Maximizing tax savings with flexible spending accounts

Flexible spending accounts, or FSAs, are powerful tools that allow you to set aside pre-tax dollars to pay for eligible out-of-pocket medical and dependent care expenses. By contributing to an FSA, you can significantly reduce your taxable income and potentially save hundreds or even thousands of dollars on taxes each year. In this comprehensive guide, we'll explore the benefits of FSAs, eligibility requirements, types of accounts, and strategies to make the most of this valuable tax-saving opportunity.

What are Flexible spending accounts?

Flexible spending accounts are employer-sponsored benefit plans that enable employees to allocate a portion of their earnings to designated accounts before any taxes are deducted from their paycheck. The money in these accounts can then be used to pay for qualifying medical or dependent care expenses throughout the year.

There are two main types of FSAs:

Health FSAs:

These accounts cover eligible out-of-pocket medical, dental, and vision expenses for you, your spouse, and your dependents. Qualifying expenses may include deductibles, copayments, prescriptions, and certain over-the-counter items.

Dependent Care FSAs:

These accounts allow you to set aside funds for child care or adult dependent care expenses that enable you (and your spouse, if married) to work, look for work, or attend school full-time. Eligible expenses may include daycare, preschool, before and after school care, and even summer day camp.

The key advantage of contributing to an FSA is that the funds are deducted from your paycheck before taxes are applied, thereby reducing your taxable income. This means you'll pay less in federal income tax, Social Security tax, and Medicare tax, and in most cases, state income tax as well.

Eligibility and contribution limits

To participate in an FSA, you must work for an employer that offers this benefit. Not all employers provide FSAs, so it's essential to check with your human resources department to see if this option is available to you.

If your employer does offer an FSA, you'll need to decide how much to contribute during the open enrollment period, which typically occurs in the fall for the following calendar year. It's crucial to carefully estimate your anticipated medical or dependent care expenses, as FSA funds are subject to the "use it or lose it" rule. This means that any money left in your account at the end of the plan year (or grace period, if applicable) is forfeited.

As of 2023, the IRS allows employees to contribute up to the following amounts:

• Health FSA:
• $3,050 per year
• Dependent Care FSA:
• $5,000 per year ($2,500 if married and filing separately) 

It's important to note that employers can set their own limits, as long as they don't exceed the maximum amounts established by the IRS.

How FSAs help you save on taxes 

The primary benefit of contributing to an FSA is the tax savings it provides. By setting aside a portion of your income before taxes are applied, you effectively lower your taxable income, which in turn reduces the amount you owe in various taxes.

Let's consider an example to illustrate the potential tax savings:

Suppose you earn an annual salary of $50,000 and are in the 22% federal income tax bracket. If you contribute $2,000 to a health FSA and $5,000 to a dependent care FSA, your taxable income would be reduced to $43,000. Assuming a combined federal and state income tax rate of 30%, you would save approximately $2,100 in taxes for the year ($7,000 x 0.30).

Additionally, since FSA contributions are exempt from Social Security and Medicare taxes (7.65% combined), you would save an extra $536.50 ($7,000 x 0.0765), bringing your total tax savings to $2,636.50.

It's evident that participating in an FSA can lead to significant tax savings, allowing you to keep more of your hard-earned money while still paying for necessary medical and dependent care expenses.

Eligible expenses for health FSAs

Health FSAs cover a wide range of medical, dental, and vision expenses for you, your spouse, and your dependents. Some common eligible expenses include:

• Deductibles, copayments, and coinsurance (A health FSA does not cover the health insurance premiums)
• Prescription medications
• Over-the-counter drugs and medical supplies (with a doctor's prescription)
• Dental treatments, including fillings, extractions, and orthodontia
• Vision care, including eye exams, glasses, contact lenses, and LASIK surgery
• Mental health services, such as therapy and counseling
• Chiropractic care and acupuncture
• Hearing aids and batteries
• Smoking cessation programs
• Weight loss programs (if prescribed by a doctor for a specific medical condition)

It's important to keep in mind that not all expenses are eligible for reimbursement under a health FSA. Some ineligible expenses include cosmetic procedures, gym memberships, vitamins and supplements (unless prescribed by a doctor), and personal hygiene items.

Be sure to check with your employer or FSA administrator for a complete list of eligible expenses, as the rules may vary slightly from one plan to another. 

