Finance 101: Understanding Your Flexible Savings Account (FSA)
Hey there! If you’re following along this is part three in my Finance 101 series.
If you’re still employed and your employer hasn’t dropped your healthcare program then your open enrollment period is about to begin. There is where you get to change your healthcare options. If your company offers a flexible savings account or an FSA this is also the time for you to select how much money you would like to contribute to that account for the next year. Last year I realized that many people didn’t understand how the whole flexible spending account thing worked and how it can benefit you. You won’t be a part of that group after this post. If you want the short, short version then it’s simple: money for healthcare expenses is deducted on a pre-tax basis thereby reducing your taxable income. Now you may go. For those who want to understand how it works, read on.
First, there are two major kinds of FSA’s. The first and probably most popular is the medical FSA. The other is dependent care FSA. The names are pretty self-explanatory. The medical FSA allows you to pay for healthcare based fees that you incur over a calendar year that are not covered by your health insurance. That includes over-the-counter medications (bandages even), vision and dental care. Sorry, but the cosmetic surgery you’ve been saving up for won’t count! The same goes for teeth whitening and insurance premiums too. Yeah that one annoys me too. I like to keep on the right side of the law so you should probably read IRS publication 502 which pretty much lists everything that’s covered and not covered. Oh, and individual employers determine the maximum that you can set aside.
A dependent care FSA allows you to pay the cost of out-of-pocket child care expenses for dependents under the age 13. Dependent care FSA funds can also be used to pay for elder care expenses for older dependents incapable for self-care as long as they are your dependent. The annual maximum is set at $5,000 per household ($2,500 if married and not filing a joint tax return) and funds are available as they are contributed. You can use these funds for things like daycare, pre-school, babysitters and home health workers. Read IRS Publication 503 for more information on that.
In order to participate in a FSA you have to let your employer know how much you would like to contribute during open enrollment. Your employer will divide the total amount that you would like to set aside by the total number of paychecks that you will get within a year. So let’s say you’re paid every two weeks and you want to put away $1,000 for the year. If you end up with 26 paychecks for the year then your employer will deduct $38.46 from each paycheck. The good part is that the total amount that you allocated for the year is typically immediately available to you! So you can spend and claim $100 and get reimbursed for it before your employer actually deducts $100 total from your paychecks. Yeah, it’s great, I know. There are some catches though.
If you don’t use the total amount of money that you set aside, you lose the balance. Some employers will give you a grace period beyond the end of the year during which you can incur and claim for additional costs. So yes, use it! Also, you can’t change your allocation amount after open enrollment. Actually, there are a few exceptions. The IRS says that you can change or stop your FSA contributions only within 31 days from the date of a “qualified change” in family status such as marriage, birth of a child, or divorce. Another thing – sometime you can’t just take the money and run! If you get reimbursement for expenses that total more that you’ve contributed and you either leave your employer or are fired, your employer can request reimbursement for the money. Don’t say that I didn’t tell you.
By now you’re probably, thinking, well that all sounds complicated so what’s in it for me? Well, if you know that you’re going to have a major medical event (like a baby or something) you can plan for these expenses. Also, the biggest benefit is that you save income taxes and reduce your taxable income. If you’re in the 30% tax bracket and put away $1,000 then you’ve just saved $300 in taxes! KA-CHING! That’s actual money in your pocket. It’s a legal way to avoid taxes.
I think that’s it! If you want to read more about flexible spending accounts and other plans, IRS Publication 969 gives a great overview of them.
2011 UPDATE: Some of the sweeping healthcare rules passed by President Obama will affect how your FSA works. The major change is that you can no longer claim OTC or over-the-counter medications for healthcare reimbursement. You can still use it to pay copays for medical visits and prescribed drugs, glasses and contact lenses, and a host of medically necessary items and procedures. For OTC medications, you can claim it on your FSA if your doctor writes a prescription for it. be sure to view the IRS publication mentioned above to get all of the rule changes.
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