Q&A What

What is an FSA and is it worth it?

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If you want to save money on ever-rising health care costs, a flexible spending account (FSA) can be a great option. An FSA allows you to save for medical expenses over the year so you can pay for them tax-free.

There were 1.9 million flexible spending accounts representing more than $2.34 billion in contributions at the end of 2020, according to a 2022 report based on the Employee Benefit Research Institute FSA database.

The Bureau of Labor Statistics estimates that 43% of private industry workers and 71% of state and government workers had access to an FSA in 2021.

What Is an FSA?

An FSA is a tax-advantaged vehicle offered by employers that allows you to save money to pay for qualified health expenses. Your FSA is funded by payroll deductions and you don’t have to pay taxes on any funds that go into the account.

The funds accumulated in an FSA can be used to pay for medical expenses for yourself, your spouse and your dependents within the year.

How Much Can You Contribute to an FSA?

Your employer decides how much you can contribute to an FSA. In 2022, the amount your employer can allow you to contribute is capped at $2,850.

The amount you can contribute is on a “per individual” basis. That means if you’re married, your spouse also can contribute the full amount that their employer allows.

How Can You Use an FSA?

An FSA can be used to pay for many—but not all—health expenses you may incur over the course of a year. Such expenses may include:

Copayments
Deductibles
Many prescription drugs
Insulin
Medical devices and equipment, including things like crutches and blood sugar test kits
Over-the-counter medicines
Menstrual care products

As a general rule, you can use an HSA to pay for most medical and dental expenses that the IRS allows you to deduct from your taxes. IRS publication 502, Medical and Dental Expenses, has more details.

An FSA can’t be used to pay for a handful of medical expenses. They include:

Health insurance premiums
Long-term care coverage or expenses
Expenses associated with another health plan

This last point is an important one: If your health insurance or dental insurance plan reimburses you for an incurred expense, you can’t “double-dip” and also make a claim for reimbursement via your FSA.

How Does an FSA work?

Each employer decides precisely how its FSA plan will work. However, as a general rule, once you incur a medical expense, you use a debit card provided to you or use the system your employer has set up to submit a claim for reimbursement.

You may need to submit proof of the expense, such as a receipt, and include a statement to the effect that your health insurance plan didn’t cover the cost of the claim you are submitting.

Some employers provide a debit card to those who have FSAs to make the process of paying expenses easier. But even if you have this option, you must retain proof of the expenses you incur.

How Is an FSA Different from an HSA?

Flexible spending accounts and health savings accounts are both vehicles that allow you to pay for medical expenses with tax-free money. However, these two types of accounts have some key differences.

An FSA is an employer-based account where you can contribute money (a maximum of $2,850) to pay for medical expenses you incur within a period, depending on your employer’s rules. If you don’t use the funds within that time frame, you lose them.

By contrast, an HSA lets you save for long-term health care costs. It’s also portable so you can take it with you to another company. Contribution limits are higher—for 2022, the limits are $3,650 to an HSA for self-only coverage and up to $7,300 for family coverage—and you can carry the money over from year to year.

Many HSA plans also allow you to put some of your money in the stock market to grow the account. You must have a high-deductible health insurance plan to contribute to an HSA.

Advantages and Disadvantages of an FSA

An FSA account comes with several pros and cons:

Advantages

You can save for and pay for health care expenses tax-free.
You don’t need to have a high-deductible health plan to participate.
The plan is easy to use—just follow your employer’s instructions.

Disadvantages

The amount you can contribute is less than in an HSA.
You lose money if you don’t use the contributions to pay for qualified health expenses within the plan year.
You can’t grow FSA contributions by investing them in stocks.

What Is a Dependent Care FSA?

Like a standard FSA, a dependent care FSA is funded by payroll deductions before taxes. A dependent care FSA gives you a tax-free way to pay for the care of your children that are under age 13 or to pay adult dependent care expenses.

Those expenses typically must be tied to care provided to eligible dependents while you or your spouse were working, looking for work or attending school full time.

Such expenses may include:

Day care
Pre-school
Senior day care
Summer camp

Single parents and married couples filing joint tax returns may contribute up to $5,000 a year. If you’re married and filing separately, each spouse can contribute up to $2,500.

FSA Frequently Asked Questions

Your employer determines whether you can carry over any FSA funds to the following year.
Typically, you have to use the funds by the end of the year. But your employer can offer one, but not both, of the following options.

Offering you 2.5 more months into the following year to spend any unspent money
Allowing you to carry over up to $500 to spend the next plan year

It is important to note that employers aren’t required to offer either of these options.

An FSA grace period is the extra 2.5 months that some employers provide so workers can use FSA money that was unspent at the end of the calendar year. This extends the period when employees can spend FSA funds by an extra 2.5 months.

An employer can contribute funds to employee FSAs, but it’s rare and a company isn’t required to do so.

Only about 2% of all FSA contributions in 2020 were from employers, according to a 2021 analysis of the Employee Benefit Research Institute FSA database. That represents $44 million.

You decide how much to allocate to your FSA during health insurance open enrollment, which is a specified time each year in which you can switch health plans or make changes to your existing plan.

However, you may also decide your FSA contribution outside of the open enrollment period if you have a qualifying event, for example if you have a baby or get married.

