Flexible Spending Accounts (FSA) – Great Benefit with a few caveats!

Flexible Spending Accounts (FSA) allows for setting money aside from before-tax paycheck for use with health and dependent care expenses. This benefit provides a potential to save on taxes, as the money reserved for this purpose is not taxed.

There are two kinds of accounts – one for medical and one for dependent care (daycare) expenses. IRS restricts the maximum amount allowed in each category. For a dependent care FSA, the maximum contribution limit varies between $3000 and $6000 based on one’s tax-filing status (married filing joint vs single, head of household) and the number of dependents. For healthcare FSA, there is no IRS limit per se, but plan administrators and/or employers put a ceiling on this ranging from $2500 to $5000.

The tax benefits also differ largely between dependent and health care FSAs. With dependent care FSA, opting for the dependent care tax credit instead of the dependent care FSA is better in numerous instances – to calculate the exact savings or deficits, please refer to the comparison tables at MHM Resources LLC. Even with the likely savings possible when opting for dependent care FSA, the “use it or lose it” rule makes it prudent to opt out, unless those savings are significant. "Use it or lose it" refers to the IRS rule that states that Employees who elect a Dependent Care FSA in a calendar year must incur and use the money by December 31st of the year the election is made.

For a healthcare FSA, the tax benefits are much more straightforward –there is no medical expenses tax credit and the medical expenses deductible only applies to expenses over 7.5% of gross income and that too only if the choice is to deduct expenses as opposed to taking the standard deductible –this combination makes it unlikely that you will benefit by not opting for the medical FSA. The trick however is in deciding how much amount to contribute. The “use it or lose it” rule is more of a problem with healthcare FSA’s as it is much more harder to predict expenses accurately – the general rule of thumb is to lean more on the conservative side when deciding on the contribution amount to reduce the risk of losing part of your contribution.

Our experience:

We have opted for both the dependent care and healthcare FSA’s whenever we were eligible. By being conservative in the contribution amounts chosen and by diligently keeping all receipts, we have been successful in claiming the entire contribution so far. The conservative strategy however is not ideal because we miss out on taxes we cannot claim on some of our expenses because of our low contribution.

Over the years, we have dealt with several FSA administrators including Blue Cross, Cigna, Aetna, and Loomis. In our opinion, the requirements for claiming expenses have become more rigid over the years. Just last year Loomis made it really tough to claim many of the routine expenses:
  • It was mandatory that we submit itemized bills for all doctor’s visits where earlier standard receipts from the office sufficed. Calls to the doctor’s office and follow-up calls were required on our part to ensure our claims qualified, and
  • Many bills were rejected the first time around on the grounds that the expenses were not allowed per IRS Publication 502. Further conversations were necessary to point out that the expenses incurred were not among those listed under exclusions in the publication.
  • Turnaround time was much longer than specified.

Caveats:

  1. Expenses that are not allowed – For healthcare FSA, IRS publication 502 lists the expenses that are not allowed including cosmetic surgery, health club dues, etc. For dependent care FSA, one can only claim expenses only for qualified dependents as defined by the exemptions on your federal income taxes.
  2. Documentation and Deadlines – The documentation for the expenses incurred that is submitted as claims vary widely based on the FSA administrator and sometimes there can be extremely stringent rules. It is best to test the waters earlier in the year to avoid a scramble as the deadline approaches. The deadline for submitting claims is usually set to March 31 of the following year.
  3. Tax ID Number – Provider Tax ID Number is required for all receipts when submitting dependent care expenses. Not all service providers include this required information in their standard receipts and can be a hassle.
  4. Conflict of Interest Issues – FSA administrator service vary widely depending on the service provider and their contract with one’s employer. The worst-case conflict of interest occurs when the contract calls for the FSA administrator to absorb the unclaimed amount. Unfortunately, then it is in their best interest to reject as many claims as possible. Usually, the funds are placed in a trust or are controlled by the employer. But, smaller employers do not have much bargaining power leaving a possibility that the agreement can be unfair to the employee. ,
  5. Dependent care FSA administrators sometimes state that a dependent care FSA can be used in conjunction with the child and dependent care credit. What they omit to mention is that doing so will not result in any additional savings since the cap for the maximum expenses claimable still applies and the same expenses cannot be claimed twice.

Summary:

It is clear that due diligence is required on our part and the benefits need to be evaluated carefully before signing up. Service levels vary widely depending on the FSA administrator and their contract with your employer. Also, there are several caveats to be considered. Even so, in most instances the tax benefits far outweigh the hassles involved.


Related Posts:
  1. Flexible Spending Accounts (FSA) – Great Benefit with a few caveats!.
  2. Writing Covered Calls against Employer Stock Plan Shares (ESPP, Restricted Stock, and Stock Options) – A Primer.
  3. Employee Stock Purchase Plan (ESPP) and 401K Retirement Plan Annual Enrollment and Contribution Review.
  4. Employee Stock Purchase Plan (ESPP) - Immediate Selling Strategy.
  5. Realizing Long-Term Capital Gains With Stock Based Compensation.
  6. Stock Based Compensation Tax Optimization Strategies.

Last Updated: 01/2011. 

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