What is a Flexible Spending Account (FSA)?
A flexible spending account (FSA) is a type of savings account that provides the account holder with specific tax advantages. An FSA, sometimes called a flexible spending arrangement, is set up by an employer for an employee. The account allows employees to contribute a portion of their regular earnings to pay for qualified expenses related to medical and dental costs.
What are the types of Flexible Spending Account?
FSAs can be established to cover either childcare (dependent) expenses or healthcare expenses. If your employer offers a program that includes both FSAs, you can enroll in either or both FSAs through separate enrollments and identified reductions in your compensation for each.
The two types are similar in some ways, but differ in their purpose, the amount of contributions allowed each year, and qualified expenditures:
- Purpose: The account is limited to the payment of medical and healthcare expenses not paid for by insurance – usually deductibles, co-payments, and coinsurance for the employer-provided health plan. Generally, any medical expenditure that can be deducted from your gross income for taxes is allowed.
- Annual Contribution Limit: Prior to the passage of the Patient Protection and Affordable Care Act (APA), there was not a statutory limit on the amount of funds an employer could contribute to an FSA. Employers that establish the accounts, however, can cap employee contributions in a single year; few plans allow more than a $5,000 annual contribution. The APA limits annual contributions to $2,500 per employee (future maximum amounts will be indexed to inflation) beginning in 2013.
- Immediate Fund Availability: The total amount that you agree to contribute to the FSA in the coming year is available to you on the first day of the year. In other words, if you agree to reduce your income by $2,400 in the coming year to participate in the account, the full $2,400 is available to you for qualified expenses on January 1st, even though your pay will be reduced $200 in each of the following 12 months of the year. This aspect of the FSA is an assumed risk of the employer in that you may not remain with the company for the full 12 months of deductions. Any amounts paid over and above your actual contributions will be at the expense of the employer. This is one reason why smaller employers or companies with high turnover rates are reluctant to offer healthcare FSAs.
- Eligible Expenses: The plans are intended to generally cover your out-of-pocket medical, dental, vision, and pharmacy expenses. In 2011, the law was changed to limit the latter to those drugs requiring a physician’s prescription; it does not include over-the-counter drugs. Fortunately, there are a wide variety of treatments and equipment that do qualify if medically necessary. IRS Publication 502 contains a detailed list of expenses that are eligible and ineligible, as well as an explanation of what is deemed to be “medically necessary” and the documents required to prove such status.
- Administration: Many employers issue debit cards to employees with FSA plans to pay for all eligible expenses. Some also require that the employees who use the cards provide itemized receipts to the plan to verify eligibility. Fortunately, the method of payment and the accounting requirements are not cumbersome for most FSA participants, and should not be a determinant in the decision of whether or not to participate in the plan.
- Coordination With a Healthcare Savings Account: Generally speaking, you cannot participate in both a healthcare FSA and a healthcare savings account (HSA). However, there are exceptions and specific rules that apply which may affect you. For example, the FSA or HSA might be limited to vision, dental, and/or preventive care services only, eliminating the possibility of a “double dip.” You need to talk to your company’s human resources department and your accountant to be sure that you safely navigate the rules governing both types of accounts.
Dependent Care FSA
- Purpose: Expenditures in this type of FSA are limited to tax-deductible daycare expenses incurred to care for your dependent children or a senior citizen who lives with you and is claimed as a “dependent” on your personal tax return. This includes children under the age of 13, as well as children or adults who are physically or mentally incapable of caring for themselves.
- Annual Contribution Limit: The annual contribution is capped at $5,000 per year per household, regardless of the number of dependents covered. The amount paid by your employer on your behalf is not limited to your deducted wages, but any amounts paid by your employer in excess of the $5,000 will be attributed as income to you at the end of the year and subject to taxes. For example, your employer might agree to pay $1,000 monthly for your childcare, even though the amount that can be excluded from your gross income for tax purposes is limited to $5,000 per year (or $2,500 for married employees filing separate returns). As a result, the $7,000 excess representing the difference between the $12,000 paid by your employer and your $5,000 maximum exclusion will be reported as income to you for taxes, FICA, and FUTA. If married, both spouses must work to use a dependent FSA (unless the non-earning spouse is either disabled or a full-time student).
