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Contribute to a 401(k) or an FSA? Why not both?

Posted by Cheryl Costa  September 8, 2008 10:44 AM

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From an investment standpoint is it better to put $3,000 in a flex account to cover my medical/child care or put the $3,000 in a tax deferred 401 plan? If I put it in the flex, I will save $900 in income taxes, but I don't know how to figure if that is really the way to go. Thank you.

I actually don't think this is an either/or question. You would only consider allocating $3,000 to a medical and/or dependent care flexible spending account (FSA) if you knew that you would have medical or childcare expenses that total at least $3,000. If it is a "given" that you have those costs, you will be paying $3,000 in expenses one way or the other. If you can use before tax dollars to cover the expenses by paying for them using an FSA, that is a pretty good deal because you will be getting a "discount".

Your question suggests that you might have $3,000 "extra" to invest. Contributing that amount to your traditional 401(k) would be great and doing so would reduce your taxable income by $3,000 -- just like contributing $3,000 to your FSAs. In addition, the $3,000 contributed to your 401(k) will grow tax deferred for many, many years

FSAs are a great employee benefit and nearly everyone who is eligible should consider participating. In a nutshell, FSAs are tax advantaged programs offered by employers that allow employees to pay eligible medical and childcare expenses using pre-tax dollars.

When you use an FSA to pay for these types of expenses, it is like getting a free discount on expenses you would be paying anyway. The discount is equal to the tax you would have otherwise paid on the money you contributed to the FSAs.

In this example, the person's taxable income is reduced by $3,000 and the "discount" they capture is equal to the tax they would have paid on that $3,000. The exact savings will vary from person to person depending on their marginal tax rate.

You can use a medical flexible spending account to get reimbursed for eligible medical expenses and you can use a dependent care flexible spending account to get reimbursed for qualified childcare expenses for children under the age of 13.

There are no statutory limits on contributions to medical flexible spending accounts, but employers often impose their own limits of $3,000 or $5,000. The limits for dependent care flexible spending accounts are $5,000.

These accounts really are worth the added headache of the associated paperwork. For example, have you ever considered laser eye surgery? This procedure can cost as much as $5,000 and it is not generally covered by insurance. If you can plan ahead and allocate $5,000 to your medical FSA, you can "save" $1,650 on this procedure if you are in the 33% marginal tax bracket. That's probably worth the cost of submitting the required reimbursement forms.


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