Flexible Spending Account
A Flexible Spending Account (FSA) also called a Full-Flex Section 125 Cafeteria Plan, let’s participating employees pay for certain qualified medical and dependent care expenses with pretax dollars. An employee can choose to participate in a medical and/or dependent care FSA depending on what their employer has made available. Once an individual decides how much their annual expenses will be, they allow their employer to deduct this amount from their income throughout the year. The employer agrees to reimburse the individual as they incur qualified medical and/or dependent care expenses.
SAMPLE FSA SAVINGS
The employee in this sample illustration would increase their spendable income by $37.50 ($450 per year). Naturally, the amount of employer paid payroll taxes would be reducing on this employee.
WHY DOES THIS PLAN WORK?
As any tax advisor can tell you, the lower your taxable income, the less taxes you have to pay. The trick is to reduce your taxable income without reducing your real income. If you pay fewer taxes, you get to keep more of the money you earn.
There are some expenses which offer little of no tax advantages if you have to pay them yourself, but which are tax free if paid by, or reimbursed to you by, your employer. These include certain kinds of group insurance, medical expenses not paid by insurance, and dependent care (day care) expenses. If you have any of these expenses, you can put your FSA plan to work and put more money in your pocket.
There are two components of an FSA that an employer can make available to their companies employees: medical expense reimbursement and dependent care expense reimbursement.
Using a medical reimbursement plan, participating employees can be reimbursed for qualified medical expenses (that are not paid by insurance) on a tax free basis. Most medical expenses incurred by participating employees (or anyone included on their tax return) for the cure of mitigation of disease or to improve bodily function can be reimbursed on a tax free basis by an employer. This includes such things as check ups, vision care, dental care, office exams and most items that count toward deductibles or co-pays. Specifically, any expense that qualifies under Section 213 of the Internal Revenue Code (except insurance premiums and long term care expenses) qualifies. Those things that are just for general health such as toothpaste, regular exercise and habit cessation programs as well as cosmetic procedures and medicines do not qualify. Please refer to IRS Publication 502 for more information
Each year participating employees choose, within the rules set up by the employer’s plan and the IRS, their personal amount of coverage. This annual coverage is called your election. This annual election is divided by the number of paychecks you receive in a year and is then payroll deducted tax free. Whenever a participating employee incurs a qualifying medical expense, they file a simple claim form with a copy of the statement of services to the employer or Third Party Administrator (TPA). Using employer's funds, the employer or TPA will reimburse the participating employee for the expense until they have been reimbursed for their entire annual election. This reimbursement is 100% tax free. Since both the payroll deduction and the reimbursement are tax free, the employee has reduced their taxable income by their election amount, but not their real income since they would have paid for the medical expense anyway. Because taxes are figured as a percentage of the taxable income the taxes they owe are less since their taxable income is less.
The higher the annual election, the more taxes saved. Taxable income is reduced for every annual election dollar increased. However, employees need to be conservative because this money can only be used for medical expenses incurred during the year, so they shouldn’t set your election too high. Below is a list of some of the medical expenses that do qualify.
If an employee pays for dependent care in order for them to work then this menu item may benefit them. Qualifying expenses include those incurred for the care of a child under the age of 13 or for a family member that otherwise cannot care for himself or herself. Please refer to IRS Publication 503 . Some employees have probably have filed for the child care credit with their tax return. This credit gives them a tax credit of 20-30% (depending on their income level) on some or all of their dependent care expenses. This credit is figured on the 1st $2,400 for one child or $4,800 for two or more children. As income goes up, the credit percentage goes down. In addition, the limit of $2,400 or $4,800 may be too low for actual dependent care costs.
Allowing an employer to reduce an employees gross pay for their dependent care and then reimburse them for dependent care, by utilizing the cafeteria plan, may give them a better tax break depending on their income level and dependent care amount. Participating employees choose the amount of dependent care they want an employer to provide on an annual basis. This annual amount is divided by the number of pay checks the employee will receive in a year and is deducted tax free from their gross pay each pay period. Since their taxable income is now lower their taxes will be less. Whenever a participating employee incurs a dependent care expense they file a claim form with their employer or TPA together with copies of the dependent care provider statement itemizing the dependent care expense. Using employer money, the employer or TPA will then reimburse the employee for the dependent care expense, up to the amount the employee has on deposit in their dependent care account. The reimbursement is also tax free. By allowing the employer to pay for dependent care, employees can reduce their taxable income by the dependent care amount, but real income has stayed the same since they would have paid the dependent care anyway. Since their taxable income is lower their taxes are lower.
With the Section 125 Cafeteria Plan, savings is based on an employee’s actual tax bracket including federal, state and social security taxes instead of a credit on your dependent care expense. If their combined tax bracket (federal + state + social security) is higher than their child care credit percentage then the FSA Plan will be better for them. As with the out of pocket medical category, the more dependent care they let their employer pay for them, the more tax savings they put in their pocket. However, once the participating employee has elected an annual dependent care amount and reduced their taxable compensation by that amount, the employer can only use this money to pay for dependent care. Employees must be conservative with how much money they put in this category.
SUMMARY PLAN DESCRIPTION
Employees should read the Summary Plan Description (SPD) for their employer's Cafeteria Plan. The SPD contains information concerning rights, obligations, and opportunities under the plan. The goal is to make the plan work the best it can for employers and employees. We will be glad to answer your questions concerning eligible expenses, the details of your plan and the mechanics of filing claims, etc.
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