Flexible spending account

What Is a Flexible Spending Account?

A flexible spending account (FSA) is a tax-advantaged account that allows individuals to set aside pre-tax money from their payroll deductions to pay for out-of-pocket qualified medical expenses or dependent care costs. It falls under the broader category of Personal Finance, specifically within employee benefits and tax benefits strategies. These accounts are typically offered by employers as part of an employer-sponsored health plan and provide a way for employees to reduce their taxable income while covering eligible healthcare or dependent care expenditures. Funds from a flexible spending account can be used for items such as deductibles, copayments, and coinsurance, though generally not for premiums.

History and Origin

The concept of flexible spending accounts emerged in the late 1970s as a response to rising healthcare costs and employers' efforts to manage benefit expenses. Congress formally introduced tax-favorable treatment for FSAs for medical expenses with the passage of the Revenue Act of 1978.¹⁶ Initially, some plans allowed employees to be reimbursed for expenses without a preset annual limit or risk of forfeiture. However, in 1984, the Internal Revenue Service (IRS) issued a ruling that solidified the "use-it-or-lose-it" rule, requiring employees to elect a specific amount each year, with any unused funds typically forfeited at the end of the plan year. This rule was implemented by the IRS due to concerns that FSAs could be used as a means of hiding income.¹⁵ Over time, legislative changes have introduced more flexibility, such as optional grace period and carryover provisions, to address the strict forfeiture rule.

Key Takeaways

• A flexible spending account allows pre-tax contributions for eligible healthcare or dependent care expenses.
• Contributions reduce an individual's taxable income, leading to tax savings.
• FSAs are typically employer-sponsored benefits and are not portable if an employee leaves their job.
• The "use-it-or-lose-it" rule means unused funds are generally forfeited at year-end, though exceptions like grace periods or carryovers may apply if offered by the employer.
• Eligible expenses are defined by the IRS and can include a wide range of medical, dental, and vision costs, as well as dependent care.

Interpreting the Flexible Spending Account

A flexible spending account is primarily a savings and tax-efficiency tool for managing predictable healthcare or dependent care costs. When interpreting an FSA, it is crucial to understand the annual contribution limits, which are set by the IRS and adjusted periodically for inflation. For instance, for plan years beginning in 2025, the maximum carryover amount for health FSAs is $660.¹⁴ The immediate availability of the full elected amount at the beginning of the plan year, even if not yet fully contributed through payroll deductions, is a key feature, potentially offering a cash flow advantage for large early-year expenses. However, the decision to contribute to a flexible spending account should align with an individual's anticipated expenses, given the "use-it-or-lose-it" stipulation. Understanding what constitutes qualified medical expenses is vital to maximize the benefits and avoid forfeiture.

Hypothetical Example

Consider Sarah, who anticipates significant out-of-pocket medical expenses for herself and her family in the upcoming year, including orthodontia for her child and new eyeglasses. Her employer offers a flexible spending account. After reviewing her estimated costs, Sarah decides to contribute $2,500 to her healthcare FSA for the year. This amount is deducted from her paycheck before taxes.

In March, her child's orthodontist bill comes to $1,000, and Sarah uses her FSA debit card to pay for it directly. In July, she purchases new eyeglasses for $400, again using her FSA. By November, she incurs another $600 in various doctor's copayments.

By the end of the year, Sarah has spent $1,000 + $400 + $600 = $2,000 from her $2,500 FSA. If her employer offers a $660 carryover option, Sarah can roll over the remaining $500 into the next plan year, rather than forfeiting it. This allows her to use those funds for future qualified medical expenses, making her initial decision to contribute a prudent personal finance move.

Practical Applications

Flexible spending accounts are widely used in employee benefits packages to help workers manage healthcare and dependent care costs. For consumer-driven healthcare models, FSAs provide a mechanism for individuals to pay for immediate out-of-pocket expenses before meeting high deductibles. They are particularly beneficial for those with predictable healthcare needs, such as ongoing prescriptions, dental work, vision care, or childcare.

