J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

3.16 Flexible Spending Arrangements

A flexible spending arrangement (FSA) allows employees to get reimbursed for medical or dependent care expenses from an account they set up with pre-tax dollars. Under a typical FSA, you agree to a salary reduction that is deducted from each paycheck and deposited in a separate account. The salary-reduction contributions are not included in your taxable wages reported on Form W-2. As expenses are incurred, you are reimbursed from the account. Reimbursements used to pay qualified medical expenses are excluded from your income even though the contributions to your account were also not taxed to you.

The tax advantage of an FSA is that your salary-reduction contributions are not subject to federal income tax or Social Security taxes, allowing your medical or dependent care expenses to be paid with pre-tax rather than after-tax income. The salary deferrals are also exempt from most state and local taxes; check with the administrator of your employer’s plan.

In the case of a health FSA, paying medical expenses with pre-tax dollars allows you to avoid the 7.5% adjusted gross income (AGI) floor (17.1) that limits itemized deductions for medical costs.

However, to get these tax advantages, you must assume some risk. Under a “use-it-or-lose-it” rule, if your out-of-pocket expenses for the year are less than your contributions, the balance is generally forfeited although your employer can give you an additional 2½ months to spend the funds, as discussed ...