We’re all looking to reduce our income tax bill.
Not sure anyone’s looking to leave Uncle Sam a tip, after all.
One of the more interesting and useful ways to take a benefit right off the top of your earned income is to use a tax-free health or flexible spending or savings account.
The dollars contributed to these accounts, when used on a wide variety of medical expenses, are never taxed.
There are a bunch of different flavors of these tax-advantaged health care accounts, and depending on your employer, you might have access to one or more kinds.
Let’s dive into FSAs with this guest post from T.R. Smith of Paychecks and Profits.
My First Encounter with an FSA
I remember the first time I encountered a Health Care Flexible Spending Account (FSA). I finished grad school and got my first good-paying job. I was sitting through a presentation on benefits and the speaker told us that we could sign up for the FSA as an employee benefit. She said we could save money on taxes and use the money for things like visits to the doctor and prescription drugs.
I thought it was interesting, but I assumed it did not apply to me. I did not have any prescriptions and I had not been to a doctor in years. I figured it was a waste of money.
Years later, I figured out I had missed the boat. The FSA allows you to reduce your taxes and spend the FSA funds on many more things. I could have used it for new eyeglasses or contact lenses. I could have used it to buy a neti pot or band-aids or a thousand other things. I just wasn’t paying close enough attention – and the person explaining the benefit did not try to drive the point home to me and the other new employees.
What is a Flexible Spending Account?
A Flexible Spending Account (FSA) can be an important tool to help you meet financial goals to save more and reduce your taxes. An FSA is generally only available as part of an employee benefits package.
FSA accounts allow you to use pretax dollars to pay out-of-pocket medical expenses. You can use the money in your FSA for medical copayments and deductibles and tons of other qualified medical expenses. See this list for a comprehensive look at what you can spend your money on.
It can be used for a wide variety of goods and services including bandages, birth control, breast pumps, some dental costs, prescriptions, eyeglasses, contact lenses, fertility treatments, guide dogs, hearing aids, medical co-payments, and much more.
FSA Tax Benefit
The maximum amount you can put into an FSA in 2022 is $2,850. When you participate in this benefit, your employer deducts an amount from each paycheck to fund it. This means that you will reduce your taxable income by whatever you put into the FSA.
Let’s assume for the moment that you are in the 35% tax bracket. This means that as a single person you earn $215,951 to $539,900 in 2022. As a married couple, you earn $431,901 to $647,850 in 2022. When you filter money through your FSA, you do not pay federal income tax on this amount and you also do not pay payroll tax. Your combined payroll tax is 7.65% (6.2% for Social Security and 1.45% for Medicare).
This means that anytime you use your FSA you are effectively earning a 42.65% profit on your contributions. Is there anywhere else you can put your money this year to earn a 42.65% profit with little to no risk? I didn’t think so. The FSA is a very valuable tool to reduce taxes and ultimately build more wealth.
Keep in mind that only the first $147,000 of your income is subject to the 6.2% social security tax. If your income is very high, you might not get the full benefit of these savings. It may depend on what you and your spouse earn and whose employer is providing the benefit.
There Is a Catch
The FSA is not a normal savings account since it is a benefit designed to finance your annual out-of-pocket medical expenses. You can lose whatever amount is left unspent in the account at the end of the year. Since there is some risk of losing money that you put into the FSA, try to plan out your health care spending ahead of time if you can.
Keep in mind that you can also use any extra money to stock up on things that you will need in the future. Check out FSAstore.com for ideas on where you can spend your money. Amazon also has an FSA store where you can browse and spend your tax-free dollars.
HSA versus FSA
How is the FSA different from the HSA?
The biggest difference between flexible spending accounts (FSA) and health savings accounts (HSA) is that you have more control over your HSA and can save up contributions over several years to build wealth. The FSA is less flexible and requires you to spend the money in the account each year.
The HSA will allow you to invest your funds and take advantage of compound interest over time. The HSA also requires you to use a high-deductible health plan (HDHP). For people that do not want to use an HDHP, the FSA will give you some of the same tax benefits you would have had with an HSA
In many cases, you cannot be enrolled in an FSA and an HSA at the same time. Consult with your specific plan provider for details on what is available to you.
The Dependent Care FSA
Check if your employer (or spouse’s employer) offers a dependent care FSA (DCFSA) plan. It is a pretax benefit account that is used to pay for eligible dependent care services including daycare, before- or after-school programs, and child care for children under the age of 13. It can also be used to care for your spouse or a relative who is physically or mentally incapable of self-care and lives in your home.
You can contribute up to $5,000 in 2022 if you are married filing jointly or are a single parent. If you have a child in daycare or if you have any type of nanny, it is likely that you will easily use up the $5,000. If you are married and filing separately, you may contribute up to $2,500. In some cases, your employer could set a lower contribution limit.
The tax benefit of this plan works the same way as the health care FSA. With our previous example above you could save 42.65% in taxes on your contributions. On a $5,000 contribution, you would get back $2,132.50 in tax savings. That is an excellent return on your money!
Any money you contribute to a dependent care FSA must be used up that year or forfeited (just like the health care FSA). A dependent care FSA plan allows a reasonable time for employees to submit claims after the end of the year, but the expenses must be incurred by the end of the year.
You should also verify if you and your spouse are eligible for the plan. If your spouse does not have any earned income, you might not be eligible for the benefit.
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Maximize Your Employee Benefits
Most of the biggest personal finance gurus and financial advisors have neglected to educate their followers about the power of using employee benefits. Maybe this is because it is hard for the advisor to make a profit from this type of advice.
However, I have written an entire book about the profits available to you through some popular benefits programs. The book is titled “Paychecks and Profits: How to Maximize Employee Benefits, Reduce Your Taxes, and Build Generational Wealth.”
It covers the most popular employee benefit programs that can help you create wealth including 401k plans, Roth IRAs, health savings accounts, health care FSAs, dependent care FSAs, employee stock purchase plans (ESPP), QTF commuter benefits, and much more.
The Missing Ingredient for FIRE
Educating people about their employee benefits could be the missing ingredient for people dedicated to FIRE. If your goal is to save as much money as possible and build wealth as rapidly as possible, it is imperative that you understand ways to reduce your taxable income and put money back in your pocket.
These are simple money hacks that can make a big difference to your financial future.