Eligible expenses for dependent care FSAs

Dependent care FSAs are designed to help you pay for child care or adult dependent care expenses that allow you (and your spouse, if married) to work, look for work, or attend school full-time. Eligible expenses may include:

• Daycare, preschool, or nursery school
• Before and after school care programs
• Summer day camps (but not overnight camps)
• Care for a disabled spouse or dependent of any age
• Babysitting or nanny services (if the provider is not your tax dependent)
• Transportation provided by a care provider
• Application fees, deposits, and other related expenses

To qualify for reimbursement, the care must be for a child under the age of 13 or an adult dependent who is physically or mentally incapable of self-care and lives with you for more than half the year.

Maximizing your FSA benefits

To make the most of your FSA and optimize your tax savings, consider the following strategies:

Plan ahead:

Before the open enrollment period, take the time to estimate your anticipated medical and dependent care expenses for the upcoming year. Review your previous year's expenses and factor in any known or expected changes, such as planned surgeries or a child starting daycare.

Keep track of your expenses:

Throughout the year, maintain accurate records of your FSA-eligible expenses, including receipts, invoices, and explanations of benefits (EOBs). Many FSA administrators offer online portals or mobile apps to help you manage your account, submit claims, and track your balance.

Use your FSA debit card:

If your FSA plan provides a debit card, use it to pay for eligible expenses whenever possible. This can help you avoid out-of-pocket costs and the need to submit claims for reimbursement. Just be sure to keep your receipts in case your administrator requests documentation.

Check for changes in eligible expenses:

The IRS periodically updates the list of eligible expenses for health FSAs. Stay informed about any changes to ensure you're using your funds appropriately and maximizing your benefits.

By implementing these strategies and carefully planning your FSA contributions, you can significantly reduce your taxable income, save money on taxes, and make the most of this valuable employee benefit.

Combining FSAs with other tax-advantaged accounts

In addition to FSAs, there are other tax-advantaged accounts that can help you save money on medical and dependent care expenses. Depending on your employer's offerings and your individual situation, you may be able to combine FSAs with the following accounts for even greater tax savings: 

Dependent Care Tax Credit:

If you have dependent care expenses, you may be eligible for the dependent care tax credit on your federal income tax return. This credit can be worth up to 35% of your qualifying expenses, depending on your income level. While you can't claim the same expenses for both the dependent care FSA and the tax credit, you may be able to optimize your tax savings by strategically allocating your expenses between the two.

Health Reimbursement Arrangements (HRAs):

Some employers offer HRAs, which are employer-funded accounts that reimburse you for eligible medical expenses. Unlike FSAs, HRAs do not require you to contribute your own money, and any unused funds may be carried over from year to year, depending on your employer's plan design. 

By understanding the interplay between these various tax-advantaged accounts and credits, you can create a comprehensive strategy to minimize your taxes and maximize your savings on medical and dependent care expenses.

Navigating FSAs with Instead

Flexible spending accounts can be powerful tools for reducing your taxable income and saving money on eligible medical and dependent care expenses. However, navigating the rules, deadlines, and eligible expenses can be complex and time-consuming.

That's where Instead comes in. Our AI-powered tax planning software is designed to simplify the process of managing your FSA and optimizing your tax savings. With Instead, you can:

• Easily track your FSA contributions, expenses, and deadlines
• Receive personalized recommendations for maximizing your FSA benefits based on your individual situation
• Access a comprehensive database of eligible expenses for both health and dependent care FSAs
• Identify opportunities to combine your FSA with other tax-advantaged accounts and credits for even greater savings
• Securely store and organize your receipts and documentation for hassle-free claims and audits

By leveraging the power of Instead's AI technology and expert knowledge, you can take control of your FSA and ensure you're making the most of this valuable tax-saving opportunity.

Embrace the future of tax planning with Instead

As the landscape of employee benefits and tax laws continues to evolve, it's more important than ever to stay informed and proactive about your tax planning strategies. Flexible spending accounts are just one piece of the puzzle, but they can play a significant role in reducing your tax liability and helping you save money on essential expenses.

With Instead's innovative platform and comprehensive approach to tax planning, you can unlock the full potential of your FSA and other tax-saving opportunities. Our team of experts is constantly monitoring changes in tax laws and employee benefits to ensure you have access to the most up-to-date information and strategies.

Don't leave money on the table – start maximizing your tax savings with flexible spending accounts and Instead today. Visit our plans page to explore the tax-saving strategies we offer and take control of your financial future with Instead!