How To Use an FSA to Lower AGI: A Little-Known Student Loan Strategy

A flexible spending account (FSA) can help pay for out-of-pocket medical costs, including copays, medications and other eligible expenses. But it can also be a valuable financial tool for reducing your adjusted gross income (AGI), which in turn, reduces your tax bill and federal student loan payments. Here’s how to use an FSA to lower your AGI.

What’s an FSA?

A healthcare FSA (also called a flexible spending arrangement) is an employer-sponsored benefit that allows you to set money aside to be used for eligible healthcare costs for yourself, spouse and dependents.

FSA contributions are made using a special pre-tax account. You simply designate how much you want to contribute annually. Your employer then automatically deducts corresponding amounts divided among your paychecks throughout the year. Your employer can also choose to make contributions, but isn’t required to.

Healthcare FSAs have an annual contribution limit, which includes any contributions made by the employer or employee. For 2024, the maximum contribution limit is $3,200.

What can an FSA be used for?

The Internal Revenue Service (IRS) regulates what can be paid for using an FSA. The list generally includes medical care expenses such as:

• Deductibles and copayments (excludes health insurance premiums).
• Prescription and over-the-counter (OTC) medications.
• Medical devices or equipment.
• Dental and vision expenses.
• Baby healthcare essentials (e.g., nursing and milk storage).
• Maternity and postpartum items.

The list of eligible items continuously changes, allowing for more products and services to qualify. If you have a medical need, there’s a good chance you can benefit from an FSA.

What’s the difference between an FSA and an HSA?

A health savings account (HSA) functions similarly to an FSA in that it serves as a pre-tax account for eligible medical expenses. Therefore, both types of accounts can help lower your AGI. But there are some distinct differences, including but not limited to:

• FSA accounts are “use-it-or-lose-it”. You must spend most or all of your FSA funds by the end of the plan year. However, some plans provide a grace period, giving you a couple of extra months to spend your FSA money. Alternatively, you might have the option to carry over funds to the next year. If so, the maximum carryover for 2024 is $640. In contrast, HSA funds are yours to keep until you spend them, even through retirement years.
• HSA funds can be invested. You can keep an adequate amount in the HSA cash account and then invest the rest for long-term financial growth.
• HSAs are available to anyone with a high deductible health plan (HDHP). You can open and contribute to an HSA as long as you have a qualifying health insurance plan. Whereas an FSA is an employer-sponsored plan. Therefore, you’ll lose access to the FSA if you change employers (in which case you’ll want to deplete your FSA funds before leaving).
• You can change your HSA contributions at any time. FSA contributions are designated at the beginning of the year and can only be changed for qualifying events.

If you aren’t likely to use the full FSA amount each year on qualifying medical expenses, you’re probably better off using an HSA if eligible. You can get a similar contribution limit, keep your funds and continue growing your money  — all while reducing your taxes and student loan payments.

How to use an FSA to lower your AGI

Your adjusted gross income is used as the starting point for calculating your taxes and determining your monthly payment on an income-driven repayment (IDR) plan. Therefore, an FSA gives you the opportunity to lower your taxable income and student loan payments since contributions are made with pre-tax dollars.

Reducing student loan payments through FSA contributions

The Department of Education offers several IDR plans with monthly payments based on your discretionary income. For example, the new SAVE plan (formerly REPAYE) uses 5% to 10% of your discretionary income, depending on whether you have undergraduate or graduate loans.

Your discretionary income is determined by factoring in your adjusted gross income and the federal poverty line deduction based on your family size. By strategically using an FSA to lower your AGI, you can chip away at your required monthly payment.

Start by calculating your annual FSA contribution based on your estimated medical expenses for the upcoming year. Keep in mind that FSAs are use-it-or-lose-it. But you can also purchase many OTC drugs and everyday items that you might otherwise overlook (e.g., menstrual care products and first aid supplies). 

You can then see how your student loan payments will be affected by your FSA contributions.

Here’s an example of how to use an FSA to lower AGI based on a student loan borrower (Alexandra) with an existing taxable income of $100,000. She has $150,000 in federal student debt from graduate school. Her current monthly payment under SAVE is $560.

By making the 2024 maximum contribution of $3,200, Alexandra can further reduce her AGI down to $96,800. In turn, her student loan payment would be $533. That’s a savings of $324 per year, or potentially $8,100 over a 25-year plan.

Opportunity for additional savings for married couples

HSAs have an annual contribution limit of $4,150 for self-only coverage and $8,300 for plans with family coverage for 2024. However, FSAs don’t have this family contribution option. Instead, both you and your spouse can have your own healthcare FSA through your respective employers, allowing you each to contribute up to the annual limit in your own account.

For example, let’s say you file your income tax return as married filing separately. If you max out both of your FSA accounts, you could save around $640 a year on student loan payments under the SAVE plan.

Related: Lowering Your AGI and Student Loan Payments with Municipal Bonds: A Win-Win Solution

Maximizing medical FSA contributions

Healthcare FSAs can be a strategic tool for reducing your taxable income and lowering your IDR monthly payment. You might even be able to further lower your AGI using a dependent care FSA, which can be used for eligible dependent expenses like preschool, childcare and summer camps.

The main thing to remember with an FSA is that you’ll lose some or all of any remaining funds if they aren’t spent within the plan year. So, it’s best to look at your previous year’s spending and forecast upcoming costs to land on a realistic annual contribution amount. That said, if you have access to an HSA, you can take advantage of triple tax savings (tax-free contributions, tax-free growth and tax-free distributions for eligible expenses) for any funds you don’t need for immediate medical expenses.

Our expert financial planners can help you maximize student loan and overall personal finance strategies such as these to save you time, money and stress. Reach out to our SLP Wealth team to learn more.