Flexible Savings Accounts

Woman counting pennies with savings jar on table — An FSA can offset your out-of-pocket medical expenses and pay for your monthly health insurance premiums. Peter Dazeley / Getty Images

A flexible spending account (FSA) is a tax-advantaged financial account into which you can automatically deposit a portion of your pretax paycheck. You can use the money in the account to pay for qualified medical expenses not covered by insurance, like dental and optometrist visits, certain "FSA-approved" over-the-counter medications and supplies for chronic conditions. FSAs can be beneficial to you and your employer -- the company can save money on payroll and tout an FSA as a great benefit, and you both can save on social security taxes. Plus, if you use it correctly, an FSA can help to offset your out-of-pocket medical expenses and pay for your monthly health insurance premiums. You can even use different types of FSAs to pay for your day-to-day expenses of caring for a dependent, or to cover adoption expenses.

Let's dig a little deeper and explore the ins and the outs, along with the pros and cons, of an FSA. There are a few kinds of FSAs available, but we're going to focus on medical FSAs.

The Ins and Outs of Flexible Spending Accounts

Once you decide to take advantage of an FSA, you need to determine an annual allotment. You can figure out the amount by totaling the health care expenses you think you'll have that year. Think about your expenses from last year and any upcoming medical procedures not covered by insurance, like LASIK eye surgery. Once you have the total, divide it by the number of pay periods remaining in the year, and the money will be automatically transferred from your pretax paycheck into an FSA.

For example, if you plan to contribute $2,000 at the beginning of the year and you get paid 26 times a year, $76.92 would automatically be deducted from each paycheck and added to your FSA. You can't change the amount once you've decided, but exceptions can be made for events like the birth of a child or the death of a spouse. You can take out money whenever you need it to cover qualified expenses.

You can use a debit card, also known as the Flexcard, to withdraw money directly from your FSA. This system also has the added benefit of automating the IRS approval process for FSAs, which, pre-Flexcard, required a good bit of paperwork and people to process it. But just because you made a qualified purchase on a Flexcard doesn't always mean you can ignore the paperwork. You'll have to prove or pay all transactions on an FSA debit card. So, because the automatic approval process still doesn't work everywhere, you could still find yourself supplying the IRS with the proper documentation from doctors, medical-equipment providers and pharmacists.

Next, we'll learn about a few more pros -- and one big con -- of the FSA.

Flexible Spending Account Advantages

There are several reasons to take advantage of an FSA if your employer offers it. In addition to the tax savings mentioned above, most FSAs are also prefunded. That means if you pledge $2,000 to the account for the year, it's available to you immediately if an emergency arises. Many users also find that an FSA is an easy and effective way to budget for medical expenses throughout the year, especially if you suffer from a chronic condition and need supplies or doctor's visits on a monthly basis.

Perhaps one of the most convincing reasons to take advantage of an FSA is that it could actually increase your amount of take-home pay. This is because the money added to the FSA is not subject to payroll taxes, which could then lower your tax bracket and lower your annual income tax payments. If your taxable income is lowered, your weekly take-home pay can go up.

This argument may make you want to run out and contribute as much as you can to your FSA, but beware -- you can get burned. A major con to an FSA is the "use it or lose it" rule. All unused money in your FSA at the end of the plan year is given to your employer. So it's really important to be conservative when figuring your yearly FSA pledge and to try and match it as precisely as you can to your actual medical expenses. If not, you could lose a lot of your own money, and you might even end up owing taxes on all that money you didn't spend. A slightly less immediate, though no less serious, consequence of this reduction in taxable earnings is that it can reduce your Social Security benefits during retirement.

Next, we'll get the details on the other kinds of FSAs.

Types of Flexible Spending Accounts

There are a few types of FSAs available, though two are more prevalent than the others. Medical is the most popular. With innovations like the Flexcard and prefunding becoming more widely available, this kind of FSA is getting easier to use and gaining a much broader popularity with both employers and employees.

A second kind of FSA reserves money for the care of dependents. Many people use them for child care expenses, but it can also fund the daily care of dependent adults. Usually, dependent-care FSAs are more complicated than medical accounts because the costs of substantiation are much higher. Dependent-care FSAs are not prefunded -- costs are reimbursed only after careful scrutiny of the appropriate documents. These accounts are also losing popularity thanks to changes in tax codes that make tax credits more attractive than the pretax deductions found in the dependent-care FSAs.

In recent years, companies have also been providing a separate FSA for adoption services, though these aren't as popular as the medical and dependent-care FSAs.

To learn more about flexible savings accounts, check out the links on the next page.

Flexible Savings Accounts

The Ins and Outs of Flexible Spending Accounts

Flexible Spending Account Advantages

Types of Flexible Spending Accounts

Lots More Information

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