Tax-Saver Accounts Can Provide Considerable Savings to a Company’s Employees

Q My husband’s company is offering a plan that would allow him to have funds taken out of his paycheck each week before taxes. The money would be used to reimburse us for any medical expenses paid out of pocket up to the amount that is taken from his paycheck when receipts are submitted for those services or goods. Do we have to declare this money as income for tax purposes? Do we save any money by participating in the plan?

--P.C.

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A These plans, which are offered by about half of the nation’s largest companies, are typically called “tax-saver” or “flexible spending” accounts, and, yes, they do save you money. In their most simple form, the plans allow taxpayers to set aside a predetermined amount of a worker’s salary--before federal and state taxes--to pay child-care, elder-care or unreimbursed medical costs during the year.

Here’s how they work: Let’s say you have a $750 medical insurance deductible and expect to spend $250 more each year out-of-pocket for unreimbursable medical expenses. If your company offers such tax-saver program, you can elect to have $1,000 withheld from your paycheck on a pretax basis and use those funds to reimburse yourself for these expenses. If you’re in the 28% federal tax bracket, you automatically save $280 in federal taxes. There will be state tax savings as well.

Some companies also provide flexible spending accounts for families with day-care expenses. With these accounts, participants are permitted to set aside up to $5,000 in certain child-care or elder-care expenses for which they can be reimbursed. That would amount to a $1,400 savings for this family in the 28% federal tax bracket.

Reimbursements are not considered taxable income by either the federal government or the state of California. If they were, you’d have no incentive to participate.

There is one potential pitfall: You must estimate your costs carefully because under most plans, any money that’s unspent at the end of the year is forfeited. There are no refunds, and most plans do not allow you to adjust the amount of money you withhold from your paycheck.

Tax-saver accounts are not related to “medical savings accounts.” These accounts are available to uninsured individuals, self-employed people and individuals employed by companies with 50 or fewer workers. Under this plan, a qualified person can set aside pretax dollars to pay the high deductible of a catastrophic health insurance policy, subject to various limits. The program also allows employers to contribute to the plan. And unlike the way it is with other pretax spending accounts, an employee doesn’t forfeit any unused money at the end of the year.

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Q. My siblings and I inherited an individual retirement account from our father. He was over age 70 1/2 and had been taking the minimum distribution required based on the single-life recalculation formula. I know we must take distributions, but we don’t know at what rate this must be done. Can you help?

--I.N.

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A. An inheritor of an IRA who is not the spouse of the deceased is not entitled to treat the funds as his or her own tax-deferred account by making additional contributions to it or by transferring the funds to another IRA. Instead, the heir must begin taking distributions from the account.

How those distributions are taken depends on whether the deceased was taking mandatory distributions from the account and, if so, what method of disbursement was being used. If the deceased was over age 70 1/2 and taking mandatory distributions, the heir generally must receive distributions at least as rapidly as the owner was receiving them. If the deceased died before mandatory distributions began, the plan may give the heir the choice of withdrawing the funds over his or her life expectancy or over the five years following the owner’s death. Some plans will say which method is to be used; others allow the owner to choose.

Distributions of pretax contributions are subject to ordinary income taxes. However, any disbursements a beneficiary receives before age 59 1/2 are not subject to the 10% early-withdrawal penalty normally associated with IRAs.

Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com