What in the world is a flexible spending account?
By Laura Bruce • Bankrate.com

A great way to get a nice tax break and provide some added financial security for your family is by opting for a Flexible Spending Account. There are two types you can set up -- one for health care (both medical and dental) and one for work-related dependent care. The accounts, which can easily be set up through your company's human resources department, let you set aside a portion of your pay, on a pretax basis. You designate how much money you want to contribute in a particular year and the money is deducted right from your paycheck -- again, it's all tax-free.

As you incur expenses for health care (things like deductibles, co-pays, eye exams, glasses, and dental work) or dependent care (whether it's daycare for kids under 13 or elder care for a dependent parent), you simply file a claim for reimbursement from your account -- some insurers even offer automatic claims transfer, which means less hassle for you. These costs still come out of your pocket, but you save on federal, Social Security and most state and local taxes. Say you decide to contribute $2,000 to an FSA and you're in the 28 percent tax bracket, you'll save $560 in federal taxes, $153 in FICA taxes plus whatever your state income tax is, if eligible.

Since flexible spending accounts offer tax advantages, the IRS does place some restrictions on them. You cannot transfer money between the health-care and dependent-care accounts and you must use the entire amount in the account each plan year or forfeit it -- In May 2005, the IRS loosened the use-it-or-lose-it constraint by allowing plan participants to make claims against their accounts, for up to two months and 15 days after the end of their benefit year. Check with your employer to see if this option is part of your plan. There is a grace period -- usually about 90 days -- after the benefit year ends to submit bills. Any money left in the account after that is lost but if you plan conservatively and carefully, you can avoid this loss.

The limit for dependent care FSAs is $5,000 per year per family (if you are married, your spouse must also work, be a full-time student or disabled and unable to work). The IRS doesn't limit how much an employee can contribute to a health care FSA, but Ann St. Martin of the Society for Human Resource Management in Alexandria, Va., says companies usually limit it to about $2,500 per year.

Since any money that remains in the accounts at the end of the year is lost, you need to be very careful about estimating medical expenses or daycare costs -- how much you contribute depends on your individual situation. Take a look at last year's medical, dental and/or dependent care expenses. Pay attention to any costs you foresee that might not be covered under your medical or dental plans. You may want to estimate conservatively the first year since Federal regulations state that once you've decided on your contribution amount, you can't change it throughout the year unless you have a family status change -- have a baby or get married, for example.

Also, check to make sure that using a flexible spending account will indeed be more beneficial than taking tax deductions. Since you can only deduct medical and/or dental expenses that exceed 7.5 percent of your adjusted gross income, you're probably better off with a FSA, but it doesn't hurt to look at all of your options.

And what happens if an employee has only made a couple contributions and suddenly needs dental work? The company will pay -- up to the amount the employee opted for in their annual election -- and then be reimbursed as the employee makes additional contributions throughout the year.

"If the employee leaves the company before reimbursing the account for the full amount, the company eats the loss," says St. Martin. "The flip side is if the employee leaves with a balance they don't have access to that money unless they elect through COBRA to continue participation."

One other thing to keep in mind: Your Social Security benefits will be reduced slightly since you're not paying Social Security taxes on the money that's put into an FSA. Certainly not enough to dissuade you from taking advantage of untaxed money for you and your family, though.

-- Updated: May 25, 2005