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 2Â½ month grace period that employers can use in their
plans, allowing use of the funds for 2Â½ 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
- 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
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
- 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
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
- 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.
From Wikipedia, the free encyclopedia