Anyone who has tried to wade through the health care tax laws knows the deeper you get, the further you can be from understanding them.

No matter what else you may think about substantive health care reform, the need for simplification of the related tax provisions is something about which we can all agree.  Sadly, that day hasn’t arrived, yet.  In the meantime, here is some helpful information about two of most common health care tax breaks—the flexible spending account (FSA) and the medical savings account (MSA), or health savings account (HSA).

Flexible Spending Account
Most of us are familiar with the flexible spending account.  It is an account provided by your employer for reimbursement of medical expenses.  Each year, you elect to have a portion of your paycheck deposited into the account pre-tax.  Then, when you have medical expenses, you submit receipts to your employer and receive reimbursement from your account.  The good news is that the money you contribute to your account is not taxed.  But the bad news is that you have to use it or lose it.  If you contribute more money to the account than you spend on medical care, your employer can’t refund your excess contribution, and it doesn’t carry over to the next year either.  It just vanishes, into the hands of your employer.

Because most of us aren’t related to Nostradamus, the “use it or lose it” system makes FSAs less than ideal for tax planning.  If you contribute too much, you lose your excess contribution.  But if you contribute too little, you forego valuable tax savings.

So what should a savvy tax planner do?

Start by keeping track of your yearly expenses.  Since some of them are recurring, like your annual checkup, your Acuvue lenses (Stock Quote: JNJ), or a year’s supply of Advil (Stock Quote: WYE), you’ll have a good starting point.  Add any other expenses you know you’ll incur.  Is this the year that you’re having knee surgery?  If so, throw in a little bit of extra dough. 

Finally, it’s better to contribute too little than too much.  There are two reasons why you should err on the side of shortchanging yourself.  First, if you contribute too much, you’ll lose your excess contributions.  Second, if your medical expenses are so hefty that your FSA won’t cover them, you may be able to deduct them on your Form 1040.  This isn’t a great option, though, because the medical expense deduction is limited, and it’s only available if you itemize.  In the end, your best bet is to make a close estimate, so be sure to keep good records from one year to the next.

Health Savings Account
If the “use it or lose it” aspect of the FSA doesn’t appeal to you, you might consider opening a health savings account or a medical savings account instead. These accounts are similar to individual retirement accounts, but they are used to pay for the cost of health care rather than the cost of retirement.  MSAs are limited to the self-employed and people who work for small employers.  Because the two accounts are nearly identical and because HSAs are more broadly available, we’ll focus on those instead. 

Contributions to an HSA are not taxed, and unlike contributions to an FSA, they remain in your account from year to year.  Like an IRA, the money in an HSA can be invested, and the investment return is not taxed.  As a result, it’s possible to contribute money to an HSA and let your money grow tax free until you need it.  This makes HSAs a good choice for people who anticipate few medical expenses in the near future.  Finally, distributions from your account are also tax free, as long as you use them for medical expenses.