The Inflexible Flexible Spending Plan

Today, in her fiscally fit column at WSJ.com, Terry Cullen discusses the difficulty of anticipating the right amount of money to put in your health care spending account.

You: Okay, remind me what this spending account thing is again?

Sure. Offered by many large employers, a flexible spending account (also known as a reimbursement account), allows you to divert part of your gross pay to a special account to be used only for a specific purpose. Typical spending accounts include:

• Health Care
• Transportation
• Child Care

You: How does it work?

Think about spending accounts (also called reimbursement accounts) as a series of straightforward steps.

1. You enroll.
2. You contribute your own money to your account. (You determine the amount. There may be a minimum and a maximum permitted annually.)
3. You incur an expense eligible for reimbursement.
4. You request reimbursement from your account.
5. You receive a reimbursement check.
6. Money remaining in your reimbursement account is typically forfeited at the end of the year. (This is the crux of Ms. Cullen’s conundrum. She did her best estimating at the beginning of the year, but her family has already gone through all of the amounts she set aside for the year – and the year’s not even half over.)

You: Why should I do this? Seems like a bunch of work just to move money around. Besides, I have no idea how much money I’ll spend on stuff eligible for reimbursement, so I could end up forfeiting money! I can’t afford that. No thanks. I’ll just pay these expenses as they come up.

You’re right—forget it.

You: Really?

No.

You: Then tell me how a spending account could make any sense for me. Or anyone.

There’s one key factor making reimbursement accounts worth considering: The contributions put in the spending account are pre-tax but the reimbursements are post-tax.

You: You said this was going to be straightforward. What are you talking about?

Let’s take an example. Say you participate in a health care reimbursement account by putting $10 each paycheck into the account. Since you are paid every two weeks, you contribute $260 during one year from 26 paychecks.

Each $10 contribution reduces your gross pay. Assuming your tax withholdings are 25 percent of your gross pay, your tax withheld decreases by $2.50. Overall, your net pay decreases by $7.50.

If you pay $260 (or more) of reimbursable expenses throughout the year and complete the reimbursement form, you will receive a check for $260.
Review what happens.

1. You divert $260 of pay before tax to your spending account.
2. You pay $260 in medical expenses from your after-tax income.
3. You receive $260 back from your spending account.

Note that numbers one and three cancel each other out. Number two happens regardless of whether you participate in the spending plan. Next comes number four:

4. Your tax decreases by $2.50 per paycheck or $65 for the year.

You are $65 richer by going through this process. No games, no gimmicks. You’re basically taking money from one hand, giving it to another, and taking it back again. And by doing so, you permanently save tax. The more you contribute and the higher your income tax rate, the more you save.

Still not sold? Here’s another way to look at it:

Wouldn’t you take advantage of a coupon for 25 percent off even if you had to complete some forms? That’s exactly what you accomplish if your top tax rate is 25 percent!

The primary drawback of a spending account is that you must typically use all your contributions to the plan in the year you make them. If you don’t, you forfeit the amount of money by which your contributions exceed your eligible spending. Therefore, don’t contribute more money to the plan than you reasonably expect to spend.

You: Does that mean I need to predict the future?

Sort of.

You: Sorry, but my time machine is at the shop.

Mine too. The risk of forfeiture causes many people to simply ignore the opportunity spending accounts provide. However, the best thing to do is to look over your records from the previous year or two and estimate your reimbursable expenses. Use an annual total as an indicator of the amount you might spend in the future. Think about expenses that can be reasonably predicted. At a minimum, put that amount in your account. You don’t have to get it exactly right for it to have been very much the right financial move.

Your next chance is likely during your next annual enrollment. Take a good look at this opportunity to live a life Beyond Paycheck to Paycheck!