Most married couples or families can attest to the fact that there never seems to be any shortage of medical or daycare bills to pay! This is why taking advantage of a flexible spending account can help you and your money design. So read on and find out how an FSA works and how it can put a little extra money in your pockets on these types of expenses.
What is a Flexible Spending Account?
If you spend a decent amount of money on medical bills or daycare, then you might be pleased to know that the U.S. government has a program setup to help you with these expenses. It’s a special type of fund called the flexible spending account or FSA for short.
There are lots of types of FSA’s, but the two most popular ones are the medical and dependent care plans. Basically, if your employer offers an FSA via their cafeteria plan options (something your Human Relations officer would know), then that can translate into a tax break for you. Here’s how:
• You elect an amount for your flexible spending account. For example, let’s say you elect to put $5,000 in for dependent care and medical expenses.
• Just like a 401k, money is taken out of your paycheck before taxes are taken. Over 26 pays, that means $192.31 will be taken out of your income each paycheck and placed in your FSA.
• Throughout the year, when you have medical or daycare payments, you request a reimbursement for those expenses. The money from the FSA account is used to pay you back!
• So the benefit? THIS MONEY IS NEVER TAXED! That means more money in your pocket!
The annual maximum that you can contribute is $2,500 for the medical FSA and $5,000 for the dependent care FSA.
How the FSA Works:
Suppose you make $60,000 per year:
• $60,000 gross income after 25% taxes = $45,000 net income
Under normal conditions, you’d simply use that $45,000 to pay for daycare and medical expenses, as well as everything else like your mortgage, car, utilities, etc.
Now suppose you have a flexible spending account setup in the amount of $5,000:
• $60,000 gross income – $5,000 FSA = $55,000 gross income remaining.
• $55,000 gross income after 25% taxes = $41,250 net income
• BUT, you will eventually get back your $5,000 from your FSA throughout the year in reimbursements for medical and daycare expenses.
• Therefore, $41,250 + $5,000 = $46,250 actual income
• That’s a difference of $1,250 in your favor!
Remember – where did that extra $1,250 come from? From not having to pay taxes on the money you contributed to your FSA!
Another Way to Look at a FSA:
Suppose you’re looking at $10,000 in daycare bills this year. I remember I could have paid my mortgage twice with my daycare bill!
What if I told you that out of that $10,000 you have to pay, we could take $3,750 of it and turn it into $5,000? Here’s how:
• $3,750 in normal income / (1 – 25% tax rate) = $5,000 in gross income = $5,000 in an FSA
The Bad News About FSA’s:
Of course there had to be a catch! The bad news with a flexible spending plan is that it’s on a “use it or lose it” system. In other words, if you elect to fund your FSA with $5,000 BUT you only spend $4,000 in expenses, then you LOSE your $1,000. This is mean to deter people from maxing these accounts out and dodging taxes. So if you do choose to setup one of these accounts, talk about a realistic number you think you will spend and pick a number carefully. The last thing you want to do is lose money that belongs to you!
Unfortunately, the only way to sign up for one of these types of accounts is if your employer offers them. You can’t setup these accounts yourself. So if you’re interested, please talk to whoever handles Human Resources at your work and see if this is something they participate in. Obviously, this can be a nice financial break for families looking to stretch their dollars. So if your employer doesn’t offer them, print off this post and persuade them! I believe your employer also gets a tax break in the process!
Readers – Who out there participates in a flexible spending account? Who just found out what one is? For my readers in other countries, do they offer anything similar?
Related Posts:
1) What Would You Do With An Extra $1,000?
2) How to Budget – Download My Excel Template
3) My Alternative Emergency Fund Strategy and How It Works
Image Credit: Microsoft Clip Art
Sweet post. I spent a fair amount of time as an advisor teaching people what these were. Nice, succinct description of the benefits and pitfalls.
Thanks Joe! I always appreciate it when someone with a financial industry background can approve my examples. It must have drove you crazy when people didn’t take advantage of FSA’s.
very good explanation! You did a good job breaking it down. Although, you might have readers that might need little bit more of a breakdown on your $10,000 daycare example. In my opinion, you were very clear and expressing the disadvantage.
Thanks Ornella. A lot of people get confused about how the savings on taxes thing works, and that is okay. I will put it out there that if anyone does not understand my example, email me and I’d be happy to explain further.
Another informative post 🙂
We don’t have that option here, but I do get a Health Spending Account with money that I can apply towards any health expense. There’s not a lot of money in it, only $400, but it’s money that is paid by the employer, not me.
Thanks CF. I do hope these types of posts are helpful. I don’t believe we qualify for a HSA. In your case, even if its just $400, every little bit helps.
Your FSA sounds like my HSA, which I’ve written about in the past – The Triple Tax Advantage of Health Savings Accounts (HSA). The tax advantages are awesome! I just did my benefit elections for next year – definitely putting in the max allowed by the IRS. Also if something unexpected comes up, like a surgery you didn’t expect (happened to me this year actually), there is money set aside for it.
Thanks DC! FSA’s are very similar to HSA, except the money does NOT roll over. So we had to be very cautious about how much we put forth into our FSA or we would lose it.
I feel like I have the best of both worlds. I use a HSA for medical bills and an FSA for daycare. Small businesses were only allowed to start these in 2011, but I certainly took advantage. I’m sorry we only got one year of daycare out of it because our daughter started kindergarten. I still use it for after care and whatever we might need in the summer. 25% off is a great deal! With our business, it was extremely easy to set up. Employers do get a tax break because they don’t have to pay tax on what portion of employee’s salary goes into the FSA. I also believe you can file an extension and use the money by March in most cases. I was looking forward to this post and you didn’t disappoint.
