Benefits Strategy

What is a Flexible Spending Account (FSA) and How to Make the Most of It

Written by Kate

In 1978, an unlikely combination of tax reform legislation and a desire to save on medical costs gave rise to the Flexible Spending Account (FSA), a key employee fringe benefit still commonly used today. For most individuals with employer-funded health plans, a flexible spending account is a flexible spending arrangement where employees enjoy pre-tax savings on out-of-pocket qualified medical costs and health expenses, like prescription medications or dependent care costs, not covered by their employer’s health plan. 

But do FSAs deliver on their promised tax savings on employee health expenses even with the recent expansion of eligible expenses? And what are the commonly associated issues? In this article, we will explore how FSA works. Click on the specific questions below to learn more:

What is a Flexible Spending Account (FSA)?

A Flexible Spending Account (FSA) is a tax advantaged savings account where employees contribute a portion of their taxable income into a spending account, and distributions from the account reimburse account holders for qualified medical expenses not covered by their employer’s health insurance plan. The deductions from an employee’s income are typically made on a pre tax basis, and you do not pay taxes on the FSA funds withdrawn from a spending account to pay for medical care.

tax benefits of flexible spending account

By making an annual contribution to a health care FSA, employees have greater control of their health care costs and reap significant tax savings. Employees can set up a health care FSA or a dependent care FSA, depending on their ongoing health care costs and medical expenses. Both employer-sponsored tax advantaged accounts allow employees to use pre tax dollars to reduce any FSA eligible medical expenses. For 2023, the Internal Revenue Service IRS increased the health care FSA accounts contribution limit to $3,050 per employee. The contribution limit for dependent care FSA is $5,000 for joint and individual tax returns and $2,500 for spouses filing separately. Spouses of married employees also have the same contribution limit with their employer FSA. Employer contributions to employee FSA funds are not mandatory or taxable.

How Does a Flexible Spending Account Work?

Flexible Savings Accounts work like an annual line of credit you can use for FSA eligible expenses. However, there are no repayment concerns because the money will be deducted from your paycheck.

Setting up an FSA is highly beneficial because of the potential tax savings benefits, but only some people need one. You must consider yourself and your family’s expected or current health care costs, including ongoing dependent care expenses, to determine if an FSA is right for you. You can use your FSA funds on several eligible medical expenses, like co-payments, dental expenses, vision care expenses, first aid supplies, home COVID-19 test kits, over the counter drugs, including doctor’s prescription medications. 

It is essential to know there are two types of Flexible Savings Accounts operating differently. They include:

Health FSA

Also known as a medical or health care FSA, it is the most common FSA type, with companies often offering health care FSAs alongside traditional health benefits plans. A health FSA is an appropriate spending account for employees with recurrent medical expenses and ongoing health care costs. And it offers the additional benefit of lowering your income taxes during the calendar year.

Account holders can use the pre tax money in their health care FSA to cover certain expenses and items allowable for the IRS medical tax deduction. Companies may issue employees with healthcare spending accounts debit cards, allowing them to pay for FSA eligible expenditures at their local pharmacies or groceries.

Dependent Care FSA

Dependent care flexible spending account is an FSA type allowing employees to achieve pre tax savings on dependent care costs. Most parents in the United States report spending more than 10% of their annual income on child care expenses. By setting up a dependent care FSA with an employer, parents can pay for the child care costs of their children under 13 while working.

dependent care FSA

Dependent care FSAs also cover daycare costs of eligible adults incapable of self-care ( adults in day camp, but not in nursing homes), including a spouse, adult child under age 26, or a parent who meets the relative qualifying test according to IRS guidelines. 

Dependent care FSAs have different IRS limits for employee contributions. Federal rules limit dependent care annual contributions to $5,000 per household, including your spouse’s contributions to their employer’s dependent care FSA. Unlike health care FSAs, where employees are reimbursed for the entire year’s contribution on day one. A dependent care FSA is not pre-funded; you can only be reimbursed for the amount deducted from your paycheck.

What Expenses Can Flexible Spending Accounts Cover?

Medical expenses typically covered by Flexible Spending Accounts depend on the FSA type. Let us take a look at some of them:

1. Health FSA

Employees can use medical or health care FSA funds to pay for eligible medical expenses not covered by their health insurance plan. Other qualified medical expenses covered by your health care include deductibles, coinsurance, copayments, your doctor’s prescription, dental care, medical equipment, medical care, and vision care. 

