Flex plans benefit 2-income families
December 22, 2011
This column is about the wisdom of signing up for your company’s Section 125 flexible spending plan to save a lot of taxes in the coming year. These plans allow employees to save a ton of money by paying for all their health-related expenses with pre-tax dollars — dollars that come right off the top of pay before taxes are calculated. Employers save money as well, since the check for half of the Social Security and Medicare we pay is written by the company.
Not to sound like a tea party member, let me just carp about how much a typical two-income middle-class family pays in taxes on that second income.
Elizabeth Warren, a one-time candidate to run the new consumer protection agency she designed, wrote a great book with her daughter 10 years ago titled “The Two-Income Trap.” It talked about the common phenomenon of young couples wherein both work. All that money coming into households had, in turn, led to the inflated prices for housing along with a host of other unintended consequences.
The most common problem is that, after taxes at the highest marginal rate, the second income take-home pay is often not enough for child care and commuting costs triggered by that second job. When they understand their high marginal tax rates, many young couples decide to live on one income.
For example, if the first spouse makes, say $60,000 and the second makes another $60,000, they are paying almost 45 percent in combined taxes on the second $60,000.
Don’t believe me? Do a rough calculation of what your tax bill will be on this year’s income and then add in the additional amount you normally pay in Social Security and Medicare taxes. On all family adjusted gross income over $60,000, the total of state, federal and social taxes combined will be roughly 40 percent.
Section 125 plans allow employees to sign up before the beginning of the year for what they think they will spend on health-related expenses and children’s day care. Out of each paycheck, before-tax money is deducted and deposited into an account. In other words, about 40 percent of what goes into the account is money that otherwise would have been paid in taxes. It amounts to a 40 percent government subsidy if you think about it.
As the year progresses, a participant in the plan can use the money to reimburse themselves tax free for any health-related expense they have that is not paid by their insurance coverage. This means deductibles, mileage to the doctor, dental work, eye glasses — almost everything anyone expanding their mind can think of that is health-related. It also allows for up to $5,000 per year for children’s day care.
There is a catch, however, and that is the “use it or lose it” feature. By the end of the year, people have to use what they sign up for. Anything left in the account is forfeited and the employer gets to keep it.
In reality, very little ever gets forfeited. Knowledgeable participants have learned how to game the system by purchases like glasses or dental work at year end to blow out the last few dollars.
Unfortunately, these plans are no longer promoted as effectively as they were in their early days. A typical employer just goes with the least expensive administration and gets little in the way of employee education and plan promotion. Short-sighted employers forget that a successful plan presented effectively will receive contribution levels that save the employer as much as twice in taxes what the plan costs to administer.
As for employee participants who are two-income families, the intelligent use of these plans can dramatically reduce the out-of-pocket cost of health care and day care that is otherwise paid with hard-earned, grotesquely-taxed second incomes. Forget what you hear about the so-called 1 percent and their heavy tax burden. Where taxes hurt the most and are at their highest proportionate rate is on the second income to a family.
And get this: while Social Security will stop when the first income reaches $110,000 next year, it starts all over again on the second income right from dollar one. When Elizabeth Warren becomes the next senator from Massachusetts, it will be in character for her to take a shot at creating a more family-friendly tax code.
Steve Butler is president of Pension Dynamics. Contact him at 925-956-0505 ext. 228.
