LAST REVIEWED Apr 05 2019 12 MIN READ
By Damian Davila
In hopes of attracting and retaining top talent, employers are offering more and better benefits options to their potential and current employees. An estimated 74% of large firms and 17% of small businesses offer their employees the option of contributing to a flexible spending account (FSA), which allows employees to use pre-tax dollars to pay for unreimbursed health care expenses incurred by the employee, the employee’s spouse, and any children who, as of the end of the taxable year, have not attained age 27. However, health FSA plans are just one of the available types of Section 125 plans that allow you to lower your taxable income. If you’re looking to learn more about lowering your taxable income and making the most out of your employer benefits, this is for you!
FSA tax savings example
Let’s review how contributing to a health FSA plan enables you to lower your taxable income reported IRS, potentially saving 15% to 30% depending on your tax bracket. Let’s assume that you make $50,000 per year, have a tax rate of 25%, and spend $2,000 in medical, dental, and vision expenses (excluding health care premiums).
|No FSA Election||With FSA Election|
|Your Annual Income||$50,000||$50,000|
|FSA Pre-Tax Election||$0||– $2,000|
|After-Tax Medical Expenses||-$2,000||$0|
|Take Home Pay||$35,500||$36,000|
By choosing to contribute to a health FSA account, you would have an extra $500 available in this year. Keep in mind that the higher your tax rate, the higher your benefit from using pre-tax dollars to cover medical expenses. The maximum contribution limit to a health FSA was $2,550 in 2016. In 2017, the IRS has increased that limit to $2,600. If your total medical, dental, and vision expenses were to increase to $2,600 and your tax rate were to remain the same, contributing a full $2,600 to your FSA would provide an extra $650 in take home pay! Here are the additional FSA and Section 125 plans options that may be available for you.
Dependent care FSA: Childcare expenses
Besides being able to use pre-tax dollars to cover eligible medical, dental, and vision examples of your spouse and dependents, you can also contribute on a pre-tax basis to a dependent care FSA up to $5,000 per family ($2,500 for those who are married but file separate tax returns) per year. The IRS allows you to exclude from taxable income the smallest of:
The total amount of dependent care benefits you received during the year
The total amount of qualified expenses you incurred during the year
Your earned income
Your spouse’s earned income, or
$5,000 ($2,500 if married filing separate)
A dependent care FSA is a great option for parents of children under the age of 13 because it allows the parent to use pre-tax dollars to cover eligible childcare, preschool, and before- or after-school expenses. Here’s an example that the IRS provides on its Publication 503: if you were to take your 3-year old child to a nursery school that provides lunch and a few educational activities as part of its childcare service. If the lunch and educational activities were to be secondary to the childcare and can’t be separated from the cost of the care, then you would be able to use the total cost of the childcare with your dependent care FSA up to to the eligible limit.
Health Savings Account (HSA)
Under the Affordable Care Act, if you’re enrolled in a qualifying high-deductible health insurance plan (HDHP), you may be eligible for an HSA. In 2017, the IRS defines an HDHP for an individual as a health with a minimum annual deductible of $1,300 for individuals ($2,600 for family coverage) and with an out-of-pocket maximum of $6,550 for individuals ($13,100 for families). In 2017, you can contribute up to $3,400 to an HSA for individual coverage and up to $6,750 for one for family coverage. If you’re age 55 or over, you can make a catch-cup contribution of up to $1,000 more. Like contributions to a health FSA, contributions to an HSA allow you to reduce your taxable income. However, an HSA differs in two ways from a health FSA. First, the full balance on your HSA plan rolls over from year to year. In a health FSA, you’re allowed up to $500 of unused amounts remaining at the end of a plan year in a health FSA to be paid or reimbursed for qualified medical expenses incurred during the following plan year. Second, monies in a HSA can be invested in mutual funds, stocks and other investment tools to generate more money.
Dental and vision: Limited-purpose FSAs
The IRS doesn’t allow you to contribute to both a health FSA and an HSA. The only exception is when you enroll in a limited-purpose FSA, then you remain eligible for both a limited-purpose FSA and a HSA. The most common limited-purpose FSA is a dental and vision FSA, which only allows employees to claim eligible dental and vision related expenses. In 2017, the contribution limit to limited purpose FSAs, including dental and vision FSAs, is $2,600. A dental and vision FSA makes sense for individuals who want to preserve contributions to a HSA for medical expenses only. That way you get the best of both worlds: your contributions to your HSA can continue to grow tax free and your dental and vision expenses are covered with pre-tax dollars from your limited purpose FSA.
Adoption assistance FSA
Your employer may offer a FSA for adoption assistance in reasonable and necessary expenses that you incur in the process of legally adopting an eligible child, including adoption fees, court costs, attorney fees, medical expenses for child prior to being placed for adoption, and related travel costs. In 2017, the maximum amount that can be deducted from an employee’s gross paycheck for the adoption of a child is $13,570, up from $13,460 in 2016. However, this adoption assistance tax credit is only fully available to those individuals with a modified adjusted gross income (MAGI) under $203,540. Those making over that threshold receive a reduced tax credit that is wiped out when the MAGI is $243,540 or more.
Transit and parking FSA
The IRS allows employers to set a transit and parking FSA for their employers for the following scenarios:
A ride in a commuter highway vehicle between the employee’s home and workplace
A transit pass
Qualified bicycle commuting reimbursement
In 2017, the maximum that you can contribute to a transit and parking FSA is $255 per month for for combined commuter highway vehicle transportation and transit passes, $255 per month for qualified parking, and $20 per month for qualified bicycle commuting month.
Premium Only Plan (POP)
A premium only plan (POP) allows employees to pay their insurance premiums with pre-tax dollars. This benefit offering is often paired with an HSA to provide an employee more control over the costs of her medical, dental, and vision expenses.
Group term life insurance
Companies with at least 10 employees can offer a group term life insurance benefit to their employees and exclude the cost of up to $50,000 in group term life insurance from the wages of an insured employee.
Last but not least, remember to check with your employer if your company provides a matching contribution to FSA accounts, including health FSAs, dependent care FSAs, and HSAs. It’s important to keep in mind the applicable limits on matching contributions set by the IRS. For employer contributions to an FSA:
Greater than $500: employer can only do up to a one-to-one match
Less than or equal to $500: employer can only match up to $500
Here are some examples:
|Employee Contribution to FSA||Employer Contribution to FSA||Total Contribution to FSA|
|$1,400||$1,400 (one-to-one match)||$2,800|
|$900||$1,000 (only $900 applies)||$1,800|
From the first example, you can see that employer matches don’t count towards the $2,600 limit in 2016 for health FSAs. The exception to this rule is the combined employer and employee contributions to a dependent care FSA. Employer contributions to a dependent care FSA do count towards the $5,000 limit in 2016.
The bottom line: Fully research your benefits options
Think beyond health coverage and health FSA and take the time to explore all of your available employer benefits. Take advantage of the four times in which you can enroll in your employer’s Section 125 and FSA plans: start date in case of new hire, setup of new plan, open enrollment period, and qualifying life event (e.g. marriage, birth of a child). Using pre-tax dollars allows you to lower your taxable income and increase your take home pay throughout the year.
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.