Medical Flexible Spending Accounts

[livingdeb]

Does your company offer health care flexible spending accounts? Then get ready for fun and adventure (well, what goes for such in my life). These accounts are part tax breaks on health care spending and part gambling.

The tax break part is that you don't have to pay income taxes or FICA taxes on money you spend on (unreimbursed) health care expenses. Woo hoo! Free money from Uncle Sam!

The gambling part is that you have to guess ahead of time how much these expenditures will be for a whole year. The appropriate fraction of that amount is deducted from each of your paychecks for the next year. Then, whenever you make healthcare payments or purchases, you request a reimbursement from that account, until the yearly amount is gone, or the end of the year arrives, whichever comes first. If you guess too low, you have to pay for the extra with after-tax money. If you guess too high, you lose the extra money in your account at the end of the year. This is where experience with those card games with the goal of bidding the exact right number of tricks could come in handy.

(Where does your lost money go? Not the IRS, like I would have guessed, but your company. Your company must spend it fairly on the employees; usually they use it to help cover the administrative costs of running this program. The amount they save on paying their share of your FICA taxes also helps.)

Should you participate?

Some reasons you might not want to participate:

• Too boring - The whole thing seems too complicated or time-consuming. Try reading this and see if you still think that.
• Expenses are too low - If your usual out-of-pocket health care expenses would not add up to the minimum deduction allowed by your company, it might be better not to participate.
• Expenses are too high - If you know your expenses are going to exceed 7.5% of your income, you might be tempted to take a deduction on your 1040 income tax form instead. Any expenses paid from this account cannot be itemized. However, with this plan you get to deduct FICA as well as income taxes, and you do it on all the money you set aside, not just the amount above 7.5% of your income, so that's better. And any amount you spend beyond what is reimbursed from this can, if that amount exceeds 7.5% of your income, still be partly deducted on your 1040.
• Bad with paperwork - If you would always forget to file claims, save receipts, etc., this may not be a good plan for you. However, knowing that filing a claim would bring you a monetary reimbursement may be more motivating for you than the usual paperwork you forget about. If your company offers a debit card, you'd only have to throw your receipts in a file you could keep track of.
• Want to maximize Social Security benefits - Participating in this program reduces your income not only for tax purposes, but also for Social Security purposes. When the Social Security administration calculates your 30 highest salaries, this one will be a bit lower. Probably the difference in your retirement income would be very small. But if you are worried, you can always take the amount that would have gone toward taxes, and put them in some kind of savings account, maybe even a retirement savings account. This will probably give you a much larger return, and may also give you more flexibility on how to spend the money. If you are barely making enough to make the minimum quarterly amount to qualify for Social Security, then that might be a good reason to stay out.
• Too much of a gambler - If you would be guessing way too high and then forfeiting too much at the end, then it would be better not to play. But guessing high means shrinking your paycheck, so maybe it's not such a temptation after all.

Here are some reasons you might want to participate:

• Tax savings - You are good with money and can tell you would save money.
• Forced doctor visits - Contribute the amount for all the doctor visits you should be doing (annual physical, dental appointments, eye exam, mammogram). Now you have to go, or that money is wasted.
• Forced prioritizing - Having the money deducted from your paycheck means you at least have that much money available for health care, even if you ordinarily live paycheck to paycheck. Now health care has to be a priority because that money can no longer be spend on anything else.
• Christmas bonus - If you don't file your claims until the end of the year, then your reimbursement feels like big winnings.
• Free loans - Once the plan period starts, you have access to all the money (because you are forced to make contributions from each paycheck). So, if all your expenses come at the beginning of the year, you can file a claim right away; it's like you get a free loan of that money. Not only that, if you quit before you have paid in the amount for which you've gotten reimbursed, you never have to repay that loan. That's right, the company eats the loss. (Because of that, companies often set a low maximum contribution to protect themselves.) Of course, if you quit before you've spent as much as you set aside, then you are losing the money.

