July 16, 2021
Whether you have out-of-pocket healthcare expenses or dependent care costs, you may want to consider your employer’s flexible spending account (FSA). An FSA may differ from employer to employer but can save you money and cut your taxes. Before enrolling in an FSA account, you should get a thorough understanding of how your employer’s FSA plan works. That’s because setting aside too much money into an FSA may cost you more in the long run.
Here is what you need to know about an FSA account.
What Is a Flexible Spending Account?
An FSA is a type of savings account that provides tax advantages. When used, it can be a great tax savings tool to effectively pay for qualified out-of-pocket expenses, whether related to healthcare costs or dependent care expenses. It is an arrangement that allows you to stash away pretax dollars for yourself, spouse or dependents. You can establish an FSA account through your employer.
How an FSA Works
The account allows you to contribute money from your paycheck tax-free. In some cases, your employer may also contribute on your behalf, but they are not required to do so. Since contributions made to your FSA are not taxed by Uncle Sam, participating allows you to save more money on qualified expenses.
For example, let’s say your earnings for 2021 are $35,000. You are in the 12% tax bracket and elect to contribute $4,000 to your FSA during the year. Since your FSA contributions are not taxed by Uncle Sam, you will save $480 ($4,000 x 0.12) in income taxes. FSAs give you buying power because they allow you to pay for out-of-pocket (after-tax) qualified expenses with pretax (before-tax) dollars.
What Is the Difference Between a Dependent Care FSA and a Healthcare FSA?
There are two different types of FSAs: a healthcare FSA and a dependent care FSA.
A healthcare FSA is solely used for qualified healthcare costs, such as medical, dental, vision and other qualified medical expenses. Qualified expenses may also include copayments and deductibles, but you cannot pay healthcare insurance premiums with your FSA.
A dependent care FSA is similar to a healthcare FSA but differs in that it only allows for qualified dependent care expenses. To qualify, you may only use your dependent care FSA for expenses for your child under the age of 13 or an adult who is physically incapable of caring for themselves. However, due to the Covid-19 pandemic, the Consolidated Appropriation Act (CAA) of 2021 increased the age limit for dependent children to up to 14 years of age. If your FSA plan permits, you may be able to use any unused FSA funds for your child age 14 and under for both the 2020 and 2021 plan years.
Qualified expenses include preschool, nursery, before and after daycare, summer daycare and other dependent care-related expenses. If your employer offers both a dependent care FSA and healthcare FSA, you can choose to enroll in both.
What Are the 2021 Limits of an FSA?
The amount you contribute to your FSA depends on the type and your filing status.
For a healthcare FSA, you can contribute up to $2,750 for the 2021 calendar year. However, your employer can elect to limit the contribution amount to an amount less than $2,750. The IRS also limits the amount your employer can contribute to your FSA: Even if you don’t fund your FSA account, your employer can make a contribution of up to $500 annually. If you fund your FSA account, your employer legally can match your deposits dollar for dollar.
In March, President Joe Biden signed a $1.9 trillion stimulus package, the American Rescue Plan Act, into law. The legislation increased the 2021 contribution limits for the dependent care FSA only: For 2021, single and married filers can contribute up to $10,500 (up from $5,000) and married filing separate filers can contribute up to $5,250 (up from $2,500) per year. While these limits allow you to set aside more funds, your employer must elect to increase the contribution limits.
What Are the Advantages of an FSA Account?
Contributing to an FSA account has many advantages. The primary ones include:
- Reducing your taxable income
- Reducing the amount of payroll taxes you pay
- Accessing FSA funds right away as needed
As an employee, one of the major advantages is that funding an FSA account allows you to reduce the amount of taxes you might otherwise owe. Your contributions to your FSA are excluded from your gross income, which may result in a significant annual income tax savings.
An FSA also reduces the amount of payroll taxes you are required to pay. Your earnings are subject to payroll taxes, which include Medicare and Social Security taxes up to certain limits:
- For 2021, your first $142,800 earned is subject to 6.2% of Social Security taxes.
- Also, all of your earnings are subject to 1.45% of Medicare taxes. For those who earn above $200,000, there is an additional Medicare tax of 0.09% assessed on earnings that exceed this threshold.
For example, let’s say you earn $75,000 for the year and elect to contribute $5,000 into an FSA. You will save $382.50 ($5,000 x 0.062 + $5,000 x 0.0145) in payroll taxes since your FSA contributions are not subject to both Medicare and Social Security taxes.
Another great advantage of an FSA is that the amount you pledge at the beginning of the year is made available immediately for use. For example, let’s say you decide to contribute $100 per month from your earnings into your healthcare FSA on Jan. 1, 2021. On Jan. 15, you incur dental expenses for uninsured qualified medical expenses of $1,000. You can use your FSA to pay the full amount, although you have only contributed $100 to date to your FSA.
What Are the Disadvantages of an FSA Account?
You have to be careful and think ahead before contributing to an FSA. While of course there are numerous advantages of an FSA, there is one disadvantage you need to consider carefully: If you contribute too much into an FSA, you may forfeit your FSA funds at year-end.
Before deciding how much to contribute, take time out and project your qualified out-of-pocket healthcare and dependent care costs for the plan year. You may want to review the amounts paid in the previous year to gauge just how much to contribute to your FSA plan.
How Long Do You Have to Use Your FSA Account?
How long you have to use your FSA account funds depends on your employer.
Typically, you are required to use your FSA funds before the end of the plan year. However, your employer may elect one of two options. These options include a rollover feature or a 2.5-month grace period.
The rollover feature allows you to roll over any unused funds up to $550 for 2021 to the following year. The amount you roll over does not reduce the amount you can contribute the following year. An employer may also opt to allow you to use your FSA funds for an additional 2.5-month grace period after the expiration of the plan year. In most cases, you will have until March 15 of the following year, if your FSA plan follows a calendar year.
However, the 2020 CAA law allows employers to amend their FSA plan due to the Covid-19 pandemic. Under the law, an employer may amend both their healthcare and dependent care FSAs to extend the grace period to up to 12 months following both 2020 or 2021. The law also allows employees to carry over unused amounts—in excess of the usual $550 limit—from 2020 to 2021 and from 2021 to 2022.
How to Submit Your Payment Request for an FSA Expense
You can request payment for your qualified expenses by submitting a claim to your employer’s FSA administrator. Typically, you will need to provide proof, which may include an itemized receipt or proof of payment. Your payment receipt should include your cost, provider’s name, type of service provided, date and the type of service rendered.
Before submitting your claim request, you should check with your employer to determine what other information is required to submit a claim.
Funding an FSA is a great way to pay for out-of-pocket healthcare or dependent care expenses while also paying less in taxes. It is important to understand your employer’s FSA plans before enrolling. You should do your research about your plan’s election amounts, forfeiture rules and the types of plans that are available to you.