Chicagoans work hard for their money and especially hate giving a lot of it to Uncle Sam. Without a tax advisor, it can be hard discovering the options for reducing taxable income. But we don’t have to look under any rocks to find one of the most common ways to establish a good strategy to reduce taxes – tax-advantaged financial accounts. Flexible Spending Accounts (FSA) are accounts set up through your employer (check specific country laws if you are working outside of the US) that allow you to set aside a portion of your earnings to pay for qualified expenses You contribute to the FSA in small increments throughout the year (for example, 1/26 of the annual amount if you are paid biweekly) and the money deducted from your paycheck for an FSA is not subject to payroll taxes, which include income tax withholding, social security and Medicare tax.
There are different type of FSAs, such as Medical Expense FSA, Dependent Care FSA and Transportation FSA. Participation in one type of FSA does not affect participation in another type of FSA, but funds cannot be transferred from one FSA to another.
Medical Expense FSA allows you to pay for medical or health expenses up to $2,500 per year that are not covered by insurance, such as co-payments, deductibles, and other over-the-counter (OTC) items that are purchased with a doctor’s subscription. Allowable OTC items are found on the IRS site.
Dependent Care FSA allows you to pay for childcare or elderly care expenses up to $5,000 per year. The dependent must be able to be claimed on your federal tax return. Which means that parents or grandparents living in a nursing home are not a qualified dependent.
There are common cons to FSAs, such as:
1) Employers may require you to provide itemized receipts for all expenses. How annoying!
2) In 2012, employers have the option to limit your annual elections.
3) You must use the funds during your plan year only.
4) If you are terminated, then you can lose whatever balance is not claimed.
To illustrate points #3 and #4, any money that is left unspent at the end of the coverage period is forfeited and can be allocated as taxable income; this is commonly known as the “use it or lose it” rule. Under most plans, the “coverage period” generally ceases upon termination of employment, unless the employee continues coverage with the company under COBRA (Consolidated Omnibus Budget Reconciliation Act, which regulates health plans for companies with twenty or more workers and allow you to maintain coverage for a period of time after employment ends) or other arrangement. Therefore, should you have unused contributions in an FSA and no additional qualifying claims during the coverage period than you will lose these funds.
If funds are forfeited, this may not eliminate the requirement to pay taxes if so required. For example, if a single person elects to withhold $5,000 for Child Care expenses and gets married to a non-working spouse, the $5,000 would become taxable. Or if this person did not submit claims by the required date, the $5,000 would be forfeited and taxes would still be owed on the amount.
But the pros far out-weigh the cons for FSAs in most cases. The benefit of reducing your taxable income and paying for necessary qualified expenses with un-taxed dollars is worth the administrative headache of keeping all your receipts.
You should know that these accounts not only benefit you, but your employer as well. Instead of paying payroll taxes to the government, your employer typically pays only a small administrative fee to the plan of $4–10 per participating employee. This is much less than your employer would have paid for its share of your payroll taxes. In addition, any money that is not used by the end of the plan year is returned to the employer, which can be a substantial boon to your employer’s bottom line.
Now, go on and call your benefits department to learn more about FSAs and their enrollment periods. Remember to estimate the correct amount of qualified expenses so you don’t lose it and always remember to keep your receipts.
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