How Flexible Spending Accounts Work

The cost of healthcare can be overwhelming. Even with insurance, individuals and families often find themselves spending a significant amount of money on medical costs.
In 2020, the average household with employer-provided insurance and an income of roughly $83,000 paid over $5,000 in healthcare expenses. This equates to 8.4% of the family's income.

Flexible spending accounts (FSAs) help offset the high price of healthcare by allowing individuals to pay for some medical expenses with pretax dollars. That means you're receiving a roughly 30% discount on your allowable healthcare costs, depending on your tax bracket. Keep reading to learn how these plans work and how they can benefit you and your family with your healthcare needs.

Key Takeaways

  • A flexible spending account allows employees to pay for healthcare costs with pretax dollars.
  • Employees choose the contribution amounts to an FSA, which are deducted from their gross pay and reduce taxable income for that year.
  • FSAs are only accessible through an employer and cannot be obtained through self-employment.
  • FSA funds can be used for medical expenses, including prescriptions, eyeglasses, dental appointments, dependent and disability care.
  • A health savings account is similar to an FSA, with both having slightly different processes and contribution limits.

Spend to Save

FSAs are offered through your place of work or business. They not only help you reduce the amount you owe for certain medical expenses, they also help you cut down your tax bill.

Let’s say you earned $1,000 on your last paycheck and your employer deducts $50 for your FSA contribution. This means you effectively made $950 and your employer then calculates and withholds your taxes based on that amount.

That drop in your take-home pay also means you pay less in taxes on that paycheck. Remember, you can only get this plan through an employer, so if you're self-employed, you're out of luck.

How It Works

You can sign up for an FSA during your company’s open enrollment period, which normally runs in November or December. It’s as simple as providing some basic information and deciding how much you want to contribute for the year. Contributions are deducted from each paycheck. Because deductions come from pretax dollars, the money is deducted from your gross income.

There are some conditions, though:

  • Since they are offered through your workplace, you can’t get an FSA unless your employer provides one.
  • Self-employed people aren’t eligible.
  • Once you elect a certain contribution amount for the year, you can’t change it.
  • The annual contribution limit for an FSA is $2,750 for 2021 and $2,850 for 2022.
  • You can only use the money on approved items, which are laid out in the Internal Revenue Service (IRS) Publication 502. Generally speaking, if your doctor prescribes a test, medication, or medical equipment, you can probably pay for it from FSA funds. You can also pay for dental appointments, chiropractors, eyeglasses, contacts, hearing aids, addiction treatments, modifications to your car or home if you or a loved one have a disability, ambulance services, and books and magazines printed in braille. You can even pay for some transportation costs related to healthcare treatments and for the training and care of a guide dog.
  • You cannot pay health insurance premiums or be reimbursed for over-the-counter medications, as well as other cost limitations. So, before making a large medical purchase, make sure it’s allowable to use FSA funds.

Don’t Underfund Your Account

FSAs are typically a use-it-or-lose-it type of plan. You have roughly one year to use the total sum contributed for the plan, or it becomes your employer's money. But all may not be lost. There are two exceptions. The IRS allows employers to carry over up to $550 into the next year for 2021, and $570 can be carried over for 2022. Another option is that employers can offer employees a grace period of up to 2½ months to use any leftover money.

Bear in mind that a company doesn't have to offer either of these options, and it's not allowed to offer both. So check ahead of time about your employer's particular rules regarding excess funds.

For 2021, special rules apply to the FSA rollover provision and the grace period. Under the Consolidated Appropriations Act, employers can allow all unused funds to be carried over from 2021 to 2022. Or, employers can extend the grace period to 12 months, rather than 2½ months. The effect of either decision is the same: all unused funds can be carried over and used throughout the entire year.

Because of the use-it-or-lose-it rule, you may be tempted to be super-conservative in how much to contribute. But Kevin Haney of ASK Benefit Solutions says to think differently. “A person electing to contribute $1,000 would reduce their tax bill by $376. If this person left 20% of their contribution unspent, they still would save $176.”

In other words, you would have to overestimate by a lot to not come out ahead, even if you don’t use the entire amount in your account. And there are always ways to spend the money. For instance, you can load up on spare pairs of contact lenses or treat yourself to some quality sunglasses with complete UVA/UVB protection.

Use Your FSA as a Loan

Haney also suggests scheduling elective procedures at the beginning of the year, if you want to use FSA funds to pay for them. Since you haven’t yet paid the money into the fund, you’re essentially taking a loan from your employer.

Certain FSAs allow you to use your total annual contributed funds on the first day for yourself, but only the actual amount in the account for dependents.

“Employers must immediately fund any qualified expense, regardless of when it occurs during the plan year. Employees can schedule planned medical procedures at the beginning of the plan year (major dental work, braces, infertility treatments, etc.). They then have 52 weeks to repay the loan using pretax dollars.”

He continues, “Employees enjoy a better than 0% interest rate because they repay the loan with pretax, rather than after-tax, money. A person paying 5% state income tax, 7.65% FICA, and 25% federal income tax would need to earn $1,603 in gross income to have $1,000 in after-tax dollars. That equates to a minus 60% interest rate.”

What if I Quit?

If you leave your company, try to use your FSA funds before you go because you don't have to pay the company back for the difference between what you spent and what you paid in, says Erik O. Klumpp, CFP, founder, and president of Chessie Advisors, LLC.

"If an employee gets reimbursed for their maximum contribution early in the year and then ends up moving and leaving their employer, they essentially get a huge discount on their reimbursed healthcare services," he says. "If the employee suddenly finds that they will be leaving their employer, they should utilize as much of the FSA account as they can before they leave."

"When employees forfeit excess money in their accounts at the end of the year, that money stays with the employer," Klumpp adds. "That forfeited money also covers employees who have been reimbursed but leave the employer prior to making the full year's contribution."

FSA or HSA?

An FSA is similar to a health savings account (HSA). Both plans allow you to contribute pre-tax dollars, have annual contribution limits, and can only be used for approved health-related expenses.

But there are a few key differences. An HSA doesn't have a use it or lose it rule, you don't have to be employed by somebody to get one, and the contribution limits are higher. As of the 2022 tax year, you can contribute $3,650 individually or $7,300 for a family.

However, you can only have an HSA in combination with a high-deductible health plan, which might or might not be the insurance choice you prefer. 

The Bottom Line

Because accounts like these are more complicated than basic checking or savings accounts, some consumers may be leery of contributing to an FSA. But, by not participating, they’re throwing away a roughly 30% discount on healthcare costs and a reduction in their income tax, too.

Article Sources
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