One of the milestones of financial literacy, hopefully an early one, is the realization that you need to earn something like $100 in order to have $70 to invest or spend. That’s because Americans pay about 30%, on average, of their income in taxes. (That’s the total of federal, state, and local income taxes, plus Social Security and Medicare (which are payroll deductions), but it does not include sales taxes, property taxes, and other taxes. Many Americans think that this level of taxation is undoubtedly the highest in the world, but actually it’s one of the lowest.)
Obviously, you could save a lot of money if you could just spend what you earn without having to pay taxes on it.
The good news: With a Flexible Spending Account (FSA) you can do exactly that.
The bad news: This only works for certain types of “qualified” spending, which are most typically medical-care spending and dependent-care spending. However, it’s still worth doing!
An FSA diverts a certain amount of your earnings, say $1,200 per year or whatever you decide, into your special FSA account. You then use the money in your FSA account to pay for qualified spending (such as doctor visits, prescription medicine, or child care). You might have a debit card that draws from your FSA account or you might need to submit receipts and obtain reimbursements. Your taxable income for the year is reduced by the amount you put into your FSA. If you earn $50,000 and put $1,200 into your FSA, your income taxes are calculated on only $48,800. Thus, for that $1,200 in qualified spending, you only needed to earn $1,200 in order to spend $1,200. If you’re a typical taxpayer, that saves you over $250 per year.
To use an FSA effectively, you need to be able to estimate how much qualified spending you will have in the upcoming year. If your estimate is too high, you might lose some of the money you’ve set aside. You should carefully review the rules as to what counts as qualified spending, when the spending must occur, and how much (if any) you can carry over to the next year. Also, be aware that these rules have changed and may change again.
It’s unfortunate that only about 40% of American workers have access to FSAs.
Also note: because diverting money to FSAs reduces your contributions to Social Security, the Social Security benefits that you eventually receive will be slightly lower.
