Are you familiar with flexible spending accounts (FSAs)? You might have heard about them through your HR department and wondered, “How would this benefit me?” or “How exactly does an FSA work?”
These were the same questions my wife and I had when we started our jobs years ago, trying to save every penny we could. Initially, an FSA might seem like another way to take money out of your paycheck. For most people, that’s a deal-breaker. With taxes, social security, and retirement contributions already reducing our take-home pay, do we really need another deduction?
Surprisingly, yes! A flexible spending account can be incredibly beneficial for tackling two major expenses: medical costs and dependent care, like daycare.
Similar to retirement accounts, the big perk of an FSA is that it allows you to set aside money from your paycheck before taxes are taken out. Though it might not seem like much at first, this tax advantage can save working families thousands each year.
Sounds good, right? So, how do you sign up for an FSA?
First, let’s define what an FSA is. Known by the IRS as “flexible spending arrangements,” an FSA is a special financial account you contribute to and use to reimburse yourself for medical and dependent care expenses using tax-free money.
Much like retirement accounts such as a 401(k) or IRA, FSAs are another way the IRS allows you a tax break to help reduce financial strain on working families. Medical and daycare costs can add up quickly, and they are often unavoidable. By giving some tax relief in these areas, it creates a saving opportunity that can result in thousands of dollars saved annually.
It’s important to note that an FSA is different from an HSA (health savings account). While both use tax-free money for medical expenses, they function differently and have different qualifications.
Despite how complicated an FSA may sound, they are actually quite simple and manageable. Here’s how an FSA works:
Think of it as a special advance payment or bank account that you receive upfront and pay back throughout the year. Now, you might wonder, if I’m just paying back the money I take out, what’s the point of having an FSA? The key is that your contributions are tax-free, meaning the money is taken out of your paycheck before taxes.
Let’s dive into an example. If you set aside $296.15 every paycheck into your FSA, without the FSA, that amount would be taxed. If you’re in the 22% tax bracket, you’d only get about $231 out of that $296.15. By contributing to your FSA, you keep the entire $296.15, effectively saving $65.15 per paycheck or $1,694 annually.
This tax saving is a significant benefit for families that often feel strapped for cash.
It’s crucial to remember that FSAs for medical and dependent care are treated as separate accounts. You can’t submit receipts for medical expenses to claim from your dependent care FSA, and vice versa. Also, you don’t need to contribute to both; you might only need a medical FSA if you don’t have dependents.
However, there’s a catch known as the “use it or lose it” rule. This means if you don’t submit enough expenses to reclaim all your contributions for the year, you lose the extra funds. So, it’s essential to estimate realistically how much you’ll need for the year. Some plans provide a grace period of a few months or allow you to roll over up to $500 to the next year. Check with your HR department for your specific plan details.
You can elect to contribute up to $5,000 annually to your Dependent Care FSA, potentially saving up to $1,100 in taxes if you’re in the 22% tax bracket. Eligible expenses include daycare bills, which can often be as significant as mortgage payments. Discovering an FSA can offer substantial relief to families with young children and their associated costs.
For a Medical FSA, you can choose to contribute up to $2,700 annually, saving up to $594 in taxes if you’re in the 22% tax bracket. Qualified medical expenses are quite broad, ranging from major medical bills to smaller health-related purchases.
FSAs are an employer-sponsored benefit similar to a 401(k) and should be offered through your workplace. Check with your HR department or your spouse’s employer if they offer FSAs.
According to the IRS, you cannot contribute to both an FSA and an HSA simultaneously as it would be considered “double-dipping” in tax benefits. HSAs differ in that they don’t follow the “use it or lose it” rule, and the funds can grow tax-free over the years.
Generally, if one spouse has an FSA, the other cannot also sign up for one, to prevent double-dipping. However, one spouse can have a dependent care FSA while the other has a medical FSA, as these are treated separately.
By utilizing a flexible spending account, families can gain significant financial benefits and better manage their medical and dependent care expenses.
