Saving Money with Flexible Spending Accounts

My wife just started a new job recently, and as part of the usual new job stuff she had to sign up for benefits. We decided to switch to her health and dental plans to save money, but the best thing is the opportunity to take advantage of Flexible Spending Accounts (FSAs). In my opinion, FSAs are great. If your employer offers them, take advantage of them.

Here’s How Flexible Spending Accounts Work.

The company takes money out of your paycheck before tax in the amount you designate for: (1) health care spending, (2) dependent care, or both. When you incur these expenses, you file for reimbursement of the covered expenses and get a check. In case of the health care spending FSA, you can even get more than you contributed thus far, as long as it’s still within the designated amount — unfortunately, you can only get out what you put in for dependent care FSA.

We pay $1,000 per month for our daughter to attend daycare, so this is an opportunity to save money — basically, you save what you would otherwise pay on income taxes for the amount you designate. In our case, we designated $5,000 for 2010 — the maximum you could reserve for dependent care FSA. As we incur the expenses, we just get our daycare provider to verify that we spent the money with them, fax the form in, and get money back.

The health care version works similarly, but without the validation part.

In case you missed how the money saving magic happens, here it is again. Since the deduction happens before you’re taxed (i.e., pretax dollars), your dependent and health care expenses aren’t costing you quite as much as they normally would. For example, assuming you’re in the 25% tax bracket, you would have to earn $1,333.33 to have $1,000 after-tax to pay for one month worth of daycare. Since the money from FSA is pretax, you essentially saved $333.33 that you would otherwise pay to the IRS and State.

But wait, there is a catch…of course!

Because you have to determine at the beginning of the benefits year how much you want deducted over the course of the year, you may get the amounts wrong.

If you deducted less than your actual expenses, you will end up spending after-tax dollars and missing out on the saving. But that’s not too bad, the worse scenario is when you deducted more than you actually spent. It this case, you’ll lose the amount that you didn’t spend — it’s called “use-it-or-lose-it.”

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