Health FSA Taxes in 2017: What You Need to Know

By Dan Caplinger Markets Fool.com

Many workers have access to a flexible spending account at work, but you might not know just how big a tax break your FSA can be. If you have an FSA, you can save toward your anticipated medical expenses and save on both income and payroll taxes as well. However, there are some tricks involved with using flexible spending accounts correctly, so it pays to know the benefits and potential pitfalls of FSAs.

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What is a flexible spending account?

A flexible spending account gives you the ability to take money out of your paycheck and put it into a special account to pay medical expenses you incur in the future. You can either pay your medical expenses directly from the FSA, or you can use other funds to pay your medical bills and then reimburse yourself by taking withdrawals from the flexible spending account.

The tax break that FSAs offer is more extensive than what most other benefits do. The money that goes into an FSA isn't subject to income tax withholding, and you also don't have to pay payroll taxes for Social Security or Medicare on whatever goes into the flexible spending account. By contrast, popular tax breaks like 401(k) contributions don't produce that much tax savings, as you still have to pay payroll taxes for Social Security and Medicare even though the contributions do typically get excluded from your income for income tax purposes.

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How can I use my FSA money?

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You can use flexible spending accounts to pay for a wide variety of medical expenses. Among them are payments for medical services, whether they're inpatient services like a hospital stay or outpatient services like doctor visits. Whatever co-pay, deductible, or coinsurance amount you have to cover out-of-pocket is eligible for FSA treatment.

In addition, prescription medications qualify for FSA payments, as does medical equipment like diagnostic testing devices, crutches, or bandages. However, over-the-counter medications for which you don't have a prescription are generally not eligible, so you can no longer simply buy aspirin or cold medicine with your FSA money.

One thing that trips up some people is that you can't use FSA money to pay health insurance premiums. Coverage has to come from other funds.

Whose medical expenses can get paid out of my FSA?

FSAs are primarily for your own medical expenses, but the rules also allow you to pay for certain family members. If you're married, then your spouse's expenses can be paid from your FSA. Any dependents that you claim on your tax return are also eligible for favorable treatment.

How much can I contribute to an FSA?

There are contribution limits for FSAs. In 2017, the maximum you can contribute to an FSA is $2,600, up from $2,550 in 2016. Some employers make additional contributions to employee FSAs out of their own funds, but any employer contributions aren't counted toward the maximum employee contribution.

Will I lose my FSA money?

The biggest restriction on FSAs is that they're designed to get spent down every year. In the past, any money you didn't spend was forfeited. That's still the case for some flexible spending accounts.

However, the IRS has made FSAs a little more flexible. Employers can choose one of two options to make things easier for employees. One option allows employees to incur medical expenses in the first two and a half months of the following year and take money out of their prior-year FSA balance. The other option allows employees to carry forward up to $500 in FSA money from the previous year and apply it to current-year expenses.

One thing to keep in mind is that employers aren't allowed to offer both options, and some employers offer neither one. Be sure to check with your HR department to see what provisions your FSA has in this regard.

If you're fortunate enough to have a flexible spending accounts at work, make sure you take advantage of it. As one of the best ways of producing tax savings, FSAs are worth looking at more closely.

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