Flexible spending accounts
From Wikicpa
A flexible spending account (FSA) is a tax-advantaged savings account set up through an employer in the United States. An FSA allows an employee to set aside a portion of his or her earnings to pay for qualified medical or dependent care expenses. Money deducted from an employee's pay into an FSA is not subject to payroll taxes, resulting in a payroll tax savings. An FSA is similar to a Health Savings Account (HSA), which is available to self-employed persons or some small businesses.
There are two different flexible spending accounts available. One is for qualified medical expenses and the other is for dependent care expenses. There is a yearly cap on the amount of money that can be deferred into an FSA. This cap for a medical FSA varies, as is set by the employer. The dependent care FSA is federally capped at $5,000. Both types of accounts can be used concurrently, and do not affect one another's cap.
An FSA allows money to be deducted from an employee's paycheck pre-tax and then spent on qualified expenses. One drawback is that the money must be spent within the plan year and any money that is left unspent at the end of the year is forfeited. This is known as the "use it or lose it" provision. In 2005, the an optional 2½ month grace period that employers can use in their plans, allowing use of the funds for 2½ months after the end of the plan year. The annual contribution amount must also remain the same throughout the year unless certain qualifying events occur, such as birth of a child or death of a spouse.
Tax savings
For an example, a person in the 28% Federal marginal tax bracket and an example 4% state tax (along with the FICA and Medicare payroll taxes of typically 7.625%, for a total tax of almost 40%), could deduct $2,000 and put that money into an FSA for health or dependent care. This would result in almost $800 in tax savings. If this example person had not utilized the FSA, they likely would not have been able to deduct this $2,000 expense because it would not have met the 7.5% of Adjusted Gross Income threshold needed to be able to deduct it on their federal tax return. If the same person had $5,000 in dependent care expenses, and put that much into their dependent care FSA, their tax savings would be roughly $2,000.
