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How to Use Flexible Spending Accounts

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Q: We currently have one child in daycare and some family healthcare expenses that are not covered under our insurance. Is a flexible spending plan worth the paperwork headache?

A: Yes, but you have to plan it right or you could forfeit some of the money you set aside. Don't worry about the paperwork. It may take an hour or so to set up the account initially, but once you do, it's easy to manage.

Flexible spending plans are special accounts offered by employers to enable workers to pay for up to $5,000 in childcare and $2,000 to $5,000 in unreimbursed medical expenses with pretax dollars each year. How much will this save you? Multiply your expenses by your tax bracket. For example, if you're in the 27% tax bracket (taxable income of $45,200 to $109,250 on a joint return, $36,250 to $93,650 if single and filing as head of household) and put $5,000 into a flexible spending account (FSA) for childcare, you'll save $1,350 in taxes.

Here's how FSAs work: At the beginning of the year, you estimate what your childcare and/or medical expenses will be for the year. Your employer withholds an amount from each paycheck and puts the money into a special account. This money is not reported as wages on your W-2. When you incur a childcare or medical expense, you submit a claim to your employer, who will reimburse you out of this account.

You forfeit any money in the account that you don't use, which means you'll need to take extra care when calculating your yearly expenses. This is easy with childcare costs because you typically pay a fixed amount each week or month. As for medical expenses, if you find that you haven't used all the money at year's end, you can always order another pair of eyeglasses or stock up on any prescription drugs that you take regularly. Even forfeiting a small amount of money is not so bad when you balance it against the tax savings.

Keep in mind that you can't claim the childcare tax credit for any daycare expenses that you pay out of a flexible spending account. This means you'll need to make a choice. The tax credit is equal to only 20% of your expenses up to $2,400 for one child or $4,800 for two (rising to $3,000 and $6,000, respectively, in 2002). The FSA is worth your tax bracket times $5,000, assuming you pay that much. If you're in the 27% tax bracket and have two children, the childcare tax credit would be worth $1,000 ($5,000 x .20 = $1,000). The FSA would be worth $1,350 ($5,000 x .27 = $1,350). An FSA is typically established before the start of the calendar year, while the childcare tax credit is not used until you file your tax return 15 months later. If you don't get around to signing up for the FSA in time, you can always claim the credit. But rather than letting procrastination be your guide, estimate next year's income and expenses so you can make the choice that will give you the most tax savings.

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Jennifer Openshaw, author of What's Your Net Worth? Click Your Way to Wealth, is the founder of Women's Financial Network (www.wfn.com), owned by the Siebert Financial Corporation of New York.

 
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