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Wednesday, March 9, 2011

Flexible Spending Accounts: Better to Overfund than to Underfund?

Oh the whining over FSAs! A Wall Street Journal writer bemoans the ineligibility of over-the-counter meds under the new law and so has decided not to do the FSA. The writer--along with many in the comments section--is also bemoaning the fact that her family overfunded the account. Well! I guess the writer has good benefits. Here in the land of FAMILY of FOUR with NO DENTAL INSURANCE I am happy to have the FSA account available. And while I liked being able to use the FSA for aspirin and cough medicine, I am OK with those very inexpensive items being on the prohibited list.

But what of the overfunding fear? Many of my colleagues--like the commenters in WSJ--don't participate because of that fear.

As you may know, I am an English major. So please point out if my math is flawed. I believe that it is better to overfund than to underfund the account--to a certain point of course.

Here's the math. Because FSAs are tax-free money, the more you make, the more you save. Those in the 28% bracket save more than those in the 15% bracket. These funds are free of state taxes too.

Let's say, you fund for $1000 in expenses. Let's say you are in the pretty low 20% bracket for federal and state taxes.

--If you hit it on the nose, you "really" only paid $800 for the services, since you only net 80% of your incomes.

--If your expenses are $1200, the first $1000 cost you $800 as above. The other $200 (after tax) costs $250 (before tax).

--If your expenses are only $800, then you have in effect broken even. Get another pair of glasses to make up the difference.

--Here's another way to look at it. I have a feeling my math is flawed. The $1000 in FSA costs you $800 (what you would have gotten after after taxes). Using regular, taxed income for the same expenses costs you $1250. So the spread is bigger than one might think. And the spread is magnified if you pay more than 20% in federal and state taxes.

It is easy to anticipate certain expenses: glasses, orthodontia, and the like. The zingers are the sudden pains that signal the incipient root canal. Sadly, we have never overfunded! That is an indicator of our poor benefits.

OK. Can you FIX MY MATH, readers? Please. I keep thinking there is a mistake here.


6e33b676-444c-11e0-b843-000bcdcb8a73 said...

Hi FS, you are right that the last step is flawed. You want to convert everything to after-tax dollars. So say (by way of an easy calculation) that your taxable income is otherwise 10k, and you are in the 20% bracket. Then for any amount of expenses up to your FSA of $1,000, you end up with $7200 after tax, while after that each dollar of expenses is $1 after tax. So you are correct that $800 in expenses is the break even point. If it was $500 in expenses, you would only have $7200 instead of $7500. At $1000 you have $7200 instead of $7000, though. At $1200, you have not gotten "extra money" but you are still $200 ahead ($7000 instead of $6800).

In short, you end up one dollar ahead for every dollar of expenses between $800 and $1000, so yes, go get an extra pair of glasses at the end of the year!

It is better to overfund up to the percentage added by your tax bracket. For example, if your tax bracket is 15% then you want to fund so that what you know you will use will be 85%=100%-15%. (Divide the amount by .85, so if you know you spend $1500, you should set your FSA to be $1765 = $1500/.85.)

6e33b676-444c-11e0-b843-000bcdcb8a73 said...

The two parts that need to change are:

--If your expenses are $1200, the first $1000 cost you $800 after tax/$1000 before tax as above. The other $200 (after tax) costs $250 (before tax).

See how the first $1000 shows up before tax, and the other $200 shows up after? So your total is $1000 after tax, i.e. saving you $200, or $1250 before tax, saving you $250 of before tax dollars

--Here's another way to look at it. I have a feeling my math is flawed. The $1000 in FSA costs you $800 (what you would have gotten after after taxes). Using regular, taxed income for the same expenses ($1000 after taxes) costs you $1250 before taxes.

The flaw you are really seeing here is a kind of double-counting. Basically, it is the same 20% whatever way you look at it; you just have to decide which end you are coming from. You get $1000 of FSA money for $1000 of work instead of having to spend $1250 of work. OR, from the other end, you have $200 more in your pocket at the end ($1000-$800).

Mixed Strat

Frugal Scholar said...

@6e....--Thanks! I can't quite process this, since I am still in the midst of grading 200plus assignments. basic point is valid, right?

6e33b676-444c-11e0-b843-000bcdcb8a73 said...

Yes, you are entirely right that you come out ahead even if you overfund slightly. ("Slightly" is defined by your tax bracket.)

And as we get older it seems more and more likely that there will be glasses, or medicine, or co-pays, or dental work, so the people who refuse FSA's outright really mystify me. You get help budgeting for your health expenses AND it's pre-tax even if you can't itemize it? Score. As you can see, I miss my FSA benefit, although as a grad student I am not in a tax bracket to benefit as much from it. (8

6e33b676-444c-11e0-b843-000bcdcb8a73 said...

Oh, and not related but I think you will appreciate this: I went to B&N to investigate Architecture of Happiness as it sounded like great pleasure reading. I came away with it (at full price, that is how excited I was, and I may start pressing it on others soon) and also a boxed set of two of Bittman's Everything cookbooks--marked down to $20. Not the cheapest trip (although still cheaper than buying an academic book) but tons of value. I believe my sweetie and I may soon be having some cookbook cuddling time!

Funny about Money said...

If you had no dental insurance, it could be worth it.

The several times I took advantage of the university's FSA, I found a) it didn't save a penny in taxes (they pitched it telling us we'd end up with more take-home pay, which was just flat wrong -- my take-home dropped); b) because my health and my teeth are excellent & my routine dental care was covered by Delta, I never could spend enough on medical stuff to use up all the money that was ripped out of my paycheck; and c) the last time I tried it, they'd tightened the rules so that the few health-related expenses I had didn't qualify.

Since I can't follow 6e33b(etc.)'s math, the only thing I can figure is that when my take-home was lower, when I couldn't even begin to spend the modest amount I estimated I'd need, and when I had to race around at year-end spending money on unnecessary medical exams and unnecessary extra pairs of glasses, in my case it must not have been a very good deal.

Presumably if you had some health problems, though, it would be smart.

6e33b676-444c-11e0-b843-000bcdcb8a73 said...

Funny, you are right that it only saves you money if you are already spending money. Think of the FSA like you are buying gift cards good towards this year's medical expenses; you don't pay tax on them, so it's a discount that way, but if you weren't going to "shop" in the "medical store" (or if they already give you stuff for free) then you shouldn't buy those gift cards at all. (And anyone who said it would increase your paycheck didn't understand what they were talking about; if you spend on medical expenses, what you end up increasing is your disposable income.)

You seem to have unusually good insurance; no one I know under 35 has anything that good (in some cases, a side effect of the tight employment market for younger people), and I can only think of a couple people I know who aren't on some kind of medication or needing some kind of specialist service or dental work (so having to pay $100/month in copays is a pretty normal thing).

You have your health AND you have the coverage to keep it. I hope that continues to be the case at least for my parents' generation. Count your blessings and have a happy St. Pat's!

Mixed Strategy Household