Learn what a Flexible Spending Account (FSA) is and get a high-level overview of everything you need to know to understand how this account type works.
Start your educational journey into this pre-tax account by expanding the questions in the left column you’d like to learn more about. Additional educational resources related to this section topic are available to the right.
Flexible Spending Accounts, commonly referred to as FSAs, are IRS-approved accounts governed by Internal Revenue Code Section 125 that allow employees to pay for eligible medical and dependent care expenses tax-free. When employees enroll in an employer-sponsored Flexible Spending Account, contributions are not subject to Federal, FICA, and most state taxes. This means by enrolling, employees bring home more money in their paycheck.
An FSA’s three most common variations are a Medical FSA, a Dependent Care FSA, and a Limited-Purpose FSA.
Employees cannot enroll in both a Medical and Limited Purpose FSA. They must elect and contribute to accounts separately, and cannot transfer funds between accounts.
An FSA is owned by the employer. If an FSA participant leaves or is terminated, the participant would not keep the account or funds.
FSA funds can be used by the accountholder, their spouse, or eligible dependents.
By law, the following cannot participate in a Flexible Spending Account:
An FSA is an employee-funded account, meaning that an employee must choose to defer a portion of their paycheck during Open Enrollment in order to have funds to spend during the plan year. But since the money is contributed to the account on a pre-tax basis, it is financially beneficial for an employee who has annual medical and/or dependent care expenses to enroll.
By offering this account type, you’re essentially providing your employees that enroll a 30% off coupon for their family’s medical and dependent care expenses. Let’s say an individual knows they will need to spend approximately $2,500 on medical expenses for the year. They’ll have these expenses regardless of whether or not they enroll in a Medical FSA. But paying through the FSA keeps an estimated $750 extra in their pocket. That’s some real savings! And since those pre-tax dollars come out of their paycheck, an employee may receive additional savings if they are dropped down to a lower tax bracket as a result of their contributions.
And good news – the company saves too! The employer will save money because FICA will not need to be paid on the tax-free salary reductions for participating employees. In some cases, state unemployment and workers’ compensation taxes can also be avoided on these amounts. Additionally, offering fringe benefits like a Flexible Spending Account tends to reduce costs related to retention and talent acquisition.
This section covers many of the key elements an employee would want to know before enrolling in an FSA (with the exception of eligible expenses, which we’ll cover in-depth in Lesson 4). Expand the questions in the left column that you’d like to learn more about. Additional educational resources related to this section topic are available to the right.
When Open Enrollment rolls around, it’s time for employees to enroll in the FSA. They must enroll during this period by following the instructions provided by their employer. Employees can also enroll if they experience a Qualified Life Event. An FSA is a benefit that employees must re-enroll in each year if they wish to participate in it.
Generally, an election can only be changed during a plan year if the participant experiences a Qualified Life Event as defined by the IRS. A change in election must be on account of the event that occurred, so the election change must be made within the time frame set by the employer during plan design.
Employees may be permitted to prospectively change an FSA election during a plan year when one of the following changes in status occurs:
Note, an FSA election can only be changed if the change in status affects eligibility for that coverage. Any change in election must be consistent with the change in status and eligibility.
In some instances, employees may be able to take advantage of both. For example, suppose an employee has two or more eligible dependents receiving eligible care. In that case, they may set aside up to $5,000 in a Dependent Care FSA and claim $1,000 of the Child and Dependent Care Credit.
An employee’s tax situation will affect which option makes more sense. Factors to consider include their income, tax bracket, and how many dependents they have. Generally, those with lower income levels (under $30,000 annually) will see a greater advantage to using the Child and Dependent Care Credit. As your income level increases, the advantages become greater under the Dependent Care FSA. Employees should consult a tax professional if they are unsure of which option is more beneficial for their need.
The IRS sets the maximum contribution limits each year. These can be found on BRI’s Plan Limits page.
Employees should be conservative when determining their annual election when electing an FSA, as all unused funds will be forfeited. Online worksheets and calculators can be useful tools for employees to use to help them determine how much they should be electing for each account they want to enroll in.
Once the plan year starts, employees can start using the funds in it. Funds can be used during the plan year, and will be forfeited if not used or if the employee leaves the company. There are some options an employer can take advantage of to help employees not lose funds that we’ll discuss in the “Plan Year End” section of this series.
Funds will be forfeited if not used by the plan year’s end or if the employee leaves the company. We’ll discuss some plan year-end options an employer can take advantage of to help employees not lose funds in the next lesson: “FSA Plan Design”.
Are you an employer or broker considering whether or not a Flexible Spending Account is a plan worth offering? In this section, we compare an FSA to other pre-tax health accounts and answer other questions you may have about customizing your plan. Additional educational resources related to this section topic are available to the right.
