Flexible spending accounts (FSAs) are special accounts set up by employers to let employees pay eligible out-of-pocket expenses with pre-tax dollars. Depending on the type of FSA, funds can apply to cover certain costs for medical or dependent care.
Employees who are eligible to participate in an FSA need to understand how it works so they can make the most of this commonly offered employee benefit.
What is a health FSA?
Health FSAs are employer-sponsored accounts that allow employees to contribute a portion of their paycheck to use for qualified medical expenses (e.g., copayments for doctor visits and prescriptions).
The paycheck deductions are pre-tax, meaning funds contributed to a health FSA are not subject to income or payroll taxes. In addition, if employers also make contributions, those amounts aren’t included in employee gross income for tax purposes. This favorable tax treatment allows employees to reduce their taxable income and save on eligible expenses—the amount they would otherwise pay in taxes on that money.
FSAs are also what’s known as “pre-funded,” meaning that funds can be used to pay qualified medical expenses before the contributions hit the account, up to the annual election amount[BN1]. For example, suppose you elect to contribute $2,000 for the plan year. In that case, you can spend up to that amount any time during the plan year, even if you have not yet contributed the full amount.
Who is eligible?
Employers typically offer health FSAs as part of a “cafeteria plan.” Cafeteria plans allow employees to enroll in and contribute to certain benefits on a pre-tax basis. (Other examples of these benefits might include adoption assistance or life insurance coverage.) If selected, the health FSA will cover the employee, their spouse, and dependents. Self-employed individuals aren’t eligible for health FSAs.
Unlike a health savings account (HSA), you don’t need to be covered by a high deductible health plan (HDHP) to have a health FSA. In fact, health insurance coverage isn’t even required to qualify for a health FSA. You can have multiple insurance plans or none—it doesn’t affect FSA eligibility. However, if you are enrolled in an HSA, you may not be able to contribute to a standard health FSA. Instead, you must enroll in a limited purpose FSA as discussed further below.
Learn more in our post about the difference between HSAs and FSAs.
How does health FSA claim reimbursement work?
Participants generally submit a claim to their employer’s health FSA along with proof of the eligible medical expense. In some instances, a statement that the claim isn’t covered by a health insurance plan may also be submitted.
In general, advance reimbursement for future and not yet incurred expenses is not permitted. Claims can only be reimbursed for services that have already been incurred during the plan year or eligible medical items purchased.
What is an FSA card?
FSA administrators often offer debit cards that participants can use to pay for qualifying medical expenses. The card can usually be used like any credit or debit card at checkout, whether online or at a brick-and-mortar store. (You typically select “Credit” when prompted by a point-of-sale card processor.)
The funds are deducted directly from the account, so there are no monthly statements or finance charges for an employee. The card won’t appear on credit reports or affect credit scores. Employers that are sponsoring FSAs may receive monthly statements on amounts withdrawn but not usually the purpose (e.g., your employer, if they are using an FSA administrator, should not see that you used your FSA funds for a prescription).
Submitting a reimbursement claim when using an FSA card isn’t always necessary, but participants should hold on to receipts. The IRS requires that all FSA payments are substantiated, and administrators may require them. In some cases, additional documentation may need to be submitted if the FSA card is denied at the point of service or the transaction is denied after a review in order to properly substantiate the claim.
Are health FSAs “use it or lose it”?
Generally, amounts that are contributed to a health FSA must be spent within that plan year. In other words, funds unspent at the end of the plan year may be forfeited to the employer.
You might, however, be able to roll over up to $550 in unused health FSA funds (in 2021) to the next plan year and still contribute the maximum for that subsequent plan year. Alternatively, employers can offer employees a grace period of up to 2.5 months after the plan year to spend the remaining funds. Any rollover or grace periods are optional, and you should review any plan documents or conditions carefully.
When employment terminates, health FSA funds may also be forfeited unless the employee remains on the health care plan under federal COBRA. In addition, under many states’ continuation rules, aka “mini-COBRA,” health FSA funds may not be continued. Talk with your employer or broker if you have questions.
