A flexible spending account (FSA) is an employer-sponsored account that lets employees pay for certain medical or dependent care with tax-free dollars.
An FSA aims to reduce the financial burden of health care and child care, two of the most significant financial hurdles for American consumers. Here’s what you should know about flexible spending accounts to determine if one makes sense for you.
Definition and Example of a Flexible Spending Account
A flexible spending account (FSA) is an account you get through your employer that lets you pay for certain medical or dependent care with tax-free dollars. FSAs are popular because of this tax benefit.
If an employer offers an FSA, employees and employers (on behalf of the employee) can contribute to a flexible spending account with pre-tax income. Employees can then spend the funds directly on qualified expenses during the covered period or pay out of pocket and request reimbur
So, for example, if your gross income for the year is $70,000 and you’ve made $4,000 in FSA contributions over the year, only $66,000 your income would be subject to income tax. That means your contributions would go into your FSA before Federal Insurance Contribution Act (FICA) tax, Federal Unemployment Tax Act (FUTA) tax, Medicare, or income taxes are taken out.
Flexible spending accounts are usually for medical or dependent care expenses. The primary types of FSAs are: health care FSA (HCFSA, health FSA, or medical FSA), special purpose FSAs (for dental and vision), and dependent care FSA (DCFSA). Less common types of FSAs include adoption assistance FSAs.
- Alternate names: Flex account, flexible-spending arrangement, FSA
Each year the average family spends roughly $11,582 per person on health care and $15,888 per child care. Medical expenses will likely remain a significant portion of the average American’s spending for some time. For many people, it’s worth investigating cost-saving strategies like FSAs.
How Flexible Spending Accounts Work
Employers aren’t legally required to offer FSAs, but if they do, you can choose whether or not to participate in the plan during the annual benefits enrollment period. If you do, you’ll set aside pre-tax dollars from your paycheck to put toward an FSA to fund future qualified expenses.
Health FSAs have contribution limits of $2,750 per person, but dependent care FSAs can have limits up to $10,500 in 2021 (up from $5,000 in 2020). Keep in mind that your employer can impose lower limits.
You can spend HCFSA funds for the year at any point during the year, regardless of how much you’ve actually contributed. But with a DCFSA, only money in the account can go toward qualifying expenses.
If your employer offers a health and dependent care FSA, you can participate in both—but you must make separate elections and contributions for each.
If you’re also contributing to a health savings account (HSA), your only FSA option may be a limited purpose flexible spending account (LPFSA), which only covers vision and dental expenses.
How to Use FSA Funds
In some cases, you can use the funds in your accounts to pay qualified expenses directly, but more often you’ll pay out of pocket and seek reimbursement afterward.
While you may be tempted to go for the maximum contribution limits to take advantage of the tax benefits, know that it’s typically a “use it or lose it” system. If you don’t use the funds in the account by the end of the year, they may expire.
Employers can elect to offer a grace period of two and a half months (though they don’t have to) that extends the time you may use the funds. Health care FSAs have the additional option of allowing a carryover of $550 instead of the grace period, but that offering is also your employer’s decision.
Due to the pandemic, employers can elect to offer either unlimited carryovers (i.e., for amounts exceeding $550) or 12-month grace periods for plans with years ending in 2020 or 2021.
Flexible Spending Accounts: Example Case
Say that your employer offers a health care FSA and dependent care FSA, and allows employees to contribute an annual maximum of $2,750 to the health care FSA and $10,500 to the dependent care FSA. You decide to put $2,000 into each FSA. Your contributions are spread out equally over the year, which is typical.
While many FSA plans align with the calendar year, they don’t have to, and can be any 12-month period. Make sure you understand when your FSA’s plan year begins and ends.
Six months into the year, you’re halfway into your funding goal, and you have $1,000 saved in each FSA account. You’ve also just received bills of $1,500 for qualifying medical expenses and $2,000 for dependent care expenses.
Because you can spend HCFSA funds at any point during the year regardless of how much you’ve contributed, you could immediately request reimbursement for all $1,500 medical expenses despite only having $1,000 in the account so far.
However, you can only use the money you actually have in a DCFSA toward dependent care expenses. Because you’re $500 short at this point, you would have to wait until you accrue more contributions to get reimbursement for the full $2,000 in dependent care bills.
If you forget to request reimbursement by the end of the plan year, your funds expire unless your employer offers a carryover or grace period.
To request a refund, submit a claim to your FSA through your employer with proof of the qualified expense and a statement saying another plan didn’t cover it.
What Do Health Care Flexible Spending Accounts Cover?
The IRS defines qualified medical expenses as the costs of diagnosis, cure, mitigation, and treatment or prevention of disease for any part or function of the body.
- Payments for services by professional medical practitioners
- Costs of equipment, supplies, and diagnostic devices for these purposes
- Transportation costs to get medical care
- Over-the-counter medicine and menstrual care products (after December 31, 2019)
While qualified medical expenses also traditionally include insurance premiums and long-term care costs for tax purposes, these aren’t reimbursable with a health care FSA, nor are any amounts covered under another health plan.
Qualified health expenses are applicable to you and your spouse, dependents, or child under age 27. But dependents that are married-filing-jointly or have gross annual incomes above $4,300 are excluded.
The IRS issued a statement notifying taxpayers that at-home COVID-19 tests and personal protective equipment such as face masks and hand-sanitizer are both considered eligible medical expenses that can be paid or reimbursed under health flexible spending arrangements (health FSAs), health savings accounts (HSAs), and health reimbursement arrangements (HRAs).
What Do Dependent Care Flexible Spending Accounts Cover?
Qualified expenses for dependent care FSAs generally include services that let you or your spouse work, look for work, or attend school full time.
Some common examples are:
- Before- and after-school child care
- In-home dependent care
- Daycare in a facility
These expenses must be for a dependent child under the age of 13 that you can claim a tax deduction for or a spouse or dependent who can’t take care of themselves.
You can’t use dependent care FSA funds to pay for services that a child’s parent provides. For example, you could not make $10,500 in contributions and use them to pay your spouse $875 a month to watch your child.
Do I Need a Flexible Spending Account?
If your employer offers one or more flexible spending accounts, it’s worth investigating their terms to see whether contributing might benefit you. Consider the elections that your employer makes for your FSA, such as their contribution limit (which can be lower than IRS limits) or whether they offer a grace period for using funds.
Always remember, FSA funds expire. Naturally, you’ll receive the most benefit if you can spend what you contribute, otherwise you will lose money. Using all your funds lowers your tax burden without reducing your effective income.
Flexible spending accounts tend to benefit people who can reliably predict their medical or dependent care expenses throughout the year. Consider using an FSA if you’ve been using childcare for 12 months and feel confident you’ll spend the same amount in the next 12 months.
You must deduct any amount you elect to contribute to a dependent care FSA from the Child and Dependent Care federal tax credit. Consult with a tax professional to determine which one works best for you.
- Flexible spending accounts (FSAs) are employer-sponsored agreements that let employees pay for either qualified medical or dependent care expenses using tax-free dollars.
- You contribute to flex accounts by withholding a portion from each paycheck throughout the year.
- Health care FSA funds are accessible from the beginning of the plan year, but you must wait until you’ve made contributions to your dependent care accounts before you can use them.
- Because you can only use flex account funds during a limited window, it’s best for people who can forecast yearly qualifying costs fairly accurately. That way, you can avoid wasting contributions.