Year-end is an ideal time to assess your benefit options for 2014 including life, health, and other cafeteria plans that may help reduce your tax liability.
One effective, yet often overlooked benefit is the Flexible Spending Account or FSA. Many workers have misconceptions and are unaware of just how helpful these plans can be when it comes to reducing tax liability.
In fact, According to the Centers for Disease Control and Prevention (CDC), only 23 percent of workers are currently taking advantage of an FSA. Since taxes place such a significant drag on household income, it is critical for taxpayers to explore opportunities like the FSA in an effort to keep more of their hard earned income in their own pocket.
So what is an FSA? If offered by your employer, an FSA allows eligible employees to set aside funds on a pre-tax basis to pay for eligible expenses. While there are two types of FSAs — medical care and dependent care — various everyday expenses are eligible and covered. Co-insurance, doctor co-pays, prescription drugs, over-the-counter drugs that are prescribed, chiropractic, psychiatric, dental, orthodontics, vision care and child-care services may all be eligible. Contribution limits apply to each plan: $2,500 per year per person for medical FSAs and $5,000 per year per family for dependent care FSAs.
Since FSA contributions are not taxed, participants may realize significant savings. Although individual savings will vary based upon the participant’s federal and state tax rates, the average worker may save 30 percent or more. For example, let’s assume that a married, working couple with federal and state marginal tax rates of 25 percent and 6.37 percent respectively decide to take advantage of an FSA offered by one of their employers.
Since they have children in daycare, they will be taking advantage of both the medical and dependent care FSA by saving the maximum amount in each. Under this scenario, the family may save nearly $2,800 in taxes — not too bad. The benefits become even more pronounced as your tax rates increase. If all this sounds too good to be true, it partially is. That is because forfeiture rules do apply. In the past, one of the biggest drawbacks of an FSA was the fact that 100 percent of any savings that were unused by the annual deadline were forfeited back to the plan.
Although the typical deadline for eligible distributions is year-end, some companies can elect to use a grace period, extending the deadline into March of the following year.
Additionally, the IRS has implemented new carry-over rules that may provide slightly more flexibility. For the first time, up to $500 of unused FSA funds can be rolled into the subsequent year. For example, if a participant had $1,000 left in an FSA account at year-end, $500 could be rolled over into the next plan year with $500 being forfeited.
Unfortunately, companies are unable to utilize a grace period and rollover feature.
Consider speaking to your human resources department to confirm the specifics of your plan in order to minimize the chance of overfunding your FSA.
In order to reduce the likelihood of saving too much in an FSA, consider putting together an estimated budget for next year’s anticipated medical and dependent care expenses.
Also, consider speaking to your health insurance provider to obtain a list of eligible out-of-pocket medical expenses that you paid this year. While health expenses can vary greatly from year to year, using the past year as a guide can certainly help identify some predictable expenses that may apply. Additionally, families who know they will spend significantly more than $5,000 for child care costs may feel secure knowing that there is not a high probability of forfeiting dependent care funds.
If you are unfortunate enough to have funds left over near year-end, consider using excess funds to purchase eligible items that your family could use. For a complete list of all eligible expenses consider reviewing IRS Publication 502.
The FSA presents taxpayers with a way to pay for out-of-pocket expenses in a tax-efficient way. Failing to take advantage may mean that tax savings are being left on the table.
While there are many advantages to these plans and new carry-over rules add a bit more flexibility, forfeiture rules require taxpayers to plan ahead and monitor their spending on an ongoing basis. Since everyone’s situation is unique, consider speaking to your tax adviser and HR department to determine if an FSA is appropriate for you.
Kurt J. Rossi, MBA, is a Certified Financial Planner Practitioner & Wealth Advisor. He can be reached for questions at (732) 280-7550, kurt.rossi@Independentwm.com or www.Independentwm.com. LPL Financial Member FINRA/SIPC.