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When people have a chance to cut their taxes, they often are willing to jump through all sorts of hoops in order to take advantage. But some coming changes to a major tax break that millions of workers benefit from could dramatically reduce the amount of tax savings you enjoy.
Flex your money muscles
The tax benefit in question is the flexible spending plan, also known simply as flex plans. If your employer offers a flex plan, then every year, you're allowed to set aside a certain amount of money toward out-of-pocket medical expenses for that year.
How it works is simple. Depending on the amount you elect to set aside, your employer will withhold a certain amount from each of your paychecks over the course of the year. In exchange, when you have eligible medical expenses, you're allowed to take the money you've set aside out of your flexible spending account. In other words, the flex plan acts as an aid to help you budget for medical expenses throughout the year.
But the true benefit of flex plans comes from the tax advantages. Flex plans allow you to save pretax money toward those medical expenses. You don't even have to pay Social Security and Medicare taxes on the money you put in your flex plan. On the other end, when you spend money from your flex plan, you don't have to pay taxes on it. So if you're in the 25% income tax bracket, putting $1,000 in a flex plan could save you $250 in income tax, plus another $76.50 in Social Security and Medicare taxes. That's a valuable benefit.
Changes are coming
Unfortunately, the health-care-reform law changed the rules for flexible spending accounts. Beginning next year, you can no longer use flex plan money to buy over-the-counter drugs or medicines unless a doctor has specifically prescribed them.
That's bad news for many of the companies that produce the over-the-counter drugs that the new law excludes. Johnson & Johnson (NYSE: JNJ ) , for instance, sold $438 million in over-the-counter medicines and nutritional products during the third quarter of 2010, and that was down sharply because of numerous product recalls. Other big brands come from Pfizer (NYSE: PFE ) , Procter & Gamble (NYSE: PG ) , and GlaxoSmithKline (NYSE: GSK ) .
Moreover, even non-name-brand companies could feel the bite. Perrigo (Nasdaq: PRGO ) , for instance, is the largest producer of store-brand generic over-the-counter drugs for companies that include both general retailer Wal-Mart (NYSE: WMT ) as well as drugstore chains CVS Caremark (NYSE: CVS ) and Walgreen.
But investors shouldn't necessarily expect a huge hit to the bottom lines of these companies. That's because most people who participate in flexible spending plans use their money for prescription drugs rather than over-the-counter products, according to HR consulting firm Towers Watson.
Perhaps more importantly, a number of over-the-counter products are exempt from the new provisions. In particular, vision products such as eyeglasses and contact lens solution, as well as bandages, dental care products, and even insulin for diabetics will still be eligible for reimbursement under the new flex plan guidelines.
What to do
So instead of overreacting to the changes in the rules, take a more measured approach. It's always a challenge to try to anticipate how much money you'll need for medical expenses in a given year. Because you forfeit unused flex plan money, however, you don't want to set aside any more than you're certain you'll be able to use.
The bigger change to flexible spending plans will come in 2013, when a new maximum of $2,500 will apply. But that's not something you need to think about in considering how much to set aside next year.
Unless you spend an extraordinary amount on over-the-counter drugs, it's likely that you'll need to reduce your flex plan election by only a small amount to reflect reduced eligibility under the new rules. That may cost you a few dollars at tax time, but you'll still be able to get a huge tax break from participating in your flex plan.