All of these accounts all allow participants to pay for medical expenses eligible under Section 213(d), but there are some key differences regarding factors including, but not limited to:
See the complete table comparison of these plans by downloading our Pre-tax Health Comparison flyer.
Effective management of your plan year end can eliminate fear of lost funds, boost participation, and ensure compatibility with alternative plans like an HSA. Options include a rollover, extended grace period, or a runout.
An FSA Rollover or Carryover allows a portion of a participant’s FSA balance (up to the maximum allowed by the IRS) to “rollover” or “carryover” into the next plan year, rather than it be forfeited. Rollover options provide the maximum availability of funds for participants.
Extended grace periods provide an extended time to use FSA funds. For example, a company on a calendar-year plan may allow an extended grace period of 90 days – meaning, a participant has until end of March the following year to spend funds from the previous year. Offering an extended grace period reduces forfeitures but may jeopardize HSA eligibility if even one Health FSA dollar is accessible during a new plan year while a grace period is also running.
A Runout Period is the length of time after the plan year ends (often 90, 60, or 30 days) for participants to submit claims for expenses that incurred over the course of the previous plan year. This extends the time for participants to spend down funds before they are forfeited.
Yes – the IRS sets the maximum contribution and rollover limits, but employers can choose to adopt a lower limit for their specific plan.
A big part of understanding FSAs is knowing what can and cannot be purchased under each account type. This section focuses on ways that FSA participants can spend their pre-tax dollars. Additional educational resources related to this section topic are available to the right.
The product or service must meet the definition of medical care as found in Internal Revenue Code (IRC) Section 213(d): Participants can use Medical FSA funds to pay for expenses that primarily prevent, treat, diagnose, or alleviate a physical or mental defect or illness – not expenses for cosmetic reasons or one’s that are merely beneficial to one’s general health. Additionally, expenses must be for an eligible medical service provided to the participant, their spouse, or their eligible dependents.
Examples of eligible expenses include:
Employers can restrict what’s eligible depending on their plan design. Visit the Eligible Expenses Page for more information on what’s eligible, including an Eligible Expense Lookup Tool.
A Limited FSA can only be used to pay for qualified vision and dental expenses, including orthodontia services and some over-the-counter drugs and medicines. You cannot use a Limited FSA for health payments such as copayments, coinsurance, or deductible. Example eligible expenses include:
A dual-purpose item is one where the primary purpose of the service isn’t medical but due to a person’s medical condition, it provides medical benefits. Examples include:
A Letter of Medical Necessity (LMN) is used when a person wants to use funds from their pre-tax account but the item or service is not universally recognized as an eligible expense by the IRS. When an LMN is completed by your health care provider certifying that the service/product is medically necessary and submitted with a claim, this will allow for reimbursement of the service/products. Note that because of the nature of dual-purpose items, participants cannot use their Benefits card to pay for the item.
Expenses must enable you or your spouse to be gainfully employed, look for work, or attend school full-time. Common eligible expenses include:
Other requirements to use funds include the following:
Employees can spend their pre-tax dollars as they are deposited into their account in one of two ways:
No. Because eligible expenses are paid with tax-free dollars from your Medical FSA, you cannot claim the same expenses on your income tax return (no double-dipping).
This section focuses on helping you understand the intricacies of submitting claims, providing proper documentation, and ensuring compliance with the substantiation process. Additional educational resources related to this section topic are available to the right.
An FSA claim is submitted by a participant to a third-party administrator asking to be reimbursed for the cost of an eligible expense they incurred. By submitting the product or service information along with an itemized receipt or EOB, the participant can be paid back from their FSA balance, allowing them to use their FSA funds even when they don’t purchase with their Benefits Card.
Receipts may need to be provided to the third-party benefits administrator for proof of substantiation.
The Internal Revenue Service (IRS) requires all FSA and HRA expenses to be substantiated or verified as eligible products or services under Section 213(d). When expenses cannot be verified through automated means, the participant must provide the receipt/supporting documentation that identifies the expense, who the service is for, the amount, and the dates of service.
A standard credit card receipt doesn’t typically provide the details required to verify the expense; a TPA generally needs an itemized receipt or Explanation of Benefits (EOB).
Requests for substantiation are more likely to happen if a participant visits a health care provider that provides some cosmetic services not eligible under a pre-tax health account, a dental or vision care provider, or a pharmacy or retailer that doesn’t utilize an inventory management system.
Per IRS guidance, cards are supposed to be suspended timely to limit further unsubstantiated spending. They are taxable when other efforts have been exhausted, such as repayment or submitting a substitute claim.
Check out our other New to Benefits Education Series topics.