Since the possible modification is not pending legislation, I believe we are ok by the forum rules (“Proposed regulations that are directly related to investing may be discussed if and when they are published for public comments.”). In any case, it’s not my intent to start a debate on whether the modification is a good idea or not; rather, I argue below that the use-it-or-lose-it rule is a fairly toothless bogeyman. Please do refrain from any comments on the ACA, or the thread will get locked. It is what it is.
Since an FSA shelters your income from federal income tax, federal AGI-based credit phaseouts, AGI-based IRA eligibility phaseouts, state income tax, social security tax, and Medicare tax, it’s a terrific tax break. For many families, it can halve medical expenses. It can even make them entirely free. Consider the following example. It may seem contrived but it’s wholly possible, and not far off what my situation has been for the past few years.
A family with two students in college, one spouse covered by a 401k, and two incomes of $98,000 would, in the absence of an FSA, not be able to reduce their AGI below about $176,000 (assuming $3,000 of pre-tax health, dental, and disability insurance premiums). That AGI would place them in the AOTC phaseout, the Roth IRA phaseout, and the spousal TIRA phaseout.
- Their nominal federal bracket would likely be 25%, possibly 32.5% if they hit the AMT.
- The AOTC phaseout for two students would add another 25%.
- Their state tax might be 8%, or effectively 6% considering that it’s deductible against federal (unless they fell in the AMT).
- The spouse covered by an employer plan would miss out on $1,500 of Roth IRA contributions (a problem possibly but not necessarily overcome with a backdoor Roth).
- The spouse not covered would miss out on $1,500 of deductible spousal TIRA contributions. This $1,500 above-the-line deduction would further reduce their tax bill since it avoids their 50% federal rate and their state tax.
But wait, there’s more! The FSA contribution would also allow them to increase their tax-advantaged savings by $3,000.
Is the FSA a huge deal for everyone? No. If you’re young and healthy and have perfect vision and good teeth, it’s not going to do much for you. Also: we hate you.
So the FSA is a wonderful (and hassleful) thing, but starting next year there is a $2,500 limit (inflation adjusted) on contributions. If a family has access to two FSAs they can contribute a total of $5,000, but if they have access to only one their limit is $2,500. How significant is the new limit? It depends on the family. A family with teenagers can anticipate significant medical expenses like braces and wisdom teeth removal. A family like mine with poor vision can anticipate significant annual expenses in eyeglasses and contacts. And I’ve reached the age where my annual dental expenses are high and my trifocal lenses are very costly. For a number of years I have contributed more than $2,500 to my FSA but regretted contributing too little. For families the new limit could mean a few thousand dollars in extra taxes each year of the teenage years – $10,000 total in new tax burden is not unlikely.
So the FSA is a wonderful thing, but is it adequately exploited by our fellow Americans? I think not. Many fear the use-it-or-lose-it rule. Many bogleheads do. Their fear is, at least in part, irrational.
Let’s consider a family with a 42% marginal tax rate (federal income tax, SS tax, Medicare tax, state income tax, and an AGI-based phaseout such as the child tax credit phaseout). They expect $4,000 of medical expenses next year, but their guess might be off by $1,000 either way. How much should they contribute to their FSA -- $3,000 (minimum), $4,000 (best guess), or $5,000 (maximum)?
If they contribute $3,000 their total gross income consumed by medical expenses will be $3,000 (minimum scenario), $4,724 (best guess realized), or $6,448 (maximum scenario).
If they contribute $4,000 their total gross income consumed by medical expenses will be $4,000 (minimum scenario, $1,000 forfeited), $4,000 (best guess realized), or $5,724 (maximum scenario).
If they contribute $5,000 their total gross income consumed by medical expenses will be $5,000 across the board.
The best guess contribution is the biggest money saver across the bulk of the probability distribution. Only when actual medical expenses are below $3,580 does the best guess contribution spend more than the minimum guess contribution. At this level the $3,000 FSA contribution has to be augmented by $1,000 of gross income with $420 lost to taxes, which is exactly equivalent to contributing $4,000 to the FSA and forfeiting $420 to the use-it-or-lose-it rule.
This simple model ignores three key factors. One is that many medical expenses (eyeglasses, for example) can be accelerated to make use of residual funds or delayed to await the next year’s FSA fund. A second is that some plans (mine, for example) include a 2.5-month grace period, further facilitating FSA fund exhaustion and reducing the guessing burden. A third is that the probability distribution is limited on the low side (and not really at zero, per the eyeglasses example), but not on the high side – that is, a medical disaster is a long tail on the high side of the distribution. Bogleheads are cocoapuffs for vast emergency funds and towering life insurance coverage, but tend to dismiss the risk of disaster when making tax mitigation decisions (especially the Roth vs. traditional decision, but that’s been covered in another thread).
The use-it-or-lose-it rule is especially galling if you are laid off with little notice, because you may not have adequate time to spend your FSA funds. However, it works both ways, since if you’re quick on your feet you can spend your entire year’s FSA amount without actually contributing that much. Certainly folks in volatile industries or failing companies should be more conservative with their FSA commitments. But overall the layoff threat is a low probability event, and letting it be determinative is like forgoing a great ESPP plan because you’re afraid your employer’s stock is going to drop precipitously during every three-day waiting period – if your company stock is dropping that consistently you have a bigger issue to address than whether to invest in the ESPP.
Working with the new $2,500 limit
Since the timing some of my significant medical expenses (eyeglasses in particular) can be managed, and since my plan has a grace period, I intend to max out my FSA at the $2,500 limit every year. Notwithstanding my rational argument above on being aggressive with FSA contributions, my irrational mind must be winning every year, because I have never failed to use every dime of my FSA contributions, even when I was in a plan with no grace period. This year I have already exhausted my FSA.
If the use-it-lose-it rule is actually abandoned, it’s likely that most Americans should contribute the maximum every year, at least until they’ve built up whatever rolling surplus the new rules allow. Couples with low medical costs and access to two FSA’s, for example, will need to see how the carryover rules actually read. I’m all atwitter.