How much should I set aside?

First, lets look at the risks. Let's start with the assumption that you're in the 15% tax bracket, you pay 7.65% of your income to FICA, you have no state income tax, and you've decided to have $1000 deducted for the year. Because this is deducted before taxes are taken out, your take home pay is reduced by only $773.50 [= $1000 * (100% - 15% - 7.65%) = $1000 * (1 - 0.2265)] over the year.

• Let's say you've guessed perfectly and spent exactly $1000 in out-of-pocket expenses. You save $226.50 or over 22% of what you would have spent. Awesome job! But highly unlikely.
• Let's say you've guessed too low, and actual expenditures came out to $2000. You've spent the $773.50 you set aside, plus an extra $1000 in after tax money for a total of $1773.50. Your total savings is over 11%. You would have paid $2000 if you hadn't been in the program. But you would have spent only $1546 if you had guessed perfectly.
• Let's say you've guessed too high, and actual expenditures came out to $500. You've still lost $773.50 from your paychecks to pay for only $500 in services. You have lost over 35% of the money you've set aside. If you had guessed perfectly, you would have paid only $386.75. So sad.
• Let's say you've guessed only a little too high; actual expenditures came out to $900. You've got $100 in your account that you will lose. You are crying in your soup. Still, you've paid only $773.50 for $900 worth of service, a savings of over 16%.

If you draw a graph of your savings versus your actual expenditures for a given guess, you can see that as you spend more than you guess, your savings drop off slowly (and never go to zero), but as you spend less, your savings drop off quickly (and can go negative). So, it's generally better to err on the side of setting aside too little.

Next you need to evaluate your risk comfort zone. Here are some approaches to participating, from most to least conservative:

• Stick toe in water - Contribute the minimum allowed by your plan (for mine it's $15/month), even though you know you will spend more, and see what happens. During the year you can find out things like how easy it really is to get reimbursed, how good you are at remembering to send in reimbursement forms or hanging on to receipts, how good you are at remembering what you can get reimbursed for, and how much various things cost. Then use that information to make a better decision next year.
• Cover maintenance costs - If you are paying for medicines you take regularly or treatments you receive regularly, you could estimate those and contribute that amount. Cover only those expenses you are absolutely sure you will incur.
• Cover maintenance costs and anticipate other costs - You may be able to anticipate some costs that don't occur annually for you such as your ten-year tetanus booster or your first mammogram.
• Hedge your bets - Cover maintenance and other costs, plus a package of services you could add near the end of the year if you hadn't yet used all the money (see next section).
• Take bigger risks for possible bigger gains - If you have a bunch of kids, you might assume that at least something extra will come up each year. If you have the data, look at how much you've spent each year, and if you always spend more than maintenance costs, just guess that you will again. In other words, assume that you will incur some unpredictable expenses. If you do, you'll have some of the money you'll need, tax-free. If not, well, that's good news too.

Given what you can guess about your expenditures and what you know about the risks and your risk tolerance, select a figure. Look at the list of expenses your company covers and mark the ones that will or may apply to you. (According to IRS guidelines, more expenditures can be covered than you might guess: doctor visits and hospitalization expenses of course, but also dentist visits, eye exams, transportation costs to and from your doctor, co-pays, deductibles, acupuncture, some over-the-counter medicines, prescriptions including birth control, glasses, contact lenses, contact lens solution, and aspirin. Not insurance premiums, toothpaste, vitamin pills, or gym membership, though. Some things are not covered unless your doctor prescribes it, such as sunscreen and weight-loss programs. Note that companies do not have to allow reimbursement for all the items allowed by the IRS guidelines, although most do. So be sure to look carefully at the information provided by your company.)

Then try to guess how much these will cost--look at what you've paid in the past, check the benefits of your insurance in the next year. There are calculators to help you figure out how much you will spend, providing that you already know how much you will spend--you enter the figures for each type of expense, they add them up for you. (Actually, they do serve a function in reminding you how many things qualify.)

