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,” can be set up by an employer for employees. The account allows you to contribute a portion of your regular earnings; employers also can contribute to employees’ accounts. Distributions from the account must be used to reimburse the employee for qualified expenses related to medical and dental services.

Another type of FSA is a dependent-care flexible spending account, which is used to pay for childcare expenses for children age 12 and under and can also be used to pay for the care of qualifying adults,
including a spouse, who cannot care for themselves and meet specific Internal Revenue Service (IRS) guidelines. A dependent-care FSA has different maximum contribution rules than a medical-related flexible spending account.

Key Takeaways

  • 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 your earnings and are not subject
    to income and payroll taxes.
  • Funds withdrawn from an FSA to pay qualified medical expenses are not subject to
    tax. 
  • 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 two-and-a-half months, through March 15 of the
    following year.
  • Due to the pandemic, the IRS will allow employers to amend FSA plans for 2020 and 2021, either to raise the carryover amounts or extend the grace period.

How a 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 your earnings before taxes, lowering your taxable income. As such, regular contributions to an FSA can reduce your annual tax liability.

The IRS limits how much can be contributed to an FSA account per year. For medical expense FSA accounts, the annual contribution limit per employee is $2,750 for each of 2020 and 2021. If you are married, your spouse can also put aside up to $2,750 through their employer. Employers can choose to contribute to an FSA, but they do not have to—if they do, their contribution does not reduce the amount that you are permitted to contribute. You are not taxed on employer contributions.

For 2020 and 2021, the contribution limit for a dependent-care FSA is $5,000 for joint and individual tax returns and $2,500 for married taxpayers filing separately.

The IRS released new guidance that allows employers more flexibility for benefit plans during the Covid-19 crisis, including special provisions for health Flexible Spending Arrangements (FSAs). If an employer elects to allow this (these provisions are entirely at the discretion of the employer), employees may revoke an existing election, make a new election, or decrease or increase an existing election. In addition, employers can elect to allow employees to apply unused amounts remaining in a health FSA at the end of a grace period or plan year ending in 2020 to pay or reimburse medical care expenses incurred through December 31, 2020. If you're not sure about your options, check with your HR or benefits person.

Advantages and Disadvantages of Flexible Spending Accounts (FSA)

The funds from an FSA can be used to reimburse payments for medical care, which is defined to include amounts paid for the diagnoses, cure, mitigation, treatment or prevention of disease, or for ailments affecting any structure of the body. However, expenses for surgery for cosmetic purposes and for items or services that are just beneficial for general health, such as vitamins, are not reimbursable. Qualified medical expenses for FSA owners, their spouses and dependents are covered.

Medical equipment purchases, such as diagnostic devices, bandages, and crutches, are covered by FSAs. Expenditures for prescription medications including over-the-counter (OTC) drugs for which you had a prescription, as well as insulin can be reimbursed with FSA funds. The CARES (Coronavirus Aid, Relief, and Economic Security) Act enacted in 2020, expanded reimbursable qualified medical expenses for 2020 and later years to include the cost of over-the-counter drugs, without a doctor’s prescription. The act also permitted the use of FSA funds to reimburse the costs of menstrual care products. Both of these CARES provisions are permanent.

Funds in an FSA may also be used to reimburse amounts paid in accordance with insurance plan deductibles and co-payments for medical services. Unfortunately, the money may not be used to pay for insurance premiums.

The recent $2 trillion CARES (Coronavirus Aid, Relief, and Economic Security) Act has expanded FSA coverage to include over-the-counter drugs that are not prescribed by a doctor and menstrual care products, and the provisions are permanent.

Special Considerations

All the money set aside in an FSA generally must be used by the end of the plan
year. However, a plan can offer a grace period of up to two-and-a-half months to finish using that funding.

If that option is not taken, a plan may allow you to roll over up to $550 per year of unused funds from
your account. Neither option is required, but only one may be offered by the plan.

When the year ends or the grace period expires, any funds that remain in your FSA are lost. Thus, you should carefully calibrate the amount of money you plan to put into your account and how you intend to spend it over the course of the year.

The Internal Revenue Service has announced that because of the impact of COVID-19, it will permit, but not require, employers to amend health plans so that employees can change elections that usually are allowed only once a year. Also, the IRS will allow employers discretion to amend FSA plans for 2020 and 2021 either to allow employees to carry over more than the current $550 maximum, or to extend the grace period for using unspent FSA funds through December 31 of each year .