Thanks Kim, but it sounds like I haven’t told you anything you don’t already know! 🙂 You’ve got a pretty good strategy going with both plans. Our kids don’t do daycare as much, but when they did, we were maxing out our FSA!
You can still easily spend 5k or more on those before/after care expenses and summer care! Until they are 13! The only negative with the daycare fsa is that it is only 5k for the whole household, whether its for one child or 5! Considering I spend $1400+ per month for daycare, that fsa is used up in the first 4 months of the year! And you can only get the money as you contribute it. So we just hold of on requesting it back until nearly year end and take that lump sum for whatever goal we are working on.
Thanks for all the additional information and experience. Aren’t daycare expenses insane?? My wife and I always said we could have bought two houses for the amount we spend. I like your strategy of getting all your money back at once – for some reason I like doing the same thing!
Our employers don’t offer it. We do have a HSA and I do like the concept. I like keeping money in there to pay for doctor’s and dentist’s appointments. I don’t keep very much in it though because it makes 0% interest!!!
That’s too bad neither of your employers offer it. The HSA is also good and its nice that the money keeps rolling over. You may not get interest on it, but it is an excellent bargain to get 25% off your bills by not paying taxes.
Good post. At my last employer we had an FSA, but now that we run our own business we have an HSA, which is very similar. It’s a great way to save on taxes and gives us money for medical needs.
With all the family expenses and costs that come with it, we could all use a little help and take all the tax breaks we can get!
i have to admit.. i have been afraid to go this route in the past, for fear of “losing the money” at the end. i have heard many stories of people rushing to do lasek or other elective surgeries at the end of the year, because they didnt want to lose the FSA money. it obviously erases the potential tax benefits and more if you don’t use the money in your account.
that said, if you know you have medical expenses on the horizon.. for example, if you know that you have braces or a childbirth coming up.. this could be an amazing great idea. i think i am going to explore setting up a low-level FSA at my work as an experiment in 2013
Jefferson, you’ve got the right idea. In the past, we always used our FSA for daycare and maxed it because we were paying an arm and a leg for daycare. However, like you, we avoided the medical aspect because we were afraid we would lose the money. We do have braces, allergy shots, and a few other known medical bills on the horizon, so that is why we set this up this year. What’s nice is you can dictate the amount, so you can start off with a pretty low amount if need be.
I haven’t had a FSA in a few years and when I did I was stuck buying a bunch of bandaids and over the counter meds to spend all of my money in time before the year was over. lol.
That’s pretty funny Jason. When you have kids some day, revisit this! The savings on daycare and medical costs are well worth the effort.
I used to stock up at year end. That was always part of my New Year’s Eve tradition…until last year and Obamacare took that ability away. Can’t buy over the counter meds with your fsa unless you have a script.
Wen we chose our medical options last year it turned out that the difference in the deductible and out of pocket max between the low premium, high deductible plan and the regular plan was LESS than difference in the premiums!
It was worth doing to low premium and having a fully funded hsa (hubby and I were both able to earn an extra $800 by doing minor tasks so with the $1600 from that and our deductions it was maxed out). I think it may be beneficial in the long run to fully fund an hsa (which eventually you do have ability to do long term investing). With healthcare costs growing as they are and employers paying less and less, it would be nice to have money saved up for my own expenses and not be concerned with being covered by someone else!
We are thinking about doing one next year. It’s a great idea, especially if you have the money earmarked for specific medical items or procedures 😉 I think it would come in especially handy when we are getting ready to start a family…might as well get a tax break on that money if you are going to spend it anyway 😉
That is 100% right! If you know you’re going to spend that money anyways, you may as well get a nice tax break! I use that same logic with my credit cards and cash back rewards.
Once again I’m feeling pretty lucky to be living North of the border where medical bills aren’t nearly as concerning. As for daycare, we don’t have any special funds, but whatever you spend on daycare is a tax deduction for whichever spouse earned less income.
Thanks Mandy and welcome to the site! I will say that you Canadians have a great system up there.
We have a Child Care Tax Credit here in the states, but the amount you can get depends on your income situation. It is always a better deal to do the FSA versus this tax credit (at least in my case it is always better). However, it can get confusing with all the claim forms to fill out for it. Not sure if we will elect for the dependent care this year due to the claim forms causing more work for me than I want. We are, however, electing the medical FSA.
My wife’s work offers this. However, we do not put money into this account. We have no children, and her company pays the first $3,000 of our deductible.
If we needed daycare or her company didn’t pay for it i would definitely put money into it. Every little bit helps.
I’m sure as things progress with your family, you’ll start to consider a tool such as this. The important thing is knowing that it exists. There are many people struggling to pay the bills who do not even know this is an option.
Ahhh, I have read a bit on FSAs mentioned before but never completely understood the full benefits. Will most certainly encourage the Hubs to persuade his employer to consider offering the option, as every bit certainly does help. So I am curious: does your family contribute the maximum amounts each year, and is there a flexible spending equivalent for self-employed / entrepreneurs?
We don’t contribute the full amount for fear of the “use it or lose it” caution. We just contribute as much as we know we’ll use during the year. As for the self-employed, that is a good question. Unfortunately, I am not sure what the options are. From the other comments, it seems as though an HSA will work for medical bills. I’m not sure if this would still work for daycare expenses. It seems as though there would be something out there.
I’ve never understood the “use it or lose it” catch in flex spending accounts. Its too much madness and theft for me.
Currently I’m enjoying an HSA account for this one reason. The $$ is mine for life. 🙂
I’m not sure why they have that clause in there either; other than it must be to protect abuse of these accounts. That is a big advantage for the HSA, and I’ll probably look further into that option as well.