Flexible spending accounts: by participating, are employees borrowing from their future?

• Author: Levitan, Alan S.

Flexibel spending accounts (FSAs) have become popular fringe benefit options, used for medical and dependent/child care expenses. They reduce tax liability, thereby increasing taxpayers' disposable income. Pretax dollars are used to pay qualified health care and/or dependent care expenses. Thus tax is not paid on that portion of income that is contributed to an FSA. The amount an employee wants to contribute for any particular year must be decided before the beginning of the applicable year (normally by November 30).

While the benefits received under an FSA may be tax free, because of the potential reduction of eventual social security benefits, employees may be borrowing from their future. This article will discuss the relevant factors and reveal who should use FSAs.

Limitations of FSAs

After an employee decides to set up an FSA, he must choose a specific FSA contribution amount to be withheld from his paycheck on a pretax basis (before Federal income tax, FICA and FUTA amounts are calculated) and deposited in his FSA. Whether state and local income taxes are required to be paid depends on the appropriate statutes; however, the authors are not aware of any state in which these FSA contribution amounts would be taxable. The result is that the employee does not pay taxes on the amount contributed to the FSA.

Contributions to an FSA that are not used in the same period (year) are forfeited; there is no refund of any unspent balances. Once the employee has specified an amount to be contributed to the FSA, he will either use it or lose it. The amount contributed to the FSA is used to reimburse the employee for certain medical and/or dependent/child care expenses incurred during this period(1) that have not been reimbursed by any other plan.

Social Security Benefits Calculation

FSAs may reduce a taxpayer's social security benefits when social security income is less than the maximum social security tax base for that year.

When contributions to an FSA reduce social security income, future social security benefits are also reduced. According to the Social Security Administration rules, the benefits are based first on the average indexed monthly earnings (AIME). To compute AIME, each year's earnings (up to the maximum social security income taxable for that year) are indexed by the cost-of-living factor for that year to inflate them to current dollars. Next, the average of the 35 highest indexed amounts is computed. (For those born before 1929, fewer than 35 years are used.) Last, that quotient, which represents an annual average, is divided by 12.

A young employee, early in his career, may likely work for more than 35 years, and expect raises greater than the cost of living. This employee would benefit by taking fringe benefits on a nontaxable basis during these early years. Even though this strategy does not maximize yearly social security income, if the employee works more than 35 years, the earlier years' earnings will not be among the 35 highest, and therefore will not be used in computing AIME.

After computing AIME, the primary insurance amount (PIA) must be calculated. The PIA is the monthly amount the social security recipients will receive in today's dollars, adjusted for future inflation. PIA is computed by taking 90% of the first $387 of AIME, plus 32% of the next $1,946 of AIME, plus 15% of the AIME in excess of $2,333. While the percentages remain the same, the upper end of each dollar bracket will rise with inflation.

As indicated in the PIA calculation, the monthly social security benefit increases at a decreasing rate as income subject to social security increases. Therefore, in order to make the most appropriate decision regarding FSAs, a taxpayer must know his effective marginal PIA bracket (90%, 32% or 15%). (Note: All computations in this article assume that the taxpayer's current PIA bracket does not change. In other words, any change in a taxpayer's current income will be due to inflation. This assumption will be relaxed later.)

Another assumption, which is not always the case, is that social security benefits will not be subject to income tax in the year receive. The taxation of social security benefits, a concern for higher income individuals, increases the attractiveness of FSAs.

Decision Variables and Assumptions

A major variable to be considered in making the FSA decision is the employee's current salary level. The lower the salary level, the less beneficial an FSA will be because the current tax saving will be less (15% tax bracket) and the loss of future social security benefits will be greater (90% PIA bracket). On the other hand, the higher the salary level, the more likely an employee will want to take advantage of an FSA because the current tax saving...