Flexible spending arrangement

What Is Flexible Spending Arrangement?

A Flexible Spending Arrangement (FSA) is a tax-advantaged account offered by employers that allows employees to set aside money on a pre-tax dollars basis to pay for certain qualified medical expenses and dependent care costs. As a type of employee benefits and a component of tax-advantaged accounts within personal finance, FSAs provide significant tax benefits by reducing an individual's taxable income. Funds are contributed through payroll deductions throughout the year, and the full election amount is typically available for reimbursement from the first day of the plan year.

History and Origin

The concept of Flexible Spending Arrangements emerged in the late 1970s as a response to rising healthcare costs and employers seeking ways to offer more flexible employee benefits. The creation of FSAs was enabled by the Revenue Act of 1978, which provided tax-favorable treatment for such accounts, initially focusing on medical expenses.⁴³, Prior to this legislation, employers faced increasing costs for health benefits, leading them to introduce deductibles and coinsurance or to exclude coverage for certain medical items.⁴² The introduction of FSAs allowed employees to pay for out-of-pocket medical and dependent care expenses with pre-tax dollars, effectively reducing their overall tax burden.⁴¹ Initially, FSAs were subject to a "use-it-or-lose-it" rule, meaning any unused funds at the end of the plan year were forfeited.,⁴⁰ This rule was implemented by the IRS in 1984 to prevent employees from using FSAs as a mechanism to hide income.,³⁹ Over time, the IRS introduced modifications to this rule, including optional grace period and rollover provisions to provide more flexibility to account holders.³⁸

Key Takeaways

• Flexible Spending Arrangements (FSAs) allow employees to contribute pre-tax income for eligible healthcare and dependent care expenses.
• Contributions to an FSA reduce an individual's taxable income, leading to tax savings.
• The "use-it-or-lose-it" rule generally applies, requiring funds to be spent by the end of the plan year, though employers may offer a grace period or a limited rollover option.
• Funds are typically available in full at the start of the plan year, regardless of how much has been contributed via payroll deductions to date.
• FSAs are tied to employment and are not portable if an individual leaves their job, with limited exceptions.

Interpreting the Flexible Spending Arrangement

Understanding a Flexible Spending Arrangement involves recognizing its tax advantages and usage rules. The primary benefit of an FSA is the ability to pay for qualified medical expenses or dependent care with untaxed dollars. This means that money allocated to an FSA avoids federal income taxes, Social Security taxes, and Medicare taxes, leading to substantial savings. For instance, an individual in a 25% federal tax bracket, plus state and FICA taxes, could save 30% or more on every dollar contributed to their FSA.

The amount an individual can contribute to a health FSA is subject to annual limits set by the IRS, which are adjusted for inflation. For 2024, the maximum amount for a health FSA is $3,200.³⁷ Employers sponsoring an employer-sponsored health plan offering an FSA can also set lower limits. The "use-it-or-lose-it" rule is a crucial aspect of FSAs: generally, funds not used by the end of the plan year are forfeited. However, employers may offer one of two exceptions: either a grace period of up to 2.5 months after the plan year to use the funds, or a limited rollover of up to $640 (for 2024) into the following year.³⁶,³⁵ It is important for participants to estimate their anticipated eligible expenses accurately to avoid forfeiture.

Hypothetical Example

Consider Sarah, who is employed by a company offering a Flexible Spending Arrangement. She anticipates significant out-of-pocket medical costs in the upcoming year, including deductibles, copayments, and prescription medications not fully covered by her employer-sponsored health plan.

Sarah decides to contribute $2,000 to her health FSA for the plan year. This amount is deducted from her paycheck in equal installments over the year on a pre-tax dollars basis.

In February, early in her plan year, Sarah undergoes a medical procedure with an out-of-pocket cost of $1,500. Even though she has only contributed a small portion of her $2,000 election through payroll deductions at this point, the full $2,000 is available for her to use. She submits a claim for reimbursement from her FSA and receives $1,500. Her remaining FSA balance is $500.

Later in the year, Sarah uses the remaining $500 for prescription refills, dental work, and new eyeglasses, which are all qualified medical expenses. By the end of the plan year, she has used all $2,000, saving a substantial amount in taxes compared to if she had paid for these expenses with after-tax income.

