Maxine Aaronson, Attorney at Law
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Reducing Tax Liability Through Flexible Spending Accounts

To provide some relief from rising health care and dependent care costs, federal tax laws authorize the establishment of “flexible spending accounts” (FSAs), sometimes known as “flexible reimbursement accounts.” Flexible spending accounts are established by employers to allow their employees to pay for certain expenses with pre-tax dollars. There are three basic types of flexible spending accounts: Health Care, Child or Dependent Care, and Commuter FSAs.

FSAs – Some Advantages

Taxpayers must generally agree to participate in a Health Care or Child or Dependent Care FSA prior to the beginning of the tax year, although employees may generally enroll in a Commuter FSA at any time. The taxpayer must agree to a reduction in salary by the employer on the condition that the funds will instead be deposited into an FSA.

As qualified expenses in these areas are incurred during the tax year, the taxpayer may pay them and seek reimbursement from the FSA, or may use a debit card to pay such expenses directly from the FSA. Money placed into an FSA is taken out of earnings before taxes are imposed, lowering taxable income and resulting in tax savings. In addition, the reimbursements are not taxable income when received from the FSA, therefore federal income and Social Security taxes are not paid on the funds in an FSA. Most states also exempt funds in the FSA from state income taxes as well.

FSAs – Some Disadvantages

One disadvantage of a Health Care or Child or Dependent Care FSA is that all of the funds in the FSA must be used by the end of the tax year, or the taxpayer may lose it; the funds cannot be carried over to the next year. The balance in a Commuter FSA, however, may be carried over to following years. Advocates for FSA reform are pressing for legislation that would allow some amount of the FSA account balance to roll over to following years.

The taxpayer is generally prohibited from changing the amount of money deposited into the FSA (a proportionate amount is usually deducted from each paycheck). Exceptions exist:

  • Commuter FSAs generally allow the taxpayer to change the amount of contributions to the FSA at any time.
  • Exceptions exist for all FSA for certain “major life changes,” such as marriage, divorce, birth of a child, job loss, or certain other events.

Health Care Flexible Spending Accounts

Health care expenses reimbursed from the FSA must be legitimate medical expenses for the taxpayer or a dependent (e.g., a spouse or certain unmarried children under a certain age). Generally, allowable medical expenses are those that may be deducted by taxpayers who itemize deductions, but there are exceptions. Such expenses may include:

  • Health insurance deductibles or co-pay amounts not reimbursed by a health plan.
  • Certain “out-of-pocket” expenses.
  • Charges for medical procedures not covered by the plan (e.g., laser eye surgery, certain dental work, etc.) or amounts above what the health care plan will cover.
  • Unreimbursed hearing and vision care expenses.
  • Weight loss and stop smoking programs, if approved and recommended by a physician to treat a specific condition.
  • Prescription and generic drugs (which many plans will not cover). Since a September 2003 Revenue Ruling by the IRS, many “over-the-counter” drugs are allowed (in reasonable amounts, if verified by receipts). Certain “dual purpose” drugs are allowed, if prescribed by a physician for a specified condition. “Drugs” that only promote general health, such as vitamin supplements, cannot be reimbursed.

The employer creates and implements the rules governing the administration of FSAs, and sets minimum and maximum contribution limits.

Child or Dependent Care FSAs

Federal tax law gives taxpayers the option to claim a child or dependent care credit against taxes or to establish an FSA. The expenses reimbursed from such an FSA must be for the care of an “eligible dependent,” defined as one who was under age 13 during the tax year and claimed as an exemption by the taxpayer, or other dependents claimed for income tax purposes who were physically or mentally unable to care for themselves.

The expenses must be incurred for the care of a qualified dependent in the home or outside by a paid provider (certain qualifications are required to qualify as a paid provider), and/or household services, provided such services at least partially benefit the dependent. Unlike the Health Care FSA, the IRS limits contributions to a Child or Dependent Care FSA to a maximum of $5,000 per year, subject to the following limitations.

  • The reimbursed amount that may be excluded from income is limited to the smallest of:
  • The total amount of child or dependent care (FSA) benefits received that year;
  • The total amount of qualified expenses incurred that year;
  • Taxpayer’s “earned income,” e.g., self-employment income, wages, salary, etc.;
  • Earned income of the taxpayer’s spouse; or
  • $5,000 ($2,500 if married filing separately).

Commuter FSAs

Commuter FSA provide for reimbursement for mass transportation, parking, and van pool expenses. Commuter FSAs are subject to strict monthly maximum amounts. As noted above, an employee may generally enroll in and change contributions to a Commuter FSAs at any time, and unused funds in a Commuter FSA may be carried over to a following tax year.