A flexible spending account, or FSA, is a special pre-tax spending account that many employers provide as an employee benefit. These accounts allow you to pay for necessary expenses without paying taxes on the money that goes into them.
Learn what an FSA can cover and how you can lower your tax burden by using one to pay for everyday expenses.
- A flexible spending account helps you pay for medical or childcare expenses.
- Contributions to the FSA are made before taxes, so they lower your taxable income.
- FSAs can also reduce your payroll taxes because the money comes out of your pay before taxes are collected.
- Note that using dependent-care FSAs may prohibit you from taking other tax credits, such as the Dependent Care Tax Credit.
What Is an FSA?
Flexible spending accounts (also referred to as FSAs or flexible spending arrangements) are savings programs designed to help you pay for necessary expenditures like:
- Medical and dental expenses, such as copays, deductibles, and prescriptions, including insulin
- Medical equipment, such as crutches, hearing aids, eyeglasses, or blood sugar testing kits
- Childcare expenses, such as daycare payments
Money in an FSA may not be used to pay for insurance premiums.
FSAs must be set up through your employer, so you can set aside pre-tax dollars to help pay for these necessary expenses. This money is taken out of your paycheck and deposited into a separate account. Your employer may contribute but is not required to.
Each FSA is limited to $2,750 per year per employer. If you are married, your spouse can have an FSA of up to $2,750 with their employer as well. In 2022, that figure increases to $2,850.
How FSAs Lower Your Tax Bill
Any contributions you make to an FSA plan are set aside pre-tax. This means you will not have to pay income taxes on the money that is put into your FSA.
After the money goes into your FSA, you must submit receipts for eligible expenses before they can be reimbursed. FSAs have scheduled reimbursement times, usually chosen by your employer.
In addition to reducing the amount of income tax you pay, FSA contributions also reduce your payroll or FICA taxes, which will constitute a fair amount of savings on your part.
This is the only way you can actively reduce your payroll tax, short of taking a cut in pay.
Disadvantage of FSAs
A big drawback with FSAs is that you must use all of the money you have set aside each year. If you don't, the contributions are forfeited. Your employer is not required to refund any of the plan's balance to you.
There are a few ways to avoid forfeiting all the money, depending on how your FSA is structured:
- The IRS will allow FSAs to pay out claims up to two and a half months after the end of the plan's benefit year.
- If your plan permits it, you may roll over up to $570 that was unused in your FSA to the next year's account.
Your plan administrator is not required to do either of these things. You can ask your human resources representative if any of your FSA money can be carried over to the following year.
Due to laws passed to help combat the impact of the pandemic, employers can allow FSA plan participants to carry over all unused funds from 2021 to 2022.
Types of FSAs
FSAs come in two varieties:
- Medical FSAs can be used to cover medical, vision, and dental expenses that are not covered by another health plan.
- Dependent care FSAs help cover child care costs.
Medical FSA Savings
Due to the escalating cost of medical care and prescriptions, medical FSAs are particularly advantageous. You can use the money in them to pay for appointments, prescriptions, and other medical costs that are not covered by another health, vision, or dental plan.
You can also use a medical FSA to cover over-the-counter health expenses or alternative treatments, such as:
- Over-the-counter medication
- Menstrual care products
- Birth control
- Denture cleaner
- Alcoholism treatment
- Fertility treatments
For most taxpayers, using an FSA is the only way to reduce the tax burden on money that you use to pay medical expenses.
Medical expenses are tax-deductible only when your expenses exceed 7.5% of your adjusted gross income. And you can only deduct them if you itemize all your deductions rather than taking the standard deduction.
Medical FSAs start by reducing your taxable income. Then, contributions in a medical FSA can be used to cover expenses, many of which would not otherwise be tax-deductible.
Dependent Care FSA Savings
Dependent care FSAs are used to set aside pre-tax dollars to pay for qualified dependent care expenses. This can include:
- Daycare or preschool
- Adult daycare for elderly or disabled adults
- A nanny, au pair, or babysitter
- Day camp
- After school care
- Custodial elder care
These expenses must:
- Be for a dependent in your care
- Allow you to work, look for work, or attend school full-time
If you use your FSA to pay for dependent care, you generally cannot take the Dependent Care Tax Credit on your income taxes. Consult a tax professional to see which type of savings will be more beneficial to you.
This is an important benefit today because of the "sandwich generation" that must care for their children as well as their ailing parents. However, anyone with young or old dependents at home who needs to work or attend school can benefit from using a dependent care FSA.
The Bottom Line
FSAs are a flexible way to reduce your tax burden while paying for important and necessary expenses such as healthcare costs, medical supplies, prescriptions, and care for your dependents.
However, because FSA contributions do not necessarily roll over into the next year, you will receive the most tax benefit if you only contribute what you know you can use by the end of the year to your FSA. If you use all the money in your FSA every year, you will get the most tax benefit.
Using an FSA to pay for childcare costs can also prevent you from receiving certain deductions or credits on your income tax return. Consult a tax professional to find out which choice will save you more money on your taxes.
Frequently Asked Questions (FAQs)
Does an FSA reduce your taxable income?
Yes, an FSA reduces your taxable income because your contributions are funded with pre-tax dollars. However, because they're pre-tax dollars, you can't claim a deduction for expenses paid with an FSA.
How much can you save on taxes with an FSA?
By using pre-tax funds, you can save up to 30% when you pay for qualified expenses with your FSA. However, you must be sure to spend everything in your account each year, or at least up to the rollover limit if your account allows for rollovers. Otherwise, you forfeit the funds, and you'd be losing money instead of saving it.