Is it generally wise to max out Health Care FSA enrollment when it is an option?

Question

My employer offers 3 health care plans and the cheapest one is a basic PPO plan. It has a pretty high deductible ($1.5k in-network single, twice that for family, double both for out-of-network) and combined out-of-pocket maximum ($9,450 single, $18,200 family). The medical OOP max is same as deductibles.

I took the basic PPO plan because I am relatively healthy. My spouse is too. But we are getting older and see doctors or specialists more than we used to. We also had our first child recently, which comes with numerous and uncertain expenses. Daycare for example is costly but enables us to bring home two salaries, and so it seems clear we should max out our Dependent Care Savings Account to spend on daycare.

What I'm trying to understand is my healthcare FSA contribution. Maximum I can contribute is $3.3k and I can rollover $300 into the next year. I figured, since this is pre-tax money, how much am I already paying in taxes anyway? My understanding - maybe this is where I need to be corrected - is that money into my FSA is taken out of money that would've gone to federal income tax withholding anyway. Well, from January to October I already had over $8k go to federal tax withholding. In that case, why wouldn't I max out my FSA every time, even if I don't spend half of it? I get to rollover $300 next year, and my dollars go to potential healthcare spending instead of eaten up by federal income tax.

Am I understanding that correctly? Or if not, where is my calculation awry, and how should I think of FSA contribution vs. federal tax withholdings (if the two should be considered together at all)?

Answer 1

money into my FSA is taken out of money that would've gone to federal income tax withholding anyway ... Am I understanding that correctly?

No. It's money that would have gone in your pocket. Yes it reduces your tax withholding but it's also money that you would have kept after taxes.

Let's say that your take-home pay after tax is $1,000, and you decide to contribute $100 to an FSA, reducing your withholding by $20 (20% of $100). Your take-home pay is now $920 because you contributed $100 but got a $20 "tax break".

Which is great so long as you spend that money on things that you would normally have spent out-of-pocket. If you don't spend it, then it's just money wasted.

My advice is to put as much away as you are reasonably sure you will spend. It's better to underestimate and have to pay a little out of pocket than to overestimate and either let the money go to waste or spend it on things that you normally wouldn't have bought.

As my father always said "It makes no sense to pay the bank (or your FSA in this case) a dollar to keep from paying the government 30 cents"

Answer 2

My understanding - maybe this is where I need to be corrected - is that money into my FSA is taken out of money that would've gone to federal income tax withholding anyway

No, this is taken out of your salary. It would have gone partially to withholding, and partially to your pocket, just as any other part of your salary. Worth remembering that withholding is not your actual taxes, and may be more or less of what you end up owing in taxes. You'll see that as a refund or amount due on your annual tax return.

Pre-tax FSA contributions means that instead of flowing with the rest of your salary this money will be taken out by the employer and will not be reported as money you've earned on your W2. As such you won't be taxed on it (for income tax purposes).

But, there's a flip side - it's "use it or lose it" kind of thing. You can only roll over $300, as you said, the rest will be forfeited if you don't use it throughout the year. How much you actually need to use is up to you.

Answer 3

This gets into the difference between a Flexible Spending Account (FSA) and a Health Savings Account (HSA). The fact the names seem similar can be confusing, but the purpose of an FSA is to use pre-tax dollars to pay for expected expenses within the current year. An HSA is a long-term savings account which can grow over time and follow you from employer to employer.

What you need to keep in mind is that if you "max out" your FSA and you do not use those funds, you lose them, or you may lose most of them if you are able to roll-over $300 per year, as you wrote.

Only you can decide what to do based on your own personal situation.

Answer 4

Your question is specific to an FSA account, which is a temporary (1 year only) savings account that must be spent or you lose it.

It is only a "use it or lose it" savings account budgeted for that yearly. It sounds like your Health Care FSA contribution has a tiny "rollover provision", which is better than nothing.

The FSA contribution has a small relationship with federal tax withholding. The consideration is your marginal tax percentage that is saved. But if that contribution is not yours to keep, then take advantage of it wisely.

Bottom line, contribute the FSA account employer-determined maximum that you KNOW YOU WILL SPEND ANYWAY on healthcare that year. You must estimate what you are HIGHLY likely going to spend on healthcare to know what YOU should contribute. If you are going to lose it at the end of the year, then there is not much benefit, only your margin tax savings. If your employer is giving you that money freely and you know you are going to spend it on healthcare anyway, then take that. But be careful about putting any of your own earnings in a place where an employer has a right or option to take it back.

HSA accounts are a different animal -- HSA accounts are portable accounts (by law) that you always "own". HSA accounts should always be maxed out, because then you will be able to use it in future years where you will have healthcare expenses. Many employers don't offer HSA account, because they can't take it back that year or ever. HSA accounts are protected by law and cannot be touched by an employer. Healthcare expenses almost always go up, so having tax-advantaged "employer-augmented" money set aside for healthcare expenses is a good thing. HSA can also be passed on to heirs.