- Limited Fund Availability: Unlike the healthcare FSA, dependent FSA is not “pre-funded.” Your employer only pays out funds as they would be collected from your paycheck had you not made the election. For example, if you have agreed to reduce your income by $400 each month, the dependent FSA would provide for a $400 reimbursement of eligible costs each month, even if actual expenses were greater.
- Eligible Expenses: The purpose of the FSA is generally to cover those expenses that are incurred in order to keep working – not expenses, no matter how beneficial, worthy, or justifiable to the dependent person. For example, the costs of a babysitter in your home or in someone else’s home while you are working is eligible; the costs of a babysitter at any other time for any other purpose is not. The wages of a housekeeper is not eligible; the portion of a housekeeper’s wages for the time he or she cares for a dependent is eligible. The costs of a nursery school is an approved expense, while kindergarten tuition is not. IRS Publication 503 details and explains approved and non-approved expenses.
- Administration: Most dependent care FSAs function as reimbursement accounts, unlike healthcare FSAs, which often make payments directly to providers. Each plan administration is different and may require different reimbursement forms and receipts. If you are considering enrolling in a dependent flexible spending account, contact your human resources department and/or the administrator of the account to be sure you understand and comply with the requirements of the plan for reimbursement.
- Coordinating With Federal and State Tax Credits: Under current tax law, there are a number of income tax credits that are available to help you pay the expenses of a child or elderly person who is claimed as your dependent. The child and dependent care tax credit provides maximum federal tax credits up to $2,100 per families under certain conditions, while the child tax credit provides up to a $1,000 credit for each qualifying child based upon your income. It is possible to take advantage of both credits and use a dependent FSA. However, you may want to consult with an accountant or CPA to avoid making a mistake in claiming either of them and incurring possible penalties.
The higher your income, the greater the benefit you can receive by coordinating the use of the various credits and exclusions available to you. It is not a question of either/or, but how to maximize the benefits of each in your favor.
What are the key takeaways for Flexible Spending Account (FSA)?
- An FSA is a type of savings account that allows employees to contribute a portion of their regular earnings to pay for qualified expenses.
- Funds contributed to the account are deducted from the employee's earnings before they are made subject to payroll taxes.
- The money in an FSA must be used by the end of the plan year but employers can offer a grace period of up to 2.5 months, through March 15 of the following year.
How does Flexible Spending Account (FSA) Works?
One of the key benefits of a flexible spending account is that the funds contributed to the account are deducted from the employee's earnings before taxes, lowering their taxable income. As such, regular contributions to an FSA can significantly lower an employee's annual tax liability.
The IRS limits how much can be contributed to an FSA account per year. For medical expense FSA accounts, the 2020 limit per employee is $2,750 (it was $2,700 in 2019). If an individual is married, their spouse can also put aside that limit through their employer. Employers can choose to contribute to an FSA, but do not have to—if they do, the employer contribution does not reduce the amount that the employee is permitted to contribute.
What are the requirements to set up a Flexible Spending Account (FSA)?
Only an employer can set up and administer an FSA under the IRS code subject to detailed rules. The guidelines cover requirements for the legal documents, including the plan description, its benefits to participants, eligibility and nondiscrimination, and the administration of the plan once established. Employers have a fiduciary and legal responsibility to provide funds to the enrolled employees when called upon; failure to provide those funds could result in severe civil, and possibly criminal, punishments.
The administration of an FSA is complex, and errors, omissions, or noncompliance with the rules can be expensive. Rules regarding medical record confidentiality (detailed by the HIPAA Privacy Rule) affect healthcare FSAs and complicate administration, intensifying the use of robust software systems and extensive security protections. As a consequence, most employers outsource the establishment, marketing, plan communication, required filings, and administration to independent third parties.
Advantages and Disadvantages of Flexible Spending Accounts (FSA)
The funds from an FSA can be used towards the payment of certain authorized dental, vision, and medical expenses, including for dependents and spouses.
Funds in the account may also be used to cover deductibles and copayments when medical services are rendered. Unfortunately, the money may not be used to pay for insurance premiums.
Prescription medications, over-the-counter drugs that have been prescribed by a doctor can be paid for through money from an FSA. This includes receiving reimbursements for insulin. Medical equipment purchases, such as diagnostic devices, bandages, and crutches can be covered by FSAs.