By Bruce D. Schobel, Corporate Vice President and Actuary, New York Life Insurance Company
In recent years, increasing numbers of workers have elected to reduce their pay in order to make contributions to so-called "flexible spending accounts." These accounts are set up by many employers as employee benefit plans. Amounts deposited into these accounts can be used to pay certain health-care expenses and dependent-care expenses, as permitted by the tax law. The amounts that workers elect to contribute to these accounts are not subject to Federal income tax, Social Security tax or Medicare tax. Amounts paid from the accounts as reimbursements of eligible expenses are not subject to those taxes, either.
This very favorable tax treatment has encouraged workers to participate in flexible spending accounts, when available, and to contribute as much as possible to them. While the accounts can provide significant tax benefits, workers need to be aware of two possible disadvantages:
- Contributions that are not used to pay eligible expenses are forfeited. In other words, a worker who contributes too much to his or her flexible spending account loses the excess contributions forever.
- For workers earning less than Social Security's maximum taxable amount ($90,000), contributions to flexible spending accounts may reduce the worker's future Social Security benefits. Because the contributions are not subject to Social Security tax, the taxable wages reported to the Social Security Administration are reduced. Those reported wages are used to determine future benefits.
While most workers are well informed with regard to the first possible disadvantage, few are aware of the second. In part, this is because the situation with flexible spending accounts is different from the situation with 401(k) plans, which are also very popular. In that case, contributions are free of Federal income tax (when paid into the 401(k) plan) but still subject to Social Security and Medicare tax; thus, the taxable wages reported to Social Security do not change, and neither do future benefits.
The reduction in future Social Security benefits due to making contributions to a flexible spending account is difficult to determine and varies from worker to worker. In most cases, the value of the tax savings exceeds the value of the benefits lost by a considerable margin. Still, workers should be fully informed as to the consequences of their actions.
This material is for information purposes only, Neither New York Life nor its agents provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions.
Questions about this article or about New York Life, our subsidiaries and the products that we offer? Please call this toll free number 800-710-7945 to arrange for a discussion with a New York Life agent or a NYLIFE Securities LLC financial services professional.
Last Updated Date 9/26/2010
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