In the scope of health care and financial planning, Americans have access to multiple tools that can help them prepare for both expected and unforeseen medical expenses. One of those instruments is a flexible spending account, commonly referred to as an FSA. An FSA can be a valuable resource, allowing workers to set aside pre-tax money to help cover certain costs that health insurance may not.
Read on to learn about FSAs, how they work, their pros and cons and whether or not they are a good fit for your savings and health care goals.
What is a flexible spending account?
A flexible spending account (FSA) is a type of employer-sponsored savings product that allows employees to set aside some of their earnings on a pre-tax basis to cover qualified health care expenses. These accounts can be used for medical costs for the employee, a spouse or dependents, as well as qualifying dependent care expenses.
An FSA is considered an employment benefit and is typically offered by many employers in the United States during new employee onboarding or open enrollment periods. The aim of an FSA is to help employees who meet eligibility requirements save for specific out-of-pocket medical costs while also reducing their tax liability.
This type of spending account allows employees to use their FSA funds to cover eligible expenses that might not be covered by health insurance or are partially covered, including coinsurance; copays; deductibles; eyeglasses, contact lenses and solution and other vision expenses; birth control; prescription medication, over-the-counter drugs; fertility treatments; menstrual care products; medical devices such as heart rate monitors, blood sugar tests and defibrillators; orthodontics and more.
Costs not covered by an FSA largely depend on IRS guidelines and your employer. However, some items that usually cannot be paid for with an FSA include dental bleaching/teeth whitening, early-pregnancy workshops, insurance premiums, life insurance, long-term care insurance, disability income insurance, massage therapy, tattoo removal and more.
How flexible spending accounts work
FSAs allow you to contribute a portion of your regular earnings before they are subject to income tax to the account. Employer payroll deductions are made based on annual contribution amounts (in equal portions) from employees’ paychecks throughout the year. These pre-tax dollars can also be combined with employer contributions, but the IRS sets annual limits on how much the various types of FSAs allow you to save.
After enrollment in an employer-sponsored plan, you can access the funds in your FSA one of two ways:
1. One option is to use an FSA debit card that is provided by your employer-sponsored plan. This will allow you to automatically make payments directly with the funds available in your account.
2. The second option is to pay upfront and then submit a reimbursement claim form to the company operating the FSA. If the charges are for qualified medical expenses, you’ll typically receive the reimbursed funds within two weeks after the claim and required supporting documentation is filed, approved and processed.
Types of flexible spending accounts
There are three types of FSAs. The following section provides details about each.
Health care FSA
A health care FSA covers an extensive list of qualified medical expenses for employees, their spouses and their dependents. Health care FSAs provide the account holder with more flexibility than a limited purpose FSA or dependent care FSA. These types of FSA plans allow you to roll over a portion of unused funds or spend them during a grace period extending into the next calendar year.
Limited purpose FSA
Whereas health care FSAs allow you to pay for a wide variety of qualified medical expenses, limited purpose FSAs restrict spending to dental and vision exclusively and are commonly used in conjunction with a health savings account (HSA). These types of FSA plans allow you to roll over a portion of unused funds or spend them during a grace period extending into the next calendar year, and they have the same annual contribution limits as a health care FSA.
Dependent care FSA
Dependent care FSAs allow you to use pre-tax dollars to pay for expenses related to eligible dependents, such as a child under the age of 13, a disabled spouse or an elderly parent. This type of FSA can cover costs including but not limited to childcare, preschool, elder daycare, nursery school, before and after school programs and summer day camp.
You must file IRS Form 2441 with your tax return if you have a dependent care FSA, and unlike health care and limited purposes FSAs, the IRS prohibits you from rolling over unused funds from one plan year to the next.
Pros and cons of flexible spending accounts
- Pre-tax savings for qualified expenses
- Can be used for numerous health care and dependent care costs
- Can be used for spouses' and dependents' qualified medical expenses
- Annual contribution limits
- Can't be used to pay insurance premiums
- Doesn't cover all health care expenses
Pros of flexible spending accounts
Pre-tax savings for qualified expenses
The foremost benefit of using an FSA is to take advantage of the tax savings it can provide. Payroll deductions are made with pre-tax dollars, thereby lowering your taxable income. Additionally, for health care and limited purpose FSAs, there are no tax reporting requirements for your income tax return. Lastly, by using pre-tax dollars, you can save an average of 21.35% on qualified purchases.