Photo by Kelly Sikkema on Unsplash

Blog by: Michael Sheeran, CFP

Flexible Spending Accounts (FSAs), are one of the most underutilized tools to save on taxes each year. For many employees, they fear the “use it or lose it” provisions so they avoid them, and for others it is just not worth the hassle. In this article, we will cover some of the highlights and whether or not it’s worth your time to take advantage of this tax advantage program.

I will cover:

What is an FSA?
Who they are best for
How to use your FSA
What can you pay for with your FSA
How they help employers
How much you can save on your taxes with a sample family tax analysis

What is an FSA?

A Flexible Spending Account (FSA), falls under IRS Section 125 which allows employees to convert some of their taxable income into non-taxable benefits. The most common FSA types are the medical and dependent care. The maximum annual election for 2020 is $2,750 for medical, and $5,000 for dependent care.

The FSA allows you to defer some of your earnings into this special account that is to be used for qualified medical expenses or for dependent care. There are some other options as well, but these are the most common uses.

How Much Can I Contribute?

The IRS allows you to defer up to $2,750 in 2020 for a medical FSA and up to $5,000 per year for a dependent care FSA.

When you elect the coverage, your employer will split up the amounts over your annual paychecks and deposit the money into your account. They do this by withholding the amount from your paycheck on a pre-tax basis. A third-party administrator will handle everything and will set up the account along with a debit card and checkbook.

As an example, if you elect a $1,200 a year benefit, your employer would deduct $100 a month from your paychecks to be used for medical expenses.

What Can I Use The Money For?

The medical FSA must be used for qualified medical expenses. This includes things like dental care, vision, medical etc. You can look up the items line by line in IRS publication 502.

For the dependent care FSA (DCA), there are a few extra rules involved. In order to qualify for the tax-free benefit, the care must be necessary to allow you and, if married, your spouse to work and earn an income or attend school full-time.

The eligible expenses are:

Child Care
Adult Care
In-home dependent care
Before and After School Care
Nursery School

What If I Don’t Use All Of The Money?

This is one of the gotchas about the FSA plans that people don’t like. Traditionally with these setups, they are use it or lose it. Meaning, if the money isn’t spent, it gets forfeited to your employer.

Thankfully, most plans now will have special rules that will allow you to have an additional grace period to use the money after the calendar year ends, OR the ability to rollover up to $500 into the next year.

The grace period provides up to 2 1/2 more months to use whatever medical FSA funds you have left. Unfortunately, there is no grace period or rollover for the dependent care account.

How FSAs Help Employers

For you to participate in an FSA, your employer has to support this and set the plan up. For them, it means extra administration and there is also a cost involved. From what I’ve seen, it can be a few hundred dollars a year or thousands depending on how many employees are in the company.

The biggest benefit for employers is that they aren’t paying FICA on any of your contributions. This means they save 7.65% on every dollar you defer.

For every thousand dollars that goes in, they save $76.50.

In addition to saving on FICA, the use it or lose it rules will benefit them. If an employee has $1000 left in their account at the end of the year, they can roll over $500, but they forfeit the other $500 to the employer. This money can be used to help pay for administration or other losses. Which leads me to my next point…

How FSAs Hurt Employers

Unfortunately, the benefits to employers aren’t so cut and dry. Yes, they save on FICA, and can recapture unused funds, but they also have some risks, especially when participation is low.

With an FSA, the money you defer is 100% available to you on the first day of the year. If your family defers $1,500, that whole sum is available on day one even if you haven’t paid a penny from your salary.

The money comes from the employer. The employer is obligated to have the money available to each employee so this can be a big risk to them if cash flow isn’t great. Picture a small employer with 10 employees that have chosen to defer $2,000 each. That’s $20,000 the employer could potentially have to contribute right away without receiving anything from the employees.

Not only that, if you use the money and then leave during the year, they have no recourse for getting the money back. It’s a loss for them. That is why they have the recapture rules for unused funds.

It’s not all bad though, if the plan runs well and participation is good, the employers stand to save over the long run.

Only the medical FSAs have the upfront funding rule. The dependent care FSAs do not. With the DCA, the money is credited to your account monthly as you contribute.

FSA Tax Savings!

Finally, the big benefit of the FSA. Tax savings!!! It’s not huge, but it adds up. If you take advantage of the FSA, along with other strategies, it can make a big difference in your financial picture.

To simulate the tax savings, I used an online tool from WageWorks, a third-party administrator of the FSA accounts. I used their tool to simulate an income a total income tax rate of 30%. I used medical expenses totaling $2,750 and dependent care expenses totaling $5,000.

WageWorks: Dependent Care FSA Savings Calculator

WageWorks: Medical FSA Savings Calculator

According to the WageWorks tool, this family would save $825 annually by using the medical FSA and $1,500 using the dependent care FSA. That’s $2,325 in savings just by using the FSA to pay for services.

Medical Expense Deduction

But can’t I deduct medical expenses anyway? Maybe, maybe not. In 2020, the IRS allows you to deduct medical expenses that exceed 10% of your adjusted gross income (AGI). This means if you have an AGI of $100,000 and expenses of $12,500, you can only deduct $2,500 of those expenses. But again it’s not that cut and dry, and to use the medical expense deduction, you have to itemize your deductions.

With the much higher standard deduction today of $24,800 for married filing jointly, its less common for families to itemize, and it favors using the FSA even more so.

*Please do your own research and consult with your trusted tax advisor before making any tax savings assumptions mentioned in the article. The laws are constantly changing and they can give you personalized advice on your situation.