An FSA can be a valuable way to save money, but you may actually be wasting your money if you aren’t careful. A Flexible Spending Account, or FSA, is a tax-advantaged account that allows individuals to set aside portions of their earned income for certain purposes: public transportation, parking, dependent care and the most common type, health care expenses. Simply put, you set aside an amount you choose, pre-tax, each month in a pre-funded account and then withdraw it when you need it. My plan, for example, gives me a benefits Mastercard that is essentially a pre-paid credit card.
Most FSAs are “use-it-or-lose-it” accounts. Any money unspent at the end of the year (or sometimes the end of the quarter after the end of the year, depending on the plan) just disappears, presumably into the pockets of your plan administrator. So let’s look at how an FSA can be a bad investment.
I will look at a fairly extreme example based on my own situation. Let’s assume a federal tax rate of 28%, a state tax rate of 6.37% (thanks, New Jersey), and FICA of 7.65% for a whopping total of 42.02% (we’ll round off to 42%). If you set aside $2000 for medical expenses at the beginning of the year, you would be saving $840 per year. So as long as you spend at least $1160, you’ll break even.
However, if your tax situation is different, you might have a very different break-even point. Let’s assume a federal tax rate of 15%, no state tax (Florida, for example) and FICA of 7.65%. In that case, if you set aside $2000 in your FSA, you would save $453. As long as you spend $1547, you’ll break even.
Sounds great so far, doesn’t it? The problem comes if you don’t have $1547 or $1160 in medical expenses. We did our best to estimate how much our insurance wouldn’t cover the year we had Little Buddy, and missed by a couple of hundred dollars. We did our best to use our card whenever we could, but still ended up wildly buying a huge supply of allowed over-the-counter medicine and other items just to use up our remaining balance. It’s all usable, and eventually we will use it, but we probably spent money we wouldn’t have spent so quickly otherwise.
The situation is even worse if you have commuting-related savings plans, because if you’re like me and move from location to location you may not know for sure whether you’ll need “public transportation” or “parking” day to day. In addition, the funds for these plans accumulate each pay period, rather than all at once at the beginning of the year like a medical FSA (although both are withdrawn from your paycheck each month). I overestimated public transportation last year. The end result of that was that I bought over $100 in Metrocards (the New York city subway pass) in late December. That was OK, since I could use them well into the next year. If I had overshot parking, though, that money would have been lost; my parking lot only allows day-by-day payment for spaces.
So a few key tips for pre-paid tax advantaged accounts:
- Estimate, then reduce. I think you should make a reasonable estimate of what you intend to spend at the beginning of the year, then set your account at about 90% of that. Don’t get into a situation where you have to buy a large amount of stuff you don’t need just to use up your balance. That money might have been useful elsewhere – for investing, emergency savings or even just day-to-day expenses.
- Make sure your type of payment is accepted. One of our doctors doesn’t accept credit cards, making reimbursement a long painful process of copying bills, filling out forms and sending in check copies. While there’s no reason this means you still can’t use the account, realistically it increases the chance that you’ll have disputes with your plan’s administrator (I did) or that you simply won’t get around to filing it (particularly for a small co-pay, for example).
- Keep track of your balance. If you are getting closer to the end of the year and haven’t spent much out of your account, start looking around for items you might need that are eligible for purchase. We waited too long and had to scramble a bit, and probably could have used our money better.
These accounts are still a great deal – anything that lets us wage-earners avoid a little bit of tax is helpful!