Practical Applications

Flexible Spending Arrangements are a common offering in employee benefits packages, primarily used by individuals to manage various healthcare and dependent care costs. One key application is covering out-of-pocket medical expenses such as doctor visit copayments, prescription drugs, dental care, vision care, and even over-the-counter medications and menstrual care products following recent rule changes.³⁴,³³ FSAs can also be used to pay down deductibles and coinsurance associated with health insurance plans.

Beyond healthcare, Dependent Care FSAs (DCFSAs) are utilized for eligible dependent care expenses, such as daycare, preschool, or elder care, enabling working parents or guardians to pay for these services with pre-tax income. This application of the Flexible Spending Arrangement is particularly valuable for families seeking to reduce their taxable income. The Internal Revenue Service provides comprehensive guidance on eligible expenses for both types of FSAs in publications such as IRS Publication 969.³²,³¹

Limitations and Criticisms

Despite their considerable tax benefits, Flexible Spending Arrangements come with notable limitations and criticisms. The most significant drawback is the "use-it-or-lose-it" rule, which mandates that funds not spent by the end of the plan year (or extended grace period or limited rollover) are forfeited to the employer.,³⁰,²⁹ This rule often leads to participants overspending at year-end to deplete their balances or losing unused funds. Some employees avoid FSAs entirely due to this forfeiture risk, despite the potential tax savings.²⁸

Another limitation is that FSAs are tied to employment. If an individual leaves their job, the FSA funds are generally forfeited, unless certain continuation rules like COBRA apply, or if the employer's plan allows for a limited reimbursement period post-employment.²⁷ Furthermore, unlike Health Savings Accounts, FSA funds do not earn interest or grow over time. Contributions to a Flexible Spending Arrangement are also fixed at the beginning of the plan year, making it difficult to adjust if an individual's healthcare needs or dependent care expenses change unexpectedly during the year, although temporary relief was provided during the COVID-19 pandemic allowing for mid-year election changes.²⁶ The IRS limits on contributions, while adjusted annually, can sometimes be insufficient for individuals with very high medical costs.²⁵

Flexible Spending Arrangement vs. Health Savings Account

Flexible Spending Arrangements (FSAs) and Health Savings Accounts (HSAs) are both tax-advantaged tools for healthcare expenses, but they differ significantly in eligibility, ownership, and flexibility.

Confusion often arises because both accounts offer tax savings for healthcare costs. However, the requirement of being enrolled in a high-deductible health plan is the primary differentiator for HSA eligibility, which does not apply to a Flexible Spending Arrangement. Individuals cannot typically contribute to both a health FSA and an HSA in the same year, though a "limited purpose" FSA (for vision/dental only) can be combined with an HSA.⁸,⁷

FAQs

Can I have both an FSA and an HSA?

Generally, you cannot have a health Flexible Spending Arrangement and a Health Savings Account simultaneously, as the eligibility requirements conflict. However, you can have a "limited purpose" FSA, which covers only dental and vision expenses, along with an HSA. You can also have a Dependent Care FSA alongside an HSA.⁶,⁵

What happens if I don't use all the money in my FSA by the end of the year?

Under the traditional "use-it-or-lose-it" rule, any unused funds in your Flexible Spending Arrangement are forfeited at the end of the plan year. However, your employer may offer one of two exceptions: a grace period of up to 2.5 months to use the funds, or allow a limited rollover amount (e.g., up to $640 for 2024) into the next plan year. It is crucial to check your specific employer-sponsored health plan details.⁴,³

What kinds of expenses are eligible for FSA reimbursement?

A wide range of qualified medical expenses are eligible for FSA reimbursement, including deductibles, copayments, prescription medications, dental care, vision care (including eyeglasses and contact lenses), and many over-the-counter medical products. For a comprehensive list, you can refer to IRS Publication 969 and Publication 502, or consult your plan administrator.²,¹ If you have a Dependent Care FSA, eligible expenses include costs for childcare for children under 13 or care for a disabled spouse or dependent, enabling you to work.