End-of-year strategies

At the end of the year, you may find that you have more money leftover than you think you will be spending, or you may find that you have spent all the money, but have more expenses. As with most tax strategies, you may be able to move expenses that should occur near the end of the plan year either before the deadline, if you still have money, or after the deadline, if it is all spent. Obviously, you do not want to take too long to take care of urgent health issues. It hurts longer and probably costs more, too.

About 20% of people participating in this plan have money leftover at the end of the year. If this is about to happen to you, there are various strategies for using up the money at the end. Warning: stocking up on more of something than you could possibly use in a year is against the rules.

• Kevin McCormally of Kiplinger.com recommends that you "consider having your teeth cleaned, buying a new pair of glasses, going ahead with that laser eye surgery or buying prescription drugs you'll need soon. Also if your plan has implemented the recent IRS decision to allow flex plan money to be spent on nonprescription drugs, you have a new way to spend your money and qualify for reimbursement from the account." Note that if you wait too long, you may have difficulty making an appointment, especially with several other people thinking the same way.
• But Sarah Max of CNN says "before you scramble to spend your FSA money on laser surgery or a massage, make sure you have claimed all the eligible expenses you've already incurred. If you haven't been saving receipts, you might ask your physician, dentist or pharmacist for a tally of the co-payments you've paid this year. Your insurance company also should have a record of deductibles and other costs it did not cover. Finally, don't forget the cost of transportation to and from your doctor's office – that will get you 13 cents a mile." She also recommends a trip to the optemtrist ("perhaps the most popular way of emptying out your flexible spending account"), stocking up on prescription drugs, visiting the dentist, paying ahead for orthodontia, and starting treatment for things you've been putting off.

Like any game, there are rules in the fine print that would be good to know before selecting an amount.

First, as in all financial savings plans, don't forget to look at not only how to get your money into the plan, but also how to get it back out. How do you request reimbursement? You'll probably need to fill out and send a claim form (my company has a toll-free fax number) with proof of purchase and perhaps proof of medical need. Is your account credited the same day? Do you receive a check later? Your company may also provide a debit card, allowing the amount to be withdrawn from your account to pay the bill in the first place (mine charges an annual fee for this card).

What kind of documentation is required? That depends on what kind of expense you are having reimbursed. Basically they need to know that it's an appropriate medical expense, it's for a qualifying person, and you incurred the expense during the plan year.

• Health care visits: According to PayFlex, "if you have insurance coverage, you must send the claim to your health (medical, dental or vision) insurance plan first. The insurance carrier will process the claim and provide an Explanation of Benefits (EOB) statement to you showing the amount paid and what you owe. The EOB can be submitted with your flex claim form. If you are covered by an HMO type plan or do not have insurance, ask your care provider for an itemized statement that includes their name/address, patient name, date of service, a description of the service or supply, and the cost."
• Prescriptions: PayFlex says, "The pharmacy receipt (not the cash register receipt), often times called a “script”, that includes the pharmacy name, patient name, date the prescription was filled, the name of the drug, and dollar amount should be submitted with your claim. Another easy way to submit prescription expenses is to ask your pharmacy to print a listing of all your prescription purchases for a given time period for each family member and submit with your claim form. Many pharmacies now allow customers to set up accounts online at their website so they can print a list of their prescriptions." A prescription alone is not good enough; you need proof that you actually bought the medicine.
• Over-the-counter medicines: According to Sarah Max at CNN, "Some items, such as cold medicine, are clearly medical in nature, in which case a receipt with the date, amount and name of the item is probably all you need to get reimbursed . . . . But with dual-purpose items, such as vitamins or sun screen, you'll [also] need a note from your doctor with a diagnosis and a recommendation."
• Travel expenses: Receipts from parking fees and tolls, plus your computation of mileage, which you then multiply by $0.12 per mile (for 2004; subject to change).