Brace Yourself: The Benefits of Flexible Spending

Oct. 27, 2009 — -- If you have a child in need of braces, now might be the time to stuff a few thousand dollars into a flexible spending account. It could save you some big money, and this might be your last chance to do so.

The reason I bring this up is that, at many workplaces, it is now open enrollment period, the time of year when employees are given up to 30 days to make changes to employer-sponsored benefit plans.

At the same time, Congress could soon cut back the tax savings available to workers through the health care version of a flexible spending account. The health care reform bill recently approved by the Senate Finance Committee includes a provision that would cap the amount workers can contribute to health care flexible spending account at $2,500 a year, beginning in the 2011 tax year with no annual adjustment for inflation.

This means that 2010 could be the last year a middle-class family facing a $5,000 bill for braces -- or some other big medical expense -- could offset that cost with nearly $1,400 in tax savings in a single year. The proposed $2,500 cap on annual flexible spending account contributions for health care expenses would reduce the tax savings under this scenario to about $700.

For a family with three children, the lost tax savings could amount to about $2,100 in just a few years.

I don't mean to devote too much attention to crooked teeth. Braces are just a way to illustrate the benefits of flexible spending plans and point out how these advantages may be cut back in the current health care debate.

Thousands in Savings

There's more at stake than just the cosmetic. Thousands of dollars are at stake for families whose members struggle with chronic diseases, or whose medical insurance carries high deductibles and large out-of-pocket expenses. These are cases where a health care flexible spending account can make a big difference to the family budget.

A flexible spending account is a popular benefit option offered by many employers that allows participants to avoid taxation on money spent for health care and dependent care expenses. At the time of hiring, or during the annual open enrollment period, employees may elect to set aside a portion of their pay for a given year into a flexible spending account.

Whatever money is directed into the account is free from all taxes, including income, Social Security and Medicare. This means after-tax pay is higher.

Flexible Spending Accounts on the Edge

Employees must be careful about how much they set aside as any funds left over at the end of the plan year are forfeited. In many cases, there is a grace period of up to two and half months after the plan year to spend the remaining funds, but ultimately it's a use-it-or-lose-it mechanism.

When an employee incurs a qualified expense, he or she can seek reimbursement from the flexible spending account, or, in some cases, use a debit card linked to the account to pay up front for the expense. Accounts for health care expenses are maintained separately from dependent care spending accounts, and rules for the two types of accounts vary slightly.

For the purposes of this column, I'm focusing on health care spending accounts as they are the ones at play in the in the health care debate. There are no serious efforts I know of that would alter dependent care spending accounts, but if you're eligible for such an account, I would give serious consideration to it. The potential savings for families with children in daycare or an aging parent at home are significant.

Under the current federal tax code, there is no limit on how much an employee can contribute to a health care spending account, but employers can set a limit, usually around $4,000 to $5,000 a year.

Qualifying expenses for these accounts include copayments for prescriptions and doctor visits, over-the-counter medications, eyeglasses, contact lenses and dental and orthodontic expenses.

Few employees contribute the maximum amount allowed as they worry about forfeiting funds they haven't spent by the end of the year. The average contribution to a health care spending account in 2007 amounted to $1,451, according to Mercer Human Resource Consulting. At this level of contribution, a worker earning $35,000 annually would save $337 in Social Security, Medicare and federal income taxes, according to the Employee Benefit Research Institute. This savings does not take into account additional savings on state income taxes.

The savings do not sound huge, but for many workers, it can be far greater than $337 a year.

Flexible Spending Accounts

My experience working with clients suggests many workers direct too little into a health care flexible spending account. Those who could save even more on taxes this way include those dealing with a chronic disease, hefty prescription copayments and large dental or orthodontic bills, which often are not covered by dental insurance.

Braces, for instance, can easily cost a family $5,000 out of pocket for one child. The $1,400 in tax savings I cite above assumes a 15 percent federal tax bracket (well within middle class), a 5.3 percent state income tax (as we have in my home state of Massachusetts) and the current 7.65 percent Social Security/Medicare tax rate. The savings would be larger for taxpayers in higher federal tax brackets or living in states with high state or local income tax rates.

This type of savings remains possible for 2010, but it's unclear whether the opportunity will be there in 2011. At least one group, Save Flexible Spending Plans, which represents companies that administer these plans, is fighting the proposal, but the effort has not garnered significant attention in the health care debate.

More details should be available soon as the final Senate health care bill is unveiled.

In the meantime, if you're facing a big bill for braces or some other medical expense in 2010, now is the time to plan.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.