Can be used for numerous health care and dependent care costs
Depending on which type of FSA you have, your plan can cover a litany of eligible expenses that an employer-sponsored health insurance plan may not cover or only partially cover. While limited purpose FSAs and dependent care FSAs have more restrictions, health care FSAs allow you to cover numerous health care costs with money saved on a pre-tax basis.
Can be used for spouses’ and dependents’ qualified medical expenses
Not only can you use your FSA funds to pay for your own eligible medical expenses, you can use them to pay for qualifying costs associated with your spouse and dependents. With an FSA, this is allowed regardless of whether or not they are on your health insurance plan. Keep in mind that if you do use funds for your dependents’ medical expenses, they must be claimed as dependents on your income tax return.
Cons of flexible spending accounts
Annual contribution limits
Per the IRS, health care FSAs and limited purpose FSAs have annual contribution caps of $3,050. For dependent care FSAs, that limit increases to $5,000 per household annually, or $2,500 if married and filing separately.
If you don’t spend all of the money in a health care or a limited purpose FSA plan year, employers may allow you to either spend the remaining funds during a grace period extending into the next plan year or roll over a portion of the unused funds from one plan year to the next. As of 2023, participants in health care or limited purpose FSA plans are allowed to roll over up to $610.
For dependent care FSAs, the rules are different. These plans are subject to “use it or lose it” conditions. Unspent funds will be returned to the employer, which can keep them, use them to pay for FSA administrative costs or return the funds to the employee. An employer cannot, however, take the unused funds as cash or transfer them to another FSA.
Can’t be used to pay insurance premiums
Despite the fact that you can use an FSA for certain health insurance-related costs, such as deductibles and copays, rules prevent you from using it for insurance premiums. According to 26 U.S. Code § 213(d)(1), which defines qualifying medical care expenses, insurance premiums are ineligible.
Doesn’t cover all medical expenses
Any treatment or product that is not used to maintain health or diagnose, treat, cure, mitigate or prevent a condition, illness or injury is ineligible for FSA payment or reimbursement. For example, this could include cosmetic procedures for reasons other than congenital deformity, disease disfigurement or personal injury; exercise equipment; marriage counseling or alternative medicine treatment.
FSA vs. HSA
Both FSAs and health savings accounts (HSAs) help employees use pre-tax income to save for qualified medical expenses. However, there are numerous differences between the two types of plans. In order to qualify for an HSA, employees must have a high deductible health plan. FSAs are owned by employers, but HSAs are owned by the individual, meaning all of the funds are eligible to roll over, and the plan remains with the account owner even if they leave their place of employment.
Annual contribution limits for HSAs are higher than they are for FSA. For 2024, the annual contribution limit for an HSA is $4,150 for employee-only plans and $8,300 for family plans. Catch-up contributions for those ages 55 and older are limited to $1,000, meaning the cap for employee-only is $5,150 or $10,300 per couple.
Lastly, HSAs allow you to invest in a variety of stocks, bonds and funds once the account meets a minimum threshold. With an FSA, you are not able to invest the funds you have saved and are limited to spending them on medical expenses.
What is a flexible spending account FAQs
What are the annual contribution limits for an FSA?
What are the tax benefits of an FSA?
How much money should I contribute to my FSA?
Summary of Money's What Is a Flexible Spending Account?
A flexible spending account (FSA) is a type of employer-sponsored savings product that allows employees to set aside a portion of their earnings on a pre-tax basis to cover qualified expenses. These accounts can be used for medical costs for employees, their spouses and dependents, as well as dependent care expenses. Because FSAs use pre-tax dollars, they lower your taxable income and can save you money on your medical expenses. With a health care or limited purpose FSA, if you don’t use all of the funds in a calendar year, and a portion of unused funds can be rolled over to a new year or spent during a grace period. Dependent care FSAs, on the other hand, are subject to “use it or lose it” rules. Learning the advantages and disadvantages of an FSA will help you understand how it can benefit you and your family with health care and financial planning.