The cost of medical care is increasing rapidly. In 2010, health care expenditures in the United States were nearly $2.6 trillion; that represents a 10-fold increase since 1980.
Over the past 10 years, health care costs have risen over three times faster than wages, just as employers have decreased coverage availability to many employees.
To help families cope with the cost of increased coverage, the Tax Code allows a deduction for medical expenses. However, the deduction is limited to those expenses which exceed 7.5 percent of adjusted gross income (AGI), making it impossible for many taxpayers to receive a benefit. In fact, according to the IRS, in 2001, the last year for which complete data is available, only about 6 percent of all taxpayers claimed the deduction. That percentage is expected to go even lower in 2013 when taxpayers who itemize can only deduct those medical expenses which exceed 10 percent of AGI.
One option that is receiving more attention these days is a flexible spending account (FSA). FSAs are tax-favored benefit plans offered by employers at most companies, including small businesses. The plans can be funded by the employer, the employee or both.
The most common arrangement for an FSA allows you to set aside a portion of your paycheck to pay for qualified health care expenses. Money that is set aside is not subject to income or payroll taxes, which means that you can pay for eligible health care expenses out of pretax dollars.
Think of the math this way. Let’s say you were in a 25 percent federal income tax bracket and pay another 7.65 percent in payroll taxes. If you contribute $2,500 to an FSA to be used to pay medical expenses, you avoid the 25 percent in federal income tax and the 7.65 percent in payroll taxes, or $816.25. That’s a lot of co-pays and prescriptions.
Qualified medical expenses include those as defined under section 213(d) of the Internal Revenue Code and include items like:
In 2013, the amount that you can put away in an FSA is limited to $2,500 per employee (yes, that means that two working spouses can contributed up to $5,000); that amount will be adjusted for inflation in future years. Contributions aren’t limited to employees: an employer may also contribute an amount into the plan on your behalf. In that event, those contributions are excluded from your gross income and are not taxed (just as if you had made the contributions). Further, FSA contributions do not need to be reported on your federal income tax return.
An FSA plan is often used together with a high deductible plan (HDHP) or high co-pay health insurance plans for employees who pay health care premiums out of pocket. That maximizes your savings since higher deductibles, which are reimbursable under the FSA plan, tend to equal lower health care premiums.
The FSA generally works like this: The plan is funded at the beginning of the calendar year and you start spending money on qualified medical expenses. Most of the time, funds are reimbursed to employees upon proof of initial payment for qualified expenses up to the amount in the plan. More recently, employers have begun issuing loaded debit cards to their employees; those largely work the same way (you may be required to offer proof of qualified expenses).
There are some cautions. For one, you may not use funds from an FSA to pay health insurance premiums, long-term care premiums or expenses and amounts that are covered under any other health plan.
Additionally, the FSA is referred to as a “use it or lose it” plan. That means that any contributions to the plan must be used for qualified medical expenses during the year or they are forfeited. In other words, if you overfund the plan, you don’t get the extra money back (it flows back to the plan to cover the costs of administration). You’ll want to plan wisely.
Finally, keep in mind that self-employed persons cannot participate in an FSA and there are limitations on eligibility and contributions for highly compensated participants and key employees.
The specifics of the plan can vary from employer to employer. For more details about how it might benefit your family, ask the personnel or human resources department at your place of work.
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