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What is a flexible spending account (FSA)? Here's how it works

A flexible spending account (FSA) is an employee benefit that allows you to save before-tax dollars on certain medical and childcare costs.

These are separate accounts (referred to here as healthcare and dependent care FSAs). For you to enroll in one or both, your employer must offer this benefit and you must sign up, designating what amount of money you want to be deducted from your pay on a yearly basis.

The amount you elect to contribute to your healthcare FSA is available on the first day of the plan year.

This is different from the dependent care FSA, where once you have actually contributed the funds in the account, you can either directly use those funds to pay for qualified expenses or use those funds to reimburse yourself for qualified expenses you have already incurred. Many employers provide debit cards that you can use to pay for medical or childcare expenses when incurred.

Many medical expenses traditionally not covered by insurance companies, such as over-the-counter medications, prescription eyeglasses and hearing aids, are covered by healthcare FSAs.

However, a doctor's prescription (or note) is now needed for over-the-counter medicines to be reimbursed through a healthcare FSA or health savings account.

In this April 9, 2019 photo, Dr. Megan Mahoney, left, examines patient Consuelo Castaneda at the Stanford Family Medicine office in Stanford, Calif. Rapidly evolving technology and a surge in options like walk-in clinics or urgent care centers are creating many new front doors to health care instead of one main opening through the doctor's office. (AP Photo/Jeff Chiu)
Dr. Megan Mahoney, left, examines patient Consuelo Castaneda at the Stanford Family Medicine office in Stanford, Calif. (Photo: AP Photo/Jeff Chiu)

A big plus

Establishing an FSA carries a significant tax advantage — because you contribute to your FSA account with your pay before taxes are taken out, those dollars are ultimately worth 30 to 40% more than the after-tax dollars that you would have otherwise used (if your combined tax rate is around 30 to 40%).

Here's an example of how it works: if you contribute $1,500 to an FSA, you'll incur a tax savings of approximately $600, assuming a 40% tax rate. The $600 is the 40% that your employer would have taken out of your pay otherwise to cover tax obligations such as Social Security and federal and state income taxes.

So, by participating in a flexible spending account, you have that extra $600 to spend on medical and childcare expenses that you likely would have incurred regardless.

You must do some homework

If you haven't had an FSA before, you need to estimate how much to contribute, because your employer will need you to designate an amount that you want deducted from your pre-tax pay this year.

FSAs have a use-it-or-lose-it feature, whereby if you don't use the money within the year it is contributed — or during a short grace period afterward — you lose the money. Under healthcare FSAs, the first $500 may be exempt from this rule, however. Also, you cannot have both the $500 exemption and the grace period.

When deciding how much to contribute to a healthcare FSA, take a look at your medical expenses for the past year, which should give you a good idea of how much you are likely to spend. If you anticipate large expenses coming up in the current year, such as orthodontic expenses for a child or new prescription glasses for yourself or your spouse, you might want to allocate a higher amount to your healthcare FSA.

In the case of a dependent care FSA, consider how many children you will have in daycare in a given year, whether they will be receiving childcare full-time or part-time, and whether there are any circumstances under which alternative childcare would be available — from a relative, for example — that would be less expensive.

The contribution limits

In 2020, there is a contribution limit of $2,750 for healthcare FSAs.

For a dependent care FSA, the IRS allows you to contribute up to $5,000 a year if you are married and filing a joint return or if you are a single parent; or $2,500 per year if you are married and filing separately. If you enroll in and use funds from a dependent care FSA, you must file IRS Form 2441 when filing your income taxes.

For more information

For more information on allowable health care FSA expenses, see IRS publication 502, Medical and Dental Expenses. This publication refers to those medical and dental expenses allowed as itemized deductions, but also outlines those that are qualified health FSA expenses.

Dive deeper: Health, dental, and vision insurance: A comprehensive guide

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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