Flexible Spending Accounts (FSA)

What is a Flexible Spending Account?

Authorized by Internal Revenue Code Section 125, Flexible Spending Accounts (aka, §125 Plan, FlexPlan, Cafeteria Plan) provide a tax-advantaged way to pay for qualified medical expenses and work-related dependent care expenses.

FSAs allow you to pay your expenses with “pre-tax” dollars, which means that you get a tax deduction for these expenses before you ever file your tax return.  You don’t pay Federal income or Social Security taxes on this money and, in most states, you don’t pay state taxes either.

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.

Medical Expense FSA

The most common type of FSA is used to pay for qualified 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. A medical FSA cannot pay for health insurance premiums, cosmetic items, cosmetic surgery, controlled substances (in violation of federal law), or items that improve "general health". All items must be intended to treat or prevent a specific medical condition. Generally, allowable items are the same as those allowable for the medical tax deduction, as outlined in IRS publication 502.

Over-the Counter items: The recent health care reform bills, the Patient Protection and Affordable Care Acts, impact how over-the-counter (OTC) drugs and medicines are treated with respect to FlexPlans. Effective January 1, 2011 - OTC drugs and medicines will be considered ineligible unless you have a prescription from your physician.

How much can an employee contribute to a Flex Plan?

The annual caps for a medical FSA varies by employer. Unlike dependent care FSAs, there is no IRS cap on medical FSAs, but employers generally limit the annual amount each employee may contribute, in order to reduce the risk of pre-funding. Should the employee leave or be terminated and thus no longer pay in to the plan, the employer does not recapture their pre-funding from the employee's payroll deduction.

Flexible Spending Accounts debit card allows for the automatic electronic transfer of pre-tax dollars from an employee account when paying for qualified expenses. Employees are able to receive immediate reimbursement of their medical, dependent care, and commuter expenses simply by using their card at the point of service. The normal paper claims process is eliminated, as are worries of forgotten purchases or lost receipts.

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, for children under the age of 13, 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. While married spouses can each elect to have this amount deducted from their paycheck and applied to expenses, at tax time all withdrawals in excess of $5,000 are taxed. Unmarried couples can each deduct and use $5,000. However, these expenses are subject to the "qualifying child" rules, which usually means unmarried couples cannot pay expenses for the same child.

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.

If married, BOTH spouses must earn income in order for the Dependent Care FSA to work. The only exception is if the non-earning spouse is disabled or a student. If one spouse earns less than $5,000 then the benefit is limited to whatever that spouse earned.

Use It Or Lose It

Any money that is left unspent at the end of the coverage period is forfeited back to the plan administer; this is commonly known as the "use it or lose it" rule.  Your "coverage period" generally ceases upon termination of your employment whether initiated by you or your employer unless you continue coverage with the company under COBRA or other arrangement.

A second requirement is that all applications for refunds must be made by a date defined by the plan.

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