Contributing to a flexible spending account (FSA) could save you several hundred dollars in taxes. FSAs do this by exempting contributions from federal and state income taxes, as well as payroll taxes. FSAs do have some limitations, including a cap on contributions, a restriction to spending funds on qualified medical expenses and a use-it-or-lose-it provision. Plus, not every employer offers these accounts as benefits.
For devising ways to pay for your medical expenses, consider talking to a financial advisor.
FSA Basics
A flexible spending account (FSA) is a kind of savings account that lets you set aside money before income and payroll taxes are assessed. As long as any withdrawals from the account are spent on eligible expenses, you don’t have to pay taxes on withdrawals either.
FSAs are only available to people whose employer sponsors the account as part of a cafeteria benefits plan. Plus, there are limits on the amount employees can contribute, as well as the type of expenses that are eligible.
Generally, FSAs are set up to pay healthcare expenses for items and services that are not covered by health insurance. Eligible expenses may include copays, specialist care, deductibles, prescriptions, over-the-counter medications, dental care and vision care.
The annual amount employees can contribute changes periodically. For 2023, the amount is $3,050. Contributions are made by paycheck deferral, so money is withdrawn and deposited in the FSA automatically for employees who elect to participate. The employer may also contribute money, and this does not count against the annual maximum.
FSA accounts have use-it-or-lose-it provisions that require enrollees to spend the funds on qualified expenses before the end of the calendar year the contribution was made. Plan sponsors can extend this to March 15 of the following year. Alternatively, they can allow up to 20% of the maximum allowed contribution to be rolled over to the next year. For 2023, the top rollover amount is $610. Funds not used or rolled over are absorbed back into the program to pay its costs.
How FSA Tax Savings Work
The benefit of an FSA is that it allows you to reduce your taxable income by the amount of your contribution to the account. This means you don’t pay taxes on that amount. The money is not lost to you, however, because you can still spend it on qualified medical expenses. The savings on an FSA contribution depend on how much you contribute and how much you would pay in taxes. FSA contributions are free of federal and state income taxes as well as FICA payroll taxes. The combination can add up to a significant amount. Here’s how it works:
As we already noted, the 2023 maximum FSA contribution is $3,050. The average federal income tax rate for American workers in 2020 was 13.6% of taxable income, according to the Tax Foundation.
FICA payroll taxes are a combination of Social Security and Medicare taxes that totals 15.3%. Half of this is paid by the employer. The employee’s share of FICA is 7.65% of total income.
Combined, the employee share of FICA taxes of 7.65% and the average income tax rate of 13.6% come to 21.25%. This means that you save approximately 21.25% of every dollar you contribute to an FSA.
If you contribute the 2023 maximum of $3,050, you would save 21.25% of that, or approximately $648.13.
These figures are inexact and your mileage may vary. Since income taxes are progressive, with higher tax rates applying to higher taxable incomes, this rate may be different for you if you don’t earn the average income. Also, some states have no income tax, which will reduce the savings.
FSA Savings Limitations
The opportunity to save several hundred dollars is attractive, but FSAs have some limitations that may make them less appealing to some people. The use-it-or-lose-it provision is the main one. If you don’t expect to have at least $3,050 in qualified expenses, your savings will be less, and you’ll lose any amount that is unspent unless your employer offers an extension or rollover.
The contribution limit also restricts their effectiveness for most employees. Higher earnings will have greater potential savings, since they are subject to higher tax rates on their taxable income. However, for most employees the savings will be limited to several hundred dollars per year.
Bottom Line
FSAs can help you save money by avoiding income and payroll taxes on contributions. You’ll have to spend the money on qualified expenses, and generally use it all in the same calendar year or risk losing it. You can only contribute a certain amount each year and you can’t use an FSA at all unless your employer offers it as part of a cafeteria benefit plan. But for many people, enrolling in and contributing to an FSA offers a simple and painless way to save several hundred dollars per year.
Tax Planning Tips
- A financial advisor can help optimize your financial plan to mitigate your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- It can be tricky to plan ahead for your future tax obligations. SmartAsset’s Federal Income Tax Calculator helps you forecast how much you’ll owe. Just enter your household income, location and filing status and the calculator will assess your marginal and effective tax rates for federal, state, local and FICA taxes, plus an estimate of your taxes for the coming year.
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