Blog by: Michael Sheeran, CFP

Flexible Spending Accounts (FSAs), are one of the most underutilized tools to save on taxes each year. For many employees, they fear the “use it or lose it” provisions so they avoid them, and for others it is just not worth the hassle. In this article, we will cover some of the highlights and whether or not it’s worth your time to take advantage of this tax advantage program.

I will cover:

• What is an FSA?
• Who they are best for
• How to use your FSA
• What can you pay for with your FSA
• How they help employers
• How much you can save on your taxes with a sample family tax analysis

What is an FSA?

A Flexible Spending Account (FSA), falls under IRS Section 125 which allows employees to convert some of their taxable income into non-taxable benefits. The most common FSA types are the medical and dependent care. The maximum annual election for 2020 is $2,750 for medical, and $5,000 for dependent care.

The FSA allows you to defer some of your earnings into this special account that is to be used for qualified medical expenses or for dependent care. There are some other options as well, but these are the most common uses.

How Much Can I Contribute?

The IRS allows you to defer up to $2,750 in 2020 for a medical FSA and up to $5,000 per year for a dependent care FSA.

When you elect the coverage, your employer will split up the amounts over your annual paychecks and deposit the money into your account. They do this by withholding the amount from your paycheck on a pre-tax basis. A third-party administrator will handle everything and will set up the account along with a debit card and checkbook.

As an example, if you elect a $1,200 a year benefit, your employer would deduct $100 a month from your paychecks to be used for medical expenses.

What Can I Use The Money For?

The medical FSA must be used for qualified medical expenses. This includes things like dental care, vision, medical etc. You can look up the items line by line in IRS publication 502.

For the dependent care FSA (DCA), there are a few extra rules involved. In order to qualify for the tax-free benefit, the care must be necessary to allow you and, if married, your spouse to work and earn an income or attend school full-time.

The eligible expenses are:

• Child Care
• Adult Care
• In-home dependent care
• Before and After School Care
• Nursery School

What If I Don’t Use All Of The Money?

This is one of the gotchas about the FSA plans that people don’t like. Traditionally with these setups, they are use it or lose it. Meaning, if the money isn’t spent, it gets forfeited to your employer.

Thankfully, most plans now will have special rules that will allow you to have an additional grace period to use the money after the calendar year ends, OR the ability to rollover up to $500 into the next year.

The grace period provides up to 2 1/2 more months to use whatever medical FSA funds you have left. Unfortunately, there is no grace period or rollover for the dependent care account.

How FSAs Help Employers

For you to participate in an FSA, your employer has to support this and set the plan up. For them, it means extra administration and there is also a cost involved. From what I’ve seen, it can be a few hundred dollars a year or thousands depending on how many employees are in the company.

The biggest benefit for employers is that they aren’t paying FICA on any of your contributions. This means they save 7.65% on every dollar you defer.

For every thousand dollars that goes in, they save $76.50.

In addition to saving on FICA, the use it or lose it rules will benefit them. If an employee has $1000 left in their account at the end of the year, they can roll over $500, but they forfeit the other $500 to the employer. This money can be used to help pay for administration or other losses. Which leads me to my next point…

How FSAs Hurt Employers

Unfortunately, the benefits to employers aren’t so cut and dry. Yes, they save on FICA, and can recapture unused funds, but they also have some risks, especially when participation is low.

With an FSA, the money you defer is 100% available to you on the first day of the year. If your family defers $1,500, that whole sum is available on day one even if you haven’t paid a penny from your salary.

The money comes from the employer. The employer is obligated to have the money available to each employee so this can be a big risk to them if cash flow isn’t great. Picture a small employer with 10 employees that have chosen to defer $2,000 each. That’s $20,000 the employer could potentially have to contribute right away without receiving anything from the employees.

Not only that, if you use the money and then leave during the year, they have no recourse for getting the money back. It’s a loss for them. That is why they have the recapture rules for unused funds.

It’s not all bad though, if the plan runs well and participation is good, the employers stand to save over the long run.

Only the medical FSAs have the upfront funding rule. The dependent care FSAs do not. With the DCA, the money is credited to your account monthly as you contribute.

FSA Tax Savings!

Finally, the big benefit of the FSA. Tax savings!!! It’s not huge, but it adds up. If you take advantage of the FSA, along with other strategies, it can make a big difference in your financial picture.

To simulate the tax savings, I used an online tool from WageWorks, a third-party administrator of the FSA accounts. I used their tool to simulate an income a total income tax rate of 30%. I used medical expenses totaling $2,750 and dependent care expenses totaling $5,000.

WageWorks: Dependent Care FSA Savings Calculator

WageWorks: Medical FSA Savings Calculator

According to the WageWorks tool, this family would save $825 annually by using the medical FSA and $1,500 using the dependent care FSA. That’s $2,325 in savings just by using the FSA to pay for services.

Medical Expense Deduction

But can’t I deduct medical expenses anyway? Maybe, maybe not. In 2020, the IRS allows you to deduct medical expenses that exceed 10% of your adjusted gross income (AGI). This means if you have an AGI of $100,000 and expenses of $12,500, you can only deduct $2,500 of those expenses. But again it’s not that cut and dry, and to use the medical expense deduction, you have to itemize your deductions.

With the much higher standard deduction today of $24,800 for married filing jointly, its less common for families to itemize, and it favors using the FSA even more so.

*Please do your own research and consult with your trusted tax advisor before making any tax savings assumptions mentioned in the article. The laws are constantly changing and they can give you personalized advice on your situation.

Related Questions

Are Flexible Spending Accounts worth it? Yes, as long as you have somewhat predictable medical expenses each year, and/or dependent care expenses. You can expect to save around 20- 25% in taxes on every dollar you put in. As your income rises, your savings increase.

Is FSA money available immediately? Yes, on the first day of the plan year or after your new employee wait period, you can access 100% of the money. Dependent Care FSA’s are not available immediately. As the money is withdrawn from your checks, it then becomes available.