Does your employer offer a cafeteria benefit package? If so, the benefits that probably pop up in your mind include: health insurance, a qualified retirement plan and life insurance. But you may have one other optional benefit that you've ignored. A healthcare flexible spending account (FSA) is a benefit that could give you a return this year that puts many other investments to shame. Read on to learn more.

A healthcare flexible spending account (FSA) is an employer-established plan that lets you deduct dollars from your paycheck and put them into a special account that's protected from taxes. You can then use this money to pay for eligible healthcare expenses incurred by you, your spouse and your dependents.

No Social Security (FICA) or federal income taxes are withheld from your contributions to this plan and, in most cases, state income taxes are not deducted.

Your employer may also contribute if specified in the plan. These contributions can be excluded from your gross income, and withdrawals are tax free if you pay qualified medical expenses.

Medical Expenses
Qualified medical expenses are those that would generally qualify for the medical and dental expense deduction on your income tax return.

They include:

  • Healthcare plan deductibles
  • Co-payments
  • Amounts over the maximum your health plan pays
  • Other expenses not covered by your health plan
  • Mileage to and from medical services

The complete list can be found in IRS Publication 502: Medical and Dental Expenses.

You cannot receive distributions from your FSA to reimburse you for amounts:

  • Paid for health insurance premiums
  • Paid for long-term care coverage, or
  • expenses covered under another health plan

And even though non-prescription, over-the-counter medicines (other than insulin) do not qualify for the medical and dental expense income tax deduction, they do qualify as expenses for FSA purposes. That means you could end up with double-digit discounts on items you take every day, such as aspirin and vitamins.

If you are self-employed, you're not eligible for an FSA.

How To Get Started
At the beginning of the plan year, you must designate how much you want to contribute to your FSA. Then, your employer will deduct money periodically (generally, every payday) in accordance with your annual election.
You can change or revoke your election only if there is a change in your employment or family status that is specified by the plan.

There is no limit on the amount you or your employer can contribute to an FSA. However, the plan must prescribe either a maximum dollar amount or maximum percentage of compensation that can be contributed to your health FSA.

Huge Savings
Let's take a look at how this works.

Suppose, for example, that you're in the 25% tax bracket and estimate that you spend $2,400 a year on qualified medical expenses. If you put that $2,400 into an FSA, these expenses would end up costing you around $1,616.40.

Amount put into FSA $2,400
Federal income tax savings ($2,400 x 25%) ($600)
Social Security tax savings ($2,400 x 7.65%) ($183.60)
Total tax savings ($783.60)
Net cost $1,616.40

After you file for reimbursement, you'll get a tax-free check for $2,400. So, if you factor in the tax savings, the net cost you'll pay for the $2,400 of medical expenses is only $1,616.40. That's a 32.65% discount. Or, put another way, your $1,616.40 grew to $2,400, a 48.5% ($2,400/$1,616.40) return.

What's more, any state income tax savings could make your FSA sweeter yet!

And if you are in the highest tax bracket (35%), you'd be looking at savings around $1,376.40.

Amount put into FSA $2,400
Federal income tax savings ($2,400 x 35%) ($840)
Social Security tax savings ($2,400 x 7.65%) ($183.60)
Total tax savings ($1,023.60)
Net cost $1,376.40

That's like getting a 42.65% discount on qualified expenses. Or/ from an investment standpoint, a 74.37% ($2,400/$1,376.40) guaranteed return on your money!

How You Get Your Money
Generally, distributions from an FSA will be paid only to reimburse you for qualified medical expenses you had during the period of coverage. You can receive the maximum amount of reimbursement (the amount you have elected to contribute for the year) at any time during the coverage period, regardless of the amount you have actually contributed.
Your company's FSA administrator will require receipts showing the amount of the expenses. And you must also provide a written statement that the expenses have not been paid or reimbursed under any other health plan coverage.

If You Snooze, You Lose
Money you contribute to your FSA that you do not spend by the end the plan year is forfeited. That's why it's very important to base your contributions on a conservative estimate of the qualifying expenses you'll have during the year.

The plan, however, can provide a grace period of up to three months after the end of the plan year. If there is a grace period, any qualified medical expenses you had in that period can be paid from any amounts left in the account at the end of the previous year.

You now know how you can cut medical expenses, pay less in taxes and end up with a hefty return on your money, but there is also one thing to remember - since participation in an FSA reduces your gross taxable income, the total taxable income used to calculate your Social Security benefits may be reduced. Usually, the current tax savings under the FSA will outweigh the slight impact on future Social Security benefits.

Check with your employer's human resource department to see if it offers an FSA. If not, send them a copy of this article. For no more than the administrative cost, your employer can add this benefit to its cafeteria plan for a surefire way to boost employee loyalty and attract new talent.

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