What Is a Flexible Spending Account (FSA)?
An FSA, short for flexible spending account, is a specialized savings scheme that offers advantageous tax benefits to holders. Referred to as a “flexible spending arrangement” in some instances, an FSA can be initiated by employers on behalf of their staff.
The primary feature of this account is the ability to set aside a portion of your regular income before taxes are deducted. Employers may also contribute to their employees’ FSAs. The funds from this account must be utilized for the reimbursement of qualified medical and dental expenses.
Another version of the FSA is the dependent-care flexible spending account, which caters to childcare expenses for children aged 12 and under. It can also cover the costs of caring for eligible adults, including a spouse, who meet specific Internal Revenue Service (IRS) criteria. Notably, there are distinct contribution limits for medical-related FSAs compared to dependent-care FSAs.
Key Takeaways
- An FSA is a tax-advantaged savings account enabling employees to allocate a portion of their income towards healthcare expenses.
- Contributions to an FSA are exempt from income and payroll taxes.
- Funds withdrawn from an FSA for qualified medical expenses are tax-free.
- Funds in an FSA typically need to be utilized by the end of the plan year, but employers can extend a grace period of up to 2 1/2 months, till March 15 of the subsequent year.
How a Flexible Spending Account (FSA) Works
One of the key advantages of an FSA is that contributions made to the account are deducted from earnings prior to tax deductions, effectively reducing taxable income and lowering annual tax liabilities.
The IRS sets annual contribution limits on FSAs, with a 2024 cap of $3,200 for medical expense FSAs.
For 2024, the contribution limit for dependent-care FSAs stands at $5,000 for joint and individual tax filers, and $2,500 for married individuals filing separately.
Employers were granted additional flexibility for benefit plans during the COVID-19 crisis by the IRS in 2021, with special considerations for health Flexible Spending Arrangements (FSAs). Most of these provisions ceased at the start of 2023, except for selected carryover periods for remaining funds into the subsequent year.
Pros and Cons of Flexible Spending Accounts (FSAs)
Beyond their tax advantages, FSAs offer various benefits to account holders, although not all medical or dental expenses are covered. Here are some of the pros and cons:
Pros
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Reimburse medical care payments
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Pay spouses’ and dependents’ qualified medical expenses
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Cover many medical equipment purchases
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Reimburse amounts paid for insurance plan deductibles
Cons
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Some procedures or health-related expenses aren’t covered
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Funds have a “use it or lose it” provision
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Can’t be used to pay for insurance premiums
Pros
- Reimburse medical care payments: FSA funds can cover a wide range of medical expenses, including those related to disease prevention and treatment.
- Pay spouses’ and dependents’ qualified medical expenses: FSA funds can be utilized for eligible costs incurred by family members.
- Cover many medical equipment purchases: FSA funds can be used for various medical equipment and prescription medications.
- Reimburse amounts paid for insurance plan deductibles: Allowable usage of FSA funds includes insurance plan deductibles and other medical service payments.
The CARES Act of 2020 expanded FSA-eligible expenses to include over-the-counter drugs without prescriptions and menstrual care products. These provisions are now permanent.
Cons
- Some procedures or health-related expenses aren’t covered: Cosmetic surgeries and non-essential items or services are excluded from reimbursement.
- Funds have a “use it or lose it” provision: Generally, FSAs require full utilization within the plan year, though some exceptions exist, such as a grace period.
- Can’t be used to pay for insurance premiums: FSAs are ineligible for premium payments, despite covering deductibles.
The IRS announced in September 2021 that FSAs, HSAs, and HRAs could cover eligible medical expenses like at-home COVID-19 tests and personal protective equipment for taxpayers
Special Considerations
Balances in a FSA that remain at the year-end or after any grace period are forfeited. Therefore, deliberate planning is necessary to determine appropriate contribution levels and usage throughout the year.
How Limited Purpose FSAs Work
A distinct FSA type, a “limited purpose flexible spending arrangement” (LPFSA), pairs with a health savings account (HSA) and is not compatible with a standard FSA. Contributions are made using pre-tax earnings.
The LPFSA is restricted to dental and vision expenses and is commonly combined with a high-deductible health plan (HDHP) where an HSA is utilized for medical costs related to the HDHP.
How Much Should I Contribute to My FSA?
No specific contribution amount suits everyone, as individual FSA elections vary based on anticipated out-of-pocket healthcare expenses for the upcoming year.
What If My Spouse is Enrolled In a Different Health Insurance Plan?
Funds from your healthcare FSA may be used for eligible medical expenses for both your spouse and tax dependents, irrespective of their insurance coverage. To utilize funds for dependents, they must be noted on your tax return, and dependents cannot file separate returns.
Can I Use an FSA with a Health Insurance Marketplace High-Deductible Plan?
FSAs are incompatible with Marketplace plans. Instead, a Health Savings Account (HSA) can be established to allocate pre-tax funds for certain health expenses with that type of health insurance.
The Bottom Line
An FSA enables individuals to reserve a portion of their income before taxes for medical and dental expenditures. Typically administered by employers for their staff, employers can also contribute to employee FSAs. Funds must be directed towards qualifying medical and dental expenses. A separate FSA is established for dependent care.
An annual maximum contribution limit applies, and the majority of funds need to be exhausted within the same calendar year to prevent loss, necessitating cautious planning by FSA account holders.