plan year starts, but because this law is new, employers can choose it for 2013 and going forward.

For more information on the tax savings of an FSA, contact Optima Tax Relief today.

This article was co-written by Teresa Ambord and Brenda Harjala, staff writers for Optima Tax Relief.

Photos: New Mexico State UniversityFSAFeds