Lower Your Taxes

Many physicians are missing a good opportunity to save themselves some money. That's because they're not taking advantage of Flexible Spending Accounts (FSAs).

Whether your work role is employer or employee, FSAs can help you reduce your tax bills and make it easier for you to pay for medical and dependent-care expenses. Recent changes in IRS guidelines and new technologies have made these accounts more attractive than ever before. 

What's an FSA?

You'll sometimes hear Flexible Spending Accounts referred to as "125 plans" (after the pertinent section of IRS code). Only an employer can set up an FSA, but once a plan is set up employees can choose whether to participate in it.  

There are two types of FSAs -- healthcare and dependent care. We'll discuss the healthcare FSA first, since it is a little more complex.

For healthcare FSAs, the employer, not the IRS, determines the maximum amount that you can contribute annually. (The average amount is generally between $2,000 and $5,000, but some employers allow much higher contributions.)

At the beginning of each plan year, you decide if you want to participate and how much money you want to contribute for that year. Keep in mind that you can use the money in an FSA to pay for medical expenses for all your dependents and for your spouse (even if your spouse is covered by another medical plan).

Plans vary, but generally your contributions are deducted in equal amounts from each paycheck. Once you're in the plan, you're in it for the year --  no changes allowed, except for 'qualified life status' changes, such as a marriage, divorce, or new baby.

During the year, when you have to pay out of your own pocket for medical expenses, you can apply for reimbursement from your healthcare account according to your plan's guidelines.  

FSA advantages

How do you save money with an FSA?

*  Like a 401(k) account, money is taken out of your paycheck pre-tax for your FSA. That reduces the amount of your reportable compensation, which in turn reduces the taxes you have to pay each year. (Your savings on health-related items depends on your tax bracket.)

* Unlike a 401(k) account, in which funds will be taxed when they are taken out of the account, the money in an FSA account is never taxed. If you put in $5,000 a year, you can use the entire $5,000 to pay medical expenses, tax free.

* You can withdraw money from the healthcare account as you incur expenses. You don't have to wait until your contributions equal the amount you've spent on healthcare. For example, suppose that you participate in a healthcare FSA plan that runs from January through December. You contribute $200 to your healthcare account each month. In mid-January you have surgery, and when you receive your bills in February, you find that you have to pay $600 out of your own pocket for deductibles and copayments. Although you have contributed only $400 to your account by February, you can be reimbursed for the entire $600. 

* With employers raising deductibles and copays, the healthcare FSA is a great way for you to pay for those increased costs pre-tax. (You may not, however, use the money in an FSA account to pay for your share of healthcare premiums.)

Expanded benefits

Until recently, money in a healthcare FSA could be used to cover items such as copays, prescription drugs, eyeglasses, and dental work. Now the IRS has expanded covered expenses to include some over-the-counter (OTC) expenses for medications and medical devices. The IRS guidelines state that the drug or device must be used primarily to treat a medical condition rather than for general health. That means that vitamins are not usually covered (although vitamins for a pregnant woman might be).

The timing for these changes depends on the cycle of your particular FSA plan, but all plans should be reimbursing these expenses by the end of 2004. 

With that change, you'll be able to buy (with pre-tax dollars) items such as:

• Medicine for headaches, bee-stings, and allergies.
• Anti-diarrhea medications or laxatives.
• Medicines for the relief of menstrual pain or cramps.
• Cold medicines, cough drops, and sinus medications.
• Nicotine gum or patches to help you stop smoking.
• First aid creams, and creams for muscle or joint pain.
• Miscellaneous first aid supplies such as bandages, gauze, cold and hot packs.
• Sleeping pills.
• Thermometers, reading glasses, contact lens cleaning solution, elastic bandages, or wrist supports.
• Contraceptives and pregnancy tests.

The new rules don't allow reimbursement for toiletry or cosmetic items such as toothpaste, soaps, or shaving cream.

The IRS made the change because it recognized that many medications that were previously available only by prescription are now sold over the counter.

Another recent change to many FSA plans that's making the concept more appealing is the expanded use of "credit/debit card" reimbursement arrangements.

In the past, an employee had to file a claim (with supporting receipts) for reimbursement after paying out-of-pocket for a covered expense. Now, however, many plans are providing participants a special "credit card" to use for covered expenses. The doctor or pharmacy receives its money, and the amount the participant spends is automatically deducted from his FSA account. It's a faster, easier process.

FSA drawbacks

Nothing from the government ever comes without some strings attached, and there is one major drawback to the FSA accounts: If you don't use the money that you've saved in your account, you lose it at the end of the plan year. (You're usually given a grace period of a few months to get in all receipts from that plan year.) Any unused money in your account is used to reduce the costs of administering the FSA.

That means it's very important to have a clear sense of how much you and your family will incur in out-of-pocket medical expenses each year. Check back over your records from last year, and try to anticipate any changes or unusual expenses that may be coming up. Have the deductibles for your medical plan been raised so you'll be paying more up-front? Is this the year that little Johnny is due to get his braces? Do you or your spouse need new glasses? With the new IRS OTC guidelines, it's also a good idea to track your purchases of OTC drugs and devices for a month or two.

Deciding how much you want to save is a balancing act. Too much in the account and you won't use it all. Too little, and you'll lose the money savings and the tax advantages.  (Although there have been many calls for Congress to permit a rollover of some unused funds each year, there is nothing definite as yet.)

There are two situations in which an FSA might not be a good option.

The first concerns those nearing retirement, who may want to consider the pension implications of an FSA. If your pension will be based on the salary you receive in the last few years before your retire, you may want to determine if funding an FSA, which lowers your earnings, will cause you to receive a lower retirement payment. The second is unlikely to apply to you -- a low-income family may find it better to claim the child-care tax credit on their income tax form. 

Dependent care FSAs

The dependent care FSA is similar to the healthcare FSA. These can be used to cover day care expenses for your children or for an adult, such as an elderly parent, who is dependent on you. The dependent care FSA offers the same tax and money-saving advantages of the healthcare FSA.

But there are a few differences. First, the maximum amount that you can contribute to a dependent care plan is $5,000 for married couples filing jointly and single people, or $2,500 each for a husband and wife filing separately, figures set by the federal government. Second, you can only take money out of a dependent care account after you have incurred the expense. (If you're contributing $300 a month to a dependent care FSA and your first month's dependent care payment is $400, you can't be reimbursed for that extra $100 until you've paid it into your account.)

Employer advantages

What's in it for employers to set up an FSA plan? 

First, remember that the money that an employee contributes is taken out pre-tax. That means you don't have to pay the matching Social Security tax (7.65 percent) on that money. Many employers find that this savings alone will pay for the plan administration.
Second, offering FSA plans is a good way to attract and keep good employees. It's an excellent benefit that saves your employees money while costing you very little.

Third, if you offer an FSA plan, you can take advantage of it yourself as an individual participant. You enjoy the tax savings both as employer and employee.

Although FSAs offer many advantages, they are underused today. If you are eligible for such a plan, you should probably use it. If you're an employer, check into offering an FSA if you don't already have one in place.

Trevor 'Chip' Lewis Jr., CFP, is Managing Director of PSA Financial Center Inc. in Lutherville, Md. He was designated one of the Top 250 Financial Planners in Worth magazine in 2001, and the Top 150 Best Financial Advisers for Physicians in Medical Economics in 2002. Among other professional organizations, Mr. Lewis has been active in the leadership of the National Financial Planning Association and the National Association of Planned Giving. He can be reached at chip@psafinancial.com or via editor@physicianspractice.com.

This article originally appeared in the March 2004 issue of Physicians Practice.