Flexible Spending Plans Offer Attractive Choices

Many workers don’t take advantage of one of the best ways to save money on contact lenses, prescription drugs, child care, cosmetic surgery or other medical or dependent care expenses.

It’s called a flexible spending account. Offered as an employee benefit by a growing number of larger companies--but used by only a small fraction of eligible workers--these accounts allow you to pay for medical or dependent care expenses using pretax income. That means you can save as much as 40% on those expenses because you can use money that otherwise would have gone to Uncle Sam in taxes.

And new Internal Revenue Service rules, due to take effect in January, could make these accounts more attractive to some workers by allowing full use of the plans immediately after opening them.

Flexible spending accounts are offered by between 50% and 60% of the nation’s 1,000 largest industrial companies, estimates Mercer Meidinger Hansen, an employee benefits consulting firm. These plans allow you to place pretax earnings, taken from your salary each month through payroll deductions, into one or both of two types of accounts.

One type allows you to use the money, usually up to $5,000, for dependent care expenses such as child or nursing home care. The other type allows you to use the funds, typically up to between $2,000 and $5,000, for health expenses not covered by your medical plan at work. Most plans allow health accounts to be used for almost any medical expense, including eyeglasses or contact lenses, dental work, hearing aids, cosmetic surgery, prescription drugs, psychiatric exams and wheelchairs. You even can use them to pay deductibles, premiums or co-payments on your company medical plan.

The benefit is clear: The money you put into these accounts escapes not just federal income tax but Social Security and state income taxes as well. So for people in the highest tax brackets that could mean big savings.

One Big Catch

There’s another big advantage: Faced with rapidly growing medical costs, many firms are cutting back their contributions to employees’ medical insurance, forcing workers to pay more of those costs themselves through higher premiums, deductibles, co-payments or other costs. But money in your flexible spending account can be used to pay those costs.

“As companies cut back, these accounts will become more attractive,” says Edward J. Susank, a principal in the Los Angeles office of Mercer Meidinger Hansen.

There is one big catch, however: You must forfeit any money left over in your accounts after each year. In other words, use it or lose it. Your employer most likely will use the leftover money to defray costs of administering the accounts.

But hold on. If you estimate your annual expenses well, leftover funds shouldn’t be a problem. The average worker with a flexible spending account does just that, only forfeiting $27 a year in health accounts and $15 a year on dependent-care versions, according to a survey by Hewitt Associates, an employee benefits consultant.

Also, you can set your contributions on the low side to minimize the possibility of forfeiture, says Duane C. Bollert, manager of the Los Angeles office of Hewitt Associates. Most employers require only a small monthly minimum contribution--often as little as $10, he says.

And even if you don’t use all the money, what you save in taxes can more than offset the amount you forfeit. For example, if you put $1,000 into an account each year and you are in the top 33% federal tax bracket, you will save $330 in U.S. taxes right way. So even if you must forfeit $100, you’d still be better off by $230 than if you had not opened an account and had paid those medical expenses using after-tax dollars. And that’s not counting your additional savings in Social Security and state taxes.

Rules Change Jan. 1

Also, there are ways of getting out of the accounts. If your personal circumstances change--for example, you get divorced and no longer have dependents--you can cut or increase your contributions, or drop the account entirely (but you cannot withdraw money you have already contributed). And you can always drop the account at the end of the annual enrollment period.

Nonetheless, concerns about forfeiting money are a major reason why many eligible workers don’t open up flexible spending accounts. Only 20% to 25% of eligible workers are using health accounts, and only 3% use dependent-care ones, according to surveys by Hewitt Associates.

One reason for the lower use of dependent-care accounts: Families with lower incomes, generally around $20,000 or less, will save more money by paying for child care directly, Bollert says. That is because they can use the child-care tax credit, which allows you to take a portion (usually about 20%) of such expenses as a tax credit, he says.

Another reason for lower use: You generally must report those receiving the money. That is because undocumented workers or others who don’t want to report income to the IRS are often used as child-care providers.

But new IRS rules, adopted in April and set to take effect Jan. 1, should make flexible spending accounts more attractive for most employees. The new rules require that employees contributing to a plan be allowed access immediately to the total amount of money that will build up in the account over the whole year.

In other words, if you elect to contribute $100 a month, for a total of $1,200 a year, and you incur a $1,200 medical expense immediately after opening an account, you are entitled to get the full amount right away. Previously, you would have only been allowed access to money already in the account--in this case, $100 a month.

There is a flip side, however. Such immediate access is likely to prompt some companies--particularly smaller ones with high employee turnover--to reduce the maximum contributions they will allow or to require waiting periods before a worker is eligible, Mercer Meidinger’s Susank predicts. Others may even drop the plans altogether. That is because of the risk to firms that some employees may file claims for the full annual amount and then leave those firms without having paid the full amount.

But the negative impact may be limited. That’s because maximums are expected to be cut only on the health versions of the accounts; expenses for dependent care don’t pose the same risks because they are incurred gradually throughout the year.

Also, most employees contribute only an average of $500 a year to health accounts. That is below the level where most companies are expected to lower their maximums.