The Tax Benefits of Spending Accounts
Crystal Rockwood used to be skeptical of “use it or lose it” company benefit plans -- such as pretax dependent-care and health-care spending accounts -- because she focused on the “lose it” possibility.
But during the last four years, she has become a believer, racking up hundreds of dollars in tax savings by using these plans, which allow workers to save on their income taxes by committing pretax dollars to pay for such things as health-care services and commuting costs. The downside is that money set aside in these accounts must be spent during the ensuing year or it’s lost.
Rockwood is both emblematic of how employees often are reluctant to sign up for these plans and why they may want to reconsider, especially now, when open-enrollment season -- the time of year when employees typically can make changes to their workplace benefits plans -- is starting at most companies. It was only at the urging of a co-worker that Rockwood, director of communications for a Costa Mesa law firm, decided to participate at all. But each year she has used the accounts, she has found them increasingly valuable. The Long Beach resident raises her contributions annually and has yet to lose a dime.
A recent survey by Fidelity Investments found that Rockwood’s case is typical. Even among families with small children and regular medical costs, only one-third participate in pretax health-care savings accounts. More than half of those who didn’t use the accounts said the main reason was the fear of losing unspent contributions -- the same worry that initially deterred Rockwood.
However, fewer than 10% of workers forfeit any contributions to a flexible spending account, said Jon Kessler, chief executive of WageWorks, a San Francisco-based employee benefits provider. Among those who do forfeit money, the average amount is just $30 a year. Paying for such things as health care through these accounts can reduce a worker’s tax bill by 30 to 40 cents for every dollar he or she contributes to the plan.
Three Ways to Save
Big companies typically offer three types of use-it-or-lose-it savings plans: dependent care, health care and commuter benefit. All three are worth considering.
In all cases, the worker deposits money in an account earmarked solely for one purpose, such as health-care or child-care costs. The worker’s contributions, which are made through payroll deductions, are deducted before both employment taxes -- that’s the 7.65% of wages taken out for Social Security and Medicare -- and income taxes are withheld. In other words, the money set aside in the special account escapes federal and state taxation, saving the worker 30% to 40% of the cost of the contributions, depending on the worker’s total tax rate.
“From a tax savings perspective, these pretax accounts are one of the best things you can do for yourself,” Kessler said. “If a family spends $1,000 a year on medical expenses, they’ll save $300 to $400 a year on taxes. You will not find, as an ordinary taxpayer, an opportunity to reduce your overall tax bill by that much money.”
Money set aside in any of these accounts can be used only for the stated purpose, though, and any money left unspent at the end of the year is forfeited. Still, experts maintain that it’s not too difficult to estimate the right amount to save.
Here’s a look at each type of account:
* Dependent-care accounts. These are geared to parents who must pay child-care expenses so that both can work or attend school. Sometimes they can be used for an elderly dependent, such as a parent, who relies on the employee to pay for home health care or nursing home care too, Kessler said.
“With many more of us having older parents -- and even grandparents -- for whom we are financially responsible, this becomes a relevant consideration,” he said.
The maximum amount that can be contributed to a dependent-care account is $5,000 annually. Generally, the employee pays the day-care bills and then applies to the plan for reimbursement.
Employees who are uncertain whether their expenses would qualify should contact the plan administrator before opting in, because once a worker sets a contribution amount, it generally can be changed midyear only if there’s a significant change in family status -- a marriage, birth or divorce.
* Health-care spending accounts. These can be used to pay almost any medically necessary health-care cost that isn’t covered by insurance. That includes dental bills, orthodontia, psychiatric care and prescription drugs. Recently, the Internal Revenue Service issued a rule that allows these accounts to be used to pay for over-the-counter drugs, such as aspirin and allergy medicines, too.
Because medical expenses are somewhat more difficult to predict than day-care costs, experts suggest that consumers use the health-care cost-comparison worksheets that many employers provide to help workers sift through medical insurance options.
With that worksheet, a worker can calculate the family’s typical out-of-pocket expenses and add in any procedures that are not covered by insurance, such as orthodontia or laser eye surgery, that might be planned for the year to estimate the right amount to put in the account.
* Commuter-benefit plans. Authorized by a 1998 law, these are the most recent addition to the employer lineup, Kessler said. Though these plans have not yet gained the broad acceptance of dependent-care and health-care spending accounts, an increasing number of employers are offering them, he said.
These accounts allow workers to set aside up to $2,000 annually for parking or up to $1,200 annually for public transit or van-pool costs.
How much difference can these accounts make?
Consider a hypothetical family with two working parents and two children. Assume this family normally pays $5,000 annually in day-care expenses, has unreimbursed medical costs of about $1,000 a year and spends $1,000 on parking.
If the family chooses to pay these expenses through employer-based benefit savings accounts, they would reduce their adjusted gross income by $7,000. Assuming they pay 30% of their income in federal and state income taxes, that saves $2,100 in income taxes alone. But because money put in these accounts also is exempt from employment taxes, which amount to $535.50 on that $7,000, their total tax savings amount to about $2,635.
“The thing is, we have great insurance coverage, but you still have out-of-pocket expenses,” Rockwood said. “The flexible spending account is so important that it would be one of the first things I’d want to know about if I was ever considering a new job.”
Times staff writer Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past columns, visit www.latimes.com /perfin.
