The FSA trade-off Flexible spending accounts can save money now, reduce Social Security benefits later

Most Americans aren't saving nearly enough for retirement. File/AP 

This time of year, employees at many companies are deciding whether to fund a flexible spending account for medical or dependent care expenses in 2016.

Those accounts can be a real money-saver. But they do come with a little risk, and there’s one drawback I’ll bet most people are unaware of.

An FSA allows you to shield income from federal income and Social Security taxes on money set aside for qualifying expenses. A medical FSA can be used for things like co-pays and prescriptions. A dependent FSA can go toward child care and certain other bills.

That’s great, but one risk is you must spend all the money set aside within the year or risk losing what’s left. The other catch — and this is the little-known part — is that an FSA will reduce your eventual Social Security check.

First, the benefits. An FSA can be handy for managing cash flow. If you have a big medical expense early in the year, you can spend the full amount you planned to set aside right away. There’s no risk, because if you lose your job, you don’t have to repay any unfunded FSA withdrawals.

Companies benefit because they, too, avoid the 6.2 percent Social Security tax on employee pay put in the accounts. And they get to keep funds unspent during the plan year — more than 10 percent on average, reports suggest.

The rules are quirky because, while FSAs are really funded by workers’ pay, they are treated in the tax code as if they are funded with employer money. That’s why you don’t have to repay FSA funds if you lose your job, and that’s why the company gets to keep any unspent money.

Here’s how the money-saving part works. On every $1 you put in an FSA, you avoid the 6.2 percent payroll tax, plus federal income tax at your top rate.

If your top federal rate is 15 percent, you would save $212 in tax for every $1,000 that goes into an FSA. If your top federal rate is 25 percent, you would save nearly a third of the money (25 + 6.2 = 31.2 percent).

The trade-off: Because contributions are exempt from the Social Security tax, the portion of your income diverted to an FSA won’t count when the government calculates your Social Security benefits.

So, an FSA account puts more money in your pocket today, but also means less money in your pocket when you retire. That doesn’t mean FSAs are a bad idea, but participants need to be aware of the details.

One strategy to consider is using savings from an FSA to increase retirement fund contributions.

Higher contributions to a company 401(k) plan would further reduce taxable federal income, while potentially compensating for the Social Security reduction.

Because of the way the federal tax code and the calculations for Social Security benefits work, higher-income FSA participants get a larger tax-savings benefit in the short term, and they take less of a hit in Social Security benefits in the long term. If you want the details on why, keep reading, but get ready for some math.

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The larger tax benefit is because federal rates escalate as incomes rise. The 2016 federal tax rates for a single filer (on taxable income after exemptions and deductions) are 10 percent on the first $9,275; 15 percent from $9,276 to $37,650; 25 percent from $37,651 to $91,150; and so on.

On the retirement side, Social Security benefits are figured by averaging up to 35 years of earnings, adjusted for inflation. Only the income subject to the Social Security payroll tax is counted (it’s only collected on taxable wages up to $118,500). Then, the formula used to calculate benefits gives heavier weight to lower levels of earnings.

It’s complicated stuff, but just 15 percent of monthly earnings above $5,157 (in 2016) count toward Social Security benefits, while 32 percent of earnings from $857 to $5,157 are counted, plus 90 percent of the first $856.

So, because lower levels of earning carry more weight, reducing those lower levels of earnings by using an FSA has greater impact on Social Security benefits.

My takeaway from this:

If your income subject to Social Security payroll tax will be above $5,157 monthly in 2016, you stand to benefit the most from contributing to an FSA, with both the largest income tax benefit, and the smallest Social Security reduction.

If your top federal tax bracket is 15 percent (like most married couples filing joint returns) it’s more of a classic trade-off — money now or money later.