Like it or not, the cost of health care is still soaring as employers continue to shift more of the financial burden to their workers.
Unfortunately, other than trying to eat right, exercising and hoping that genetics are on your side, there isn't much you can do to lower your medical bills. But you can lower the after-tax cost of your out-of-pocket expenditures if you participate in an employer-sponsored Flexible Spending Account (FSA), also referred to as a Medical Spending Account. More than 94% of large employers offer such a plan, according to Hewitt Associates, a benefits consulting firm. An FSA allows you to use pretax dollars to pay for medical expenses that aren't reimbursed by your health-insurance plan, such as your deductible, copayments for prescriptions, and noncovered expenses like eyeglasses. For someone in the 25% federal tax bracket, that typically means saving about $31 on every $100 of medical costs because you also save on Social Security and Medicare taxes.
Not a bad deal at all. By taking advantage of this benefit, you can stretch the money available for medical expenses and reduce your federal taxes — and depending on where you live, your state and local income taxes as well. These accounts represent the only tax break available on medical expenses for many people these days. Very few taxpayers have medical costs that exceed 7.5% of their adjusted gross income, the level at which they can begin to itemize medical deductions on their income taxes.
So how do these plans work? Every year, your employer will ask you how much you'd like to contribute from your pretax income into the account. There is no tax-law limit, although most companies allow maximum annual contributions of only $3,000 to $5,000. Each pay period, your employer will deduct a proportionate amount from your paycheck. But note that while this means you won't have the total contribution amount taken out of your income until you receive your last paycheck at the end of the year, you can spend the full annual amount that you've signed up for at any time during the year. So if you have a lot of doctors' appointments and other medical costs in January, you can still use your pretax dollars to pay for those expenses. All you have to do is submit your expenses to your plan's administrator (usually your health-insurance provider) for reimbursement.
The key to using an FSA effectively is making an accurate estimate of your upcoming expenses. That's because you'll forfeit any money you don't use during the year (or during a two-and-a-half month grace period at the beginning of the following year, if your company plan allows that). Also, if you leave your job, voluntarily or not, you'll also give up any unused contributions year-to-date. To come up with a good estimate, take a look at how much you spent last year. Then try to predict any other major expenses you may incur. For example, if your son is getting braces you can easily plan for that.
Our FSA calculator will tell you just how much you stand to save in taxes by participating. In order to get an accurate estimate, you'll need to know your tax bracket. For a tax-rate schedule for single filers click here. Joint filers can click here.
* This is just an estimate. Tax savings will vary somewhat for those earning more than $110,100 for 2012 since any income above that threshold is not subject to 4.2% Social Security tax withholding.