Important note: Due to the COVID-19 pandemic, many employees may have unused funds at the end of 2020 and 2021. In recognition of this problem, the Consolidated Appropriations Act, signed in late 2020, provides some temporary exceptions to the use-it-or-lose-it, rollover, and terminated employment rules.
How much can I contribute?
Employees should estimate their out-of-pocket health costs for the upcoming year and use this figure to elect how much they want to contribute. Employers will then make regular, equal deductions from their paychecks throughout the plan year, based on the employees’ elections.
The IRS announces the maximum annual contribution for each year. For 2021, workers can contribute up to $2,750 (regardless of whether their employer contributes).
Election amounts usually can’t be changed or revoked during the plan year unless there’s a qualifying life event. For plan years ending in 2021, however, employers may allow modifications to the amount going forward without a qualifying life event. Like the use-it-or-lose-it, rollover, and terminated employment exceptions, though, it’s up to employers and FSA administrators—they aren’t required to grant exceptions.
What can FSA funds be spent on?
Eligible medical expenses include those incurred by:
- An employee and their spouse.
- Any dependent they claim on their income tax return.
- Any person they could have claimed as a dependent except that:
- The person filed a joint tax return,
- The person had gross income of $4,300 or more, or
- The employee or their spouse (if filing jointly) could be claimed as a dependent on someone else’s tax return.
- A child under age 27 at the end of the tax year.
Health FSA funds can generally be spent on expenses that would qualify for the medical and dental expense deduction. As of Dec. 31, 2019, that includes certain over-the-counter medicine (with or without a prescription) and menstrual care products.
FAQ for spending FSA funds
- Are diapers FSA-eligible expenses? The amounts you spend on diapers or diaper services aren’t qualified medical expenses unless diapers are needed to relieve the effects of a particular disease.
- Is sunscreen an FSA-eligible expense? Sunscreen that’s SPF 15 or higher and protects against UV-A and UV-B radiation is FSA-eligible.
- Is a humidifier an FSA-eligible expense? Humidifiers are eligible for FSA reimbursement with a Letter of Medical Necessity from a licensed medical care provider.
- Is PPE an FSA-eligible expense? As of March 2021, according to the IRS, amounts paid for personal protective equipment (PPE)—such as masks, hand sanitizer, and sanitizing wipes—for the primary purpose of preventing the spread of COVID-19 are eligible to be paid or reimbursed with health FSA funds.
What is a Dependent Care FSA?
Your employer also might offer a dependent care FSA (DCFSA).
DCFSAs, also known as dependent care assistance programs (DCAPs), cover qualified dependent care expenses. You can use the funds for work-related expenses to care for children of a certain age (or other qualifying dependents)—basically, care that makes it possible for you to go to or search for work.
Unlike health FSAs, the annual limit for tax-free DCFSA contributions is set by statute and isn’t indexed for inflation annually. The limit is $5,000 per year for single tax filers or married couples who file jointly and $2,500 for married couples filing separately, subject to restrictions based on earned income.
Read more in our article about Dependent Care FSAs.
Important note: For plan years beginning in 2021, the American Rescue Plan Act, the so-called COVID stimulus package enacted in March 2021, more than doubles the contribution limits for DCFSAs, to $10,500 (up from $5,000) for single taxpayers and married couples filing jointly and $5,250 (up from $2,500) for married individuals filing separately. [BN3] This is an optional allowance determined by the employer or third-party administrator. At this time, Gusto is not supporting this increase.
What is a Limited Purpose FSA?
A limited-purpose FSA (may also be called LPFSA) is a twist on a standard health FSA. You typically can use the funds to cover only eligible vision and dental expenses and not other eligible medical expenses. For example, a limited purpose FSA cannot be used for prescriptions. Limited purpose FSAs are eligible to be used by participants in an HSA because a person cannot be enrolled in an HSA and a standard health FSA.