A Flexible Spending Account (FSA) is a tax-advantaged financial account set up through the cafeteria plan of an employer in the United States. An FSA allows an employee to set aside a portion of his or her earnings to pay for qualified expenses as established in the cafeteria plan, most commonly for medical expenses but often for dependent care or other expenses. Money deducted from an employee's pay into an FSA is not subject to payroll taxes, resulting in a substantial payroll tax savings.

The most common FSA, the medical expense FSA (also medical FSA or health FSA), is similar to a health savings account (HSA) or a health reimbursement account (HRA). However, while HSAs and HRAs are almost exclusively used as components of a consumer driven health care plan, medical FSAs are commonly offered with more traditional health plans as well.

Advantages and disadvantages of all FSAs

An FSA allows money to be deducted from an employee's paycheck pre-tax and then spent on qualified expenses.

For an example of potential tax savings associated with a flexible spending account, a person in the 28% Federal marginal tax bracket and an example 4% state tax (along with FICA taxes of typically 7.65%, for a total tax of almost 40%), could deduct $2,000 and put that money into an FSA for health care. This would result in almost $800 in tax savings.

If this example person had not utilized the FSA and instead itemized their deductions, they likely would not have been able to deduct this $2,000 expense because it would not have met the 7.5% of Adjusted Gross Income threshold needed to be able to deduct it on their federal tax return. Even if the expenses had met the 7.5% threshold, only the part in excess of 7.5% would count as an itemized deduction; and itemized deductions are only beneficial if they exceed the standard deduction, which is hard to meet unless you have home mortgage interest or large charitable contributions. Finally, expenses for over-the-counter drugs cannot be deducted or counted towards the 7.5% threshold, but they can be paid for by the FSA.

One major drawback is that the money must be spent within the "plan year" as defined by the cafeteria plan (commonly the calendar year), and any money that is left unspent at the end of the plan year is forfeited; this is commonly known as the "use it or lose it" rule. In 2005, the Internal Revenue Service authorized an optional 2½ month grace period that employers can use in their plans, allowing use of the funds for 2½ months after the end of the plan year.

Also, the annual contribution amount must remain the same throughout the year unless certain qualifying events occur, such as birth of a child or death of a spouse.

• Methods of withdrawal from FSAs

In recent years, the FSA debit card was developed to eliminate "double-dipping" by allowing employees to access the FSA directly, as well as to simplify the substantiation requirement which required labor-intensive claims processing; the debit card also enhances the effect of "pre-funding" medical FSAs. However, the substantiation requirement itself did not go away, and has even been expanded on by the IRS for the debit-card environment; therefore, withdrawal issues still remain for FSAs.

Types of FSAs

Most cafeteria plans offer two different flexible spending accounts; one is for qualified medical expenses and the other is for dependent care expenses. A few cafeteria plans offer other types of FSAs, especially if the employer also offers a HSA. Participation in one type of FSA does not affect participation in another type of FSA, but funds cannot be transferred from one FSA to another.

• Medical expense FSA

The most common type of FSA is used to pay for medical expenses not paid for by insurance; this usually means deductibles, copayments, and coinsurance for the employee's health plan, but may also include expenses not covered by the health plan, such as dental and vision expenses and over-the-counter drugs. A medical FSA cannot pay for health insurance premiums, cosmetic items, cosmetic surgery, or items that improve "general health". All items must be intended to treat or prevent a specific medical condition; this can be as significant as diabetes or pregnancy, or as trivial as skin cuts.

The annual cap for a medical FSA varies, as it is set by the employer thru the cafeteria plan.

Pre-Funding.

One very important advantage of medical FSAs is that they are "pre-funded": If you set aside $2,000 per year in a medical FSA (as in the earlier example), the entire $2,000 is available for your use immediately--either at the start of the plan year (commonly January 1) or after the first contribution to the FSA is received by the FSA vendor, depending on the plan--even though you only contribute to the FSA in small increments throughout the year (for example, 1/26 of the annual amount if you are paid biweekly).

Over-the-counter drugs & medical items.

Another very powerful medical FSA feature that has been introduced in recent years is the ability to pay for over-the-counter (OTC) drugs and medical items. In addition to substantially expanding the range of "FSA-eligible" purchases, adding OTC items made it easier to "spend down" medical FSAs at year-end to avoid the dreaded "use it or lose it" rule.

However, substantiation has again become an issue; generally, OTC purchases require either manual claims or, for FSA debit cards, submission of receipts after the fact. Most FSA providers require that receipts show the complete name of the item; the abbreviations on many store receipts are incomprehensible to many claims offices. Also, some of the IRS rules on what is and isn't eligible have proven rather arcane in practice. The recently-developed inventory information approval system (IIAS), which separates eligible and ineligible items at point-of-sale and provides for automatic debit-card substantiation, should eliminate these issues and make medical FSAs very attractive for OTC purchases.

• Dependent care FSA

FSAs can also be established to pay for certain expenses to care for dependents that live with you while you are at work. While this most commonly means child care, it can also be used for adult day care for senior citizen dependents that live with you, such as parents. It cannot be used for summer camps (other than "day camps") or for long term care for parents that live elsewhere (such as in a nursing home).

The dependent care FSA is federally capped at $5,000 per year.

Unlike medical FSAs, dependent care FSAs cannot be "pre-funded"; employees can only receive reimbursement as funds are deposited into the FSA. Also, although FSA debit cards can be used with dependent care FSAs, they are subject to restrictive IRS requirements that generally require employees to pay the first child-care bill of each year by other means, among other things.

While medical FSAs almost always favor the taxpayer, dependent care FSAs are a more complicated matter because they are a tradeoff between pre-tax deductions and tax credits, not itemized deductions. Enhancements to child tax credits in recent years have made them more attractive than dependent care FSAs for many taxpayers.

• Other FSAs

Though not as common as the FSAs listed above, some employers have offered adoption assistance through an FSA. Also, though medical FSAs cannot reimburse for health premiums, some small employers without a health plan have established FSAs to reimburse their employees for individual health premiums.

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