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Empty out your FSAs

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in Small Business Tax

Have you contributed to a flexible spending account (FSA) in 2016? If you estimated on the high side, you may have plenty of cash sitting in your account as the year draws to a close.

Strategy: Withdraw as much as you can before Jan. 1. Unless other provisions are made, you have to forfeit any remainder under the “use-it-or-lose-it” rule. In other words, the money is gone—forever.

However, an employer may choose to grant either a grace period or a carryover to 2017 (see box below).

Here’s the whole story: Like a 401(k) plan, an FSA is funded with pretax dollars, so there are significant tax savings for employees. Furthermore, the employer doesn’t have to pay Social Security and Medicare taxes or federal unemployment (FUTA) tax on amounts contributed to FSAs. Those benefits may offset some or all of the cost of administering an FSA. Plus, the FSAs are good for morale. It’s a win-win for employees and employers.

An FSA may be funded to provide for health care or dependent care expenses. Although the rules vary slightly between the two, the basic premise is the same. Distributions paid for qualified expenses—for example, to have LASIK eye surgery or to a day care center—are exempt from tax. But withdrawals made for nonqualified expenses are fully taxable.

Prior to 2013, there was no limit on contributions to FSAs used for health care expenses. Currently, the annual contribution can’t exceed $2,500, indexed for inflation. The limit for 2016 is $2,550 ($2,600 in 2017). The maximum amount allowed for a dependent care FSA is $5,000. Note: This figure isn’t indexed for inflation.

How much can you save with an FSA? Plenty. Suppose you earn $115,000 a year and you’re in the 28% tax bracket. You set aside the maximum $5,000 a year in an FSA to pay for your children’s after-school care. If you use up the entire $5,000, you save $1,400 in federal income tax (28% of $5,000), plus another $383 in Social Security and Medicare taxes (7.65% of $5,000). Total annual savings: $1,783.

Your firm also saves $382 on the employer’s share of the Social Security and Medicare taxes. If 10 employees in similar circumstances participate, the firm would save over $3,000.

Although you don’t have too much leeway with doling out money from an FSA, you might decide to, say, buy new eyeglasses before the end of the year. Allocate your withdrawals judiciously.

At the same time, make a guesstimate of your anticipated expenses for 2017. The best way to do this is to factor in health care expenses you’re reasonably sure you’ll be incurring during the year and review your recent medical history (and the expenses of your spouse and dependents). The same thing is true for dependent care expenses.  

Tip: Make the necessary payroll adjustments in time.

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