The types of expenses that can be reimbursed through a flexible spending account are extensive and are defined by the Internal Revenue Service in publications such as IRS Publication 502, "Medical and Dental Expenses".¹³ This publication details what constitutes a deductible medical expense, covering everything from diagnostic services and treatments to necessary equipment and supplies.¹² FSAs can be used for a variety of services, including dental and vision care, eyeglasses, and hearing aids.¹¹ Additionally, since January 1, 2020, the CARES Act expanded eligible expenses to include over-the-counter medicines without a prescription, as well as menstrual care products.

Limitations and Criticisms

Despite their tax benefits, flexible spending accounts have notable limitations. The most significant is the "use-it-or-lose-it" rule, which historically required participants to spend all funds within the plan year or forfeit any unspent balance to the employer.⁹, ¹⁰ This rule often leads to a scramble at year-end to deplete funds, sometimes on unnecessary items, to avoid forfeiture. While the IRS has since allowed employers the option to offer either a grace period of up to 2.5 months to use funds or a carryover of a limited amount (e.g., up to $660 for 2025 into 2026), these are employer options, not universal mandates.⁷, ⁸ An employer can choose to offer either the grace period or the carryover, but not both.⁶

Another limitation is the lack of portability; flexible spending account funds are typically tied to employment. If an individual leaves their job, any unspent funds are generally forfeited, unless COBRA is elected for the FSA, which is rare. Furthermore, self-employed individuals are not eligible to establish an FSA, as these accounts are exclusively offered through employers.⁵ This can limit their applicability for those not in traditional employment.

Flexible Spending Account vs. Health Savings Account

Flexible spending accounts (FSAs) and Health Savings Accounts (HSAs) are both tax-advantaged accounts designed to help individuals save for healthcare costs, but they differ significantly in eligibility, flexibility, and portability.

The key distinction lies in the requirement for an HDHP for an HSA, making it inaccessible to many. While a flexible spending account offers less long-term flexibility and potential for retirement planning compared to an HSA due to its use-it-or-lose-it nature and lack of portability, it still provides valuable tax benefits for managing immediate out-of-pocket medical and dependent care expenses for a broader range of individuals.², ³, ⁴

FAQs

1. What expenses are eligible for a flexible spending account?

Eligible expenses for a flexible spending account include a wide range of medical, dental, and vision costs not covered by your insurance. This can encompass deductibles, copayments, prescription medications, eyeglasses, contacts, dental work, and even some over-the-counter medicines and menstrual products. The Internal Revenue Service provides detailed guidance on what qualifies as a qualified medical expense.

2. Can I use my flexible spending account if I leave my job?

Generally, no. Funds in a flexible spending account are typically tied to your employer's plan and are usually forfeited if you leave your job. Some plans may offer a limited grace period to incur expenses after your employment ends, or you might be able to continue coverage through COBRA, but this is uncommon for FSAs.

3. What happens if I don't use all the money in my flexible spending account by the end of the year?

Historically, unused funds were forfeited under the "use-it-or-lose-it" rule. However, many employers now offer one of two options: a grace period (typically an extra 2.5 months into the new year to use funds) or a carryover (allowing you to roll over a limited amount, such as up to $660, to the next plan year). Your employer will determine which, if any, of these options are available for your flexible spending account.

4. How much can I contribute to a flexible spending account?

The IRS sets annual contribution limits for flexible spending accounts, which are subject to inflation adjustments. For example, for 2025, the employee contribution limit for a health FSA is $3,200.¹ Employers may also set their own lower limits, and any employer contributions generally do not count against the employee's limit.

5. Can I have both a Flexible Spending Account and a Health Savings Account?

Typically, you cannot have a general-purpose flexible spending account and a Health Savings Account (HSA) simultaneously because HSAs require you to be enrolled in a high-deductible health plan without other disqualifying health coverage. However, some employers offer a "limited-purpose FSA" (for dental and vision expenses only) or a "post-deductible FSA" (for medical expenses after your deductible is met), which can be combined with an HSA.