Flexible spending accounts cut taxes

In these tough economic times, many people are seeking ways to stretch their buying power. Although cutting back on purchases and avoiding extravagances make sense, another good strategy is to look for ways to trim your tax bill.

As workplace benefits open enrollment season approaches, consider participating in health care and dependent care flexible spending accounts (FSAs), an increasingly common employer-provided benefit that can save you hundreds or even thousands of dollars in federal taxes.

FSAs (also known as reimbursement accounts) let you pay eligible out-of-pocket medical and child care expenses on a pre-tax basis; that is, before federal, state and Social Security taxes have been deducted from your paycheck. Using FSAs to cover expenses you would've paid for anyway reduces your taxable income by those amounts, which in turn lowers your tax bill.

Here's how it works: Say you earn $35,000 a year and have a 25 percent marginal tax rate. By contributing $1,000 to a health care FSA and $3,000 to a dependent care FSA, your taxable income would drop to $31,000, in turn lowering your taxes by $1,000. Larger contributions result in even bigger tax savings.

You can use a health care FSA to pay for any IRS-allowed medical expenses not covered by your medical, dental or vision coverage. This includes deductibles, copayments, braces and other dental work over plan limits, contact lenses, glasses, prescription and over-the-counter medicines, acupuncture and chiropractic care, smoking cessation programs and many more. Check IRS Publication 502 at www.irs.gov for a complete list of allowable expenses.

Dependent care FSAs let you use pre-tax dollars to pay for eligible expenses related to care for your child, disabled spouse, elderly parent, or other dependent incapable of self-care, so you (and your spouse) can work. For some people taking a federal income tax dependent care tax credit is more advantageous, so ask you tax advisor which alternative is better in your situation.

FSA contribution amounts are deducted from paychecks throughout the year. As you incur eligible expenses, you submit receipts to the plan administrator for reimbursement.

Keep in mind these FSA restrictions:

• Maximum contribution amounts vary by employer, but commonly are $2,000 to $5,000 a year for health care and $5,000 for dependent care FSAs.
• Estimate planned expenses carefully because you must forfeit unused account balances. Some employers offer a grace period of up to 2 ½ months after the end of the plan year to incur expenses, but that's not mandatory, so check your enrollment materials carefully.
• Outside of open enrollment, you can only make mid-year FSA changes after a major life or family status change, such as marriage, divorce, death of a spouse or dependent, birth of a child, or a dependent passing the eligibility age. If one of those situations should occur mid-year, re-jigger your FSAs accordingly for maximum savings.
• You must re-enroll in FSAs each year – amounts don't carry over from year to year.

 

To learn more about how FSAs work, go to Visa Inc.'s free personal financial management site, Practical Money Skills for Life (www.practicalmoneyskills.com/learn/life_events/health_care/employer_provided_benefits). If your company doesn't offer FSAs, consult a financial advisor about other ways you can save taxes on health and dependent care-related expenses.

It's not that difficult or time-consuming to estimate next year's health and dependent care expenses – especially if you know it will save thousands of dollars on your tax bill.