Over the last month, I have written about a couple of CVS shopping trips in which I saved a good deal of money by using Extra Care Bucks (ECBs) , CVS coupons & deals, and manufacturer coupons.

In that article I also mentioned that we purchased over-the-counter medicine through our Flexible Spending Account (FSA), in order to get ECBs.

So, what exactly is an FSA? Well, FSA actually stands for Flexible Spending Arrangement – although most people (and companies) refer to it as a Flexible Spending Account (much like an IRA). Very simply, it is a way to pay for medical expenses with pre-tax income.

Normally, when you pay for medical expenses, this is how it goes: You get paid from your job, taxes are taken out, you take the net amount and spend a portion on medicine or copays.

However, if your employer allows you to establish a Flexible Spending Account, this is how it looks: You get paid from your job, and BEFORE taxes are calculated, a portion is moved into another account that you use to make medically related purchases, then taxes are taken out and you receive a net pay.

How a Flexible Spending Account Works:

The great thing about this is that you pay less money in taxes. Here is a concrete example – let’s say you are paid $52,000 per year and are in the 25% tax bracket. Let’s also simplify this further and assume that this is a steady (not marginal) tax rate – meaning you pay 25% of every dollar you make. We will also assume that the 25% represents all FSA-affected taxes.

You make $2,600 in FSA-eligible purchases in a year. Without the Flexible Spending Account, your normal annual pay would be $52,000 minus $13,000 in taxes or $39,000. You would then spend $2,600 out of that $39k and be left with $36,400 to spend on everything else.

However, if you choose to set up a Flexible Spending Account for $2,600, things would look different. You would be paid $52,000 then the $2,600 would be taken out before taxes are calculated and you would be left with $49,400 in taxable income. You would then pay $12,350 in taxes and have $37,050 to spend on all non-medical spending. Then when you needed money for a copay or a prescription, you would then take it from your Flexible Spending Account.

So in this little example, you had the same gross pay, tax rate, and medical expenses, but you are left with more money to spend on other “stuff”. This is one of the reasons why these plans are so popular.

So, what are some of the specifics of a Flexible Spending Account?

 

• Money diverted into a Flexible Spending Account is not charged any federal income, Medicare, or Social Security tax.
• Most state and local taxes are charged against this money.
• The IRS does not limit the amount that you can put into a Healthcare FSA – however, many employers will set a limit at $5,000 per year.
• You can also establish a Dependent Care FSA, but the IRS limits your contributions. These accounts are outside of the scope of this article.
• You lose the ability to claim on your income tax return any expenses that you paid for using your FSA.
• You lose any money that is not used up by the end of the plan year.
• You can use a Healthcare FSA under COBRA.
• You cannot change your contribution amount during the year unless you have a “qualifying life event” (such as marriage, birth or adoption of a new child, spouse getting a job, etc).
• Only certain expenses are eligible.

How does this affect your tax return?

Normally, you would be able to claim certain medical expenses as a deduction on your taxes. However, since taxes are never taken out of your FSA contributions, any items purchased with FSA money will have to be left off of your tax return. We’ll talk more about this below in the “benefits” section.

The Downsides to a Flexible Spending Account:

The biggest downside to having an FSA is the fact that you are not allowed to carry over unused funds to the next plan year. This “use it or lose it” clause can be difficult to navigate especially since you are not allowed to change your contribution amount (unless you have a qualifying event) during the year.

Before the year starts you have to come up with an estimate of the amount of medical expenses you will have in the next year. And if during the year you realize that your estimate was too high, you will not be able to change it.

But, since you have the ability to buy a wide range of items (even exercise equipment if your doctor suggests it), you can usually find a way to spend the money before the year is out.

Additional Benefits to an FSA:

You Don’t have to Itemize Your Taxes

In order to be able to claim medical expenses on your tax return, you must benefit from itemizing. This means (in most cases) that the total of your itemized deductions must exceed the standard deduction – something that won’t be true for many taxpayers. Even if you are able to itemize your deductions, you still have another hurdle to jump.

The IRS doesn’t even want to hear about your medical expenses unless they are at least 7.5% of your adjusted gross income (AGI)! This means that if your AGI is $50,000 you must have at least $3,750 in medical expenses in order to start counting. That’s right, the IRS only counts expenses OVER 7.5% – meaning that you’ll have to spend $6,350 during the year in order to get a $2,600 deduction!!!

However, with a FSA you only need to spend $2,600 to get a $2,600 deduction, because every penny you put into the account escapes taxation up front!

Get a tax break on a much larger list of items!

Another great benefit of a Flexible Spending Arrangement is that you can get a tax break on many items that you can’t claim on your tax return. On your tax return you can claim copays and coinsurance, deductibles, prescription costs, and other basic medical expenses. Unfortunately, you can’t claim over-the-counter medication, humidifiers, condoms, and other FSA-eligible items.

If you have an FSA, every time you buy Advil, condoms, laxatives, Icy-Hot, and any other medical product, you can pay for it out of your tax-favored account!

No claim forms or reimbursements to worry about!

Also, many FSAs allow you to have a Visa or Mastercard tied to the account, so you can pay for purchases directly out of your FSA! This can save tons of time compared to paying out of pocket and then filing a claim to get reimbursed.

Built in medical budget.

Having a FSA is a great way to establish a budget for your medical expenses. If you know that you will be having certain diagnostic procedures (mammogram, colonoscopy, etc), or must take certain drugs and pay copays for them, or any other medical expense that can be anticipated, you can use the total for your FSA contribution amount.

Reader Questions:

Does your employer offer a FSA? If so, do you take advantage of it?

What is the weirdest FSA purchase that you have made?

Do you have any questions about FSAs?

I look forward to your comments below.

photo credit: Photos8.com