The list of everyday over-the-counter items covered by your health care FSA includes:

  • Menstrual products
  • Pain relief drugs
  • Diagnostic devices like blood sugar testing kits
  • Birth control
  • Insulin
  • Crutches
  • Bandages
  • Reading glasses
  • Eyeglasses repair kits
  • Pregnancy tests
  • Psychological treatment
  • Sunscreen

You can not use the funds in your health FSA to pay for the following expenses, however:

  • Insurance premiums
  • CBD products
  • Cosmetic procedures

2. Dependent care FSA

You can spend the money in a dependent care FSA on childcare expenses (for kids under 13) while at work. Funds in your dependent care FSA also cover the care costs of eligible adult dependents, including your spouse. Eligible expenses include the following:

  • Daytime babysitting (during work hours)
  • Nanny
  • Preschool
  • Nursery school
  • After-school programs
  • Day camp
  • Adult or elder day care

Funds in a dependent care FSA can not be used for the following purposes:

  • School tuition
  • Tutoring program
  • Sleep away camps
  • Long-term assistance living facilities, including nursing homes

What Is the Difference Between HSA and FSA?

Although employers generally offer a Health Spending Account (HSA) as a consumer-driven health care plan component, it shares a similar tax structure with an FSA. Both tax-advantaged accounts allow taxable income to be used as payment for certain expenses resulting in lower tax liabilities for the account owner. There are key differences between an FSA and an HSA; the table below highlights a few:

health spending accounts vs.flexible spending accounts

What are the Pros and Cons of a Flexible Spending Account?

As more companies adopt Flexible Spending Accounts as a key component of their health benefits strategies, several employees remain cautious about setting up an FSA account despite its unique benefits. According to a survey by Mercer, approximately 88% of large employers offer FSA programs, while only 22% of employees are enrolled. 

Below are some pros and cons of FSAs, allowing you to decide if you need one:

Pros of FSA accounts

  • Tax savings on FSA eligible medical expenses, reducing income tax payments.
  • Reimbursements for spouse or dependent qualified medical expenses, including treatments, care, diagnosis, and preventative tests.
  • Pay for over-the-counter drugs and everyday medical items like bandages, sunscreen, reading glasses, etc. with pre-tax dollars.
  • Conveniently use pre-loaded debit cards to shop online and through point-of-sale outlets in pharmacies and grocery stores.
  • Receive reimbursements for insurance plan deductibles and copayments.
  • Employers can claim any unspent funds in employees’ FSA accounts at the plan year’s end under the use-it-or-lose-it rule, a major incentive to set up an FSA program.

Cons of FSA accounts

  • FSA does not cover all employee health expenses, including surgeries, specific health benefits, or procedures deemed not beneficial for general health, like gym memberships and cosmetic surgery. 
  • Employees can lose access to unused funds after the plan year ends. Employers often include a rollover limit into the following year or a grace period of up to two months, allowing you to spend the remaining funds in your account 
  • FSA limit contributions restrict the funds available to cover eligible medical expenses. 
  • Because FSA is tied to an employer and is not portable, employees lose access to its funds when leaving jobs.

What Happens to Funds from an FSA that You Don’t Use?

Funds in employee FSA accounts are allocated year-to-year and must be spent within the plan year, or leftover funds are subject to the IRS use-it-or-lose-it rule. However, employers may (but are not compelled) offer the following options under new guidelines.

  • Allow employees to carry over a maximum of $610 each year into the following plan year.
  • Provide a grace period of two and a half months, allowing employees to spend the money in their accounts.
FSA allocated year to year

Closing Thoughts

Having an FSA offers two benefits: reducing the employee tax burden incurred by high medical costs and lowering the employer’s payroll taxes. However, employees must consider the following if they want to enjoy the maximum benefits of their FSA money.

  • Carefully plan your medical and other expenses allowed by your FSA so as not to lose leftover funds at the year’s end or when the FSA grace period ends.
  • Employers set the rollover rules. Understanding your employer’s rollover instructions on accessing your funds after the year ends is crucial.
  • Check your employer’s health plan to know the extent of your FSA coverage of coinsurance, copayments, prescription drugs, and other expenses.

Making your FSA work for you is our priority at IncentFit. Our team of experts is a phone call away from helping your organization develop a great FSA benefits program.

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