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This Tax Benefit Is Getting Less Flexible

Dan Caplinger
November 29, 2010

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: