Flexible Spending Accounts:
Free Money or Fine Print?

Free money! The flexible spending accounts (FSA) available through payroll deductions may seem a little complex at first, but once you understand how they work, it is like getting money for free, because of the tax savings. So what is the catch? You have to use up all of your money before the end of the year. Whatever is left in the account at the end of the year is forfeited.

So how does this work? As an employee, you can set aside a certain amount of money, through payroll deduction, to be held in an account for you. Throughout the year, as you incur medical expenses that are not covered by your health insurance you send in your receipts and get reimbursed from the account. You can also set up a dependant care account to pay for childcare expenses. The real benefit is that all of this money comes out pre-tax, so you are essentially saving a percentage equal to your marginal tax rate (or tax bracket). In other words, if you are in the 26% federal tax bracket and you set aside $1,000 in your FSA, you will save $260 in taxes.

What can you use the money for? The FSA can be used to pay for things such as dental and vision expenses that may not be covered by your regular health insurance. It can also be used for prescription drugs (as well as certain over-the-counter medications), co-payments and deductibles. If the money is for dependent care, it must be used for daycare or eldercare (if you are the primary caregiver).

How much should you set aside? The recent changes allow you to set aside as much as $4,000 for medical expenses and $5,000 for dependent care. The best way to decide how much of that you will need is to look at what you paid out of pocket last year. If you estimate that you paid about $1,000 out of pocket and expect to spend the same this year, then you may want to set aside about $35 per pay, which would be $910 for the year.

Why not just contribute the maximum amount? Be conservative, especially your first year. Any money you contribute that you do not use will be lost at the end of the year. If you leave any money in your account at the end of the year, then you have just wasted the tax savings. On the other hand, if you have a prescription that costs $50 per month, then you may as well contribute at least that much, since you know for sure you will be spending it. The same applies to dependent care. Of course, you cannot deduct your health insurance premium that is taken from your pay since it is already deducted pre-tax.

So go home tonight and estimate how much you will be spending out-of-pocket next year for medical expenses and have that much (or a little less just to be safe) deducted from your paycheck into an FSA. But hurry, you have to make your decision by December 15th. (For more information, see IRS Publication 502 for medical expenses and IRS Publication 503 for dependent care expenses).

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Bill Pratt is the author of "Extra Credit: The 7 Things Every College Student Needs to Know About Credit, Debt & Ca$h" and "Money Made Simple". You can find tons of useful articles and calculators and have your questions about money answered at www.ExtraCreditBook.com