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,” is set up by an employer for an employee. The account allows you to contribute a portion of your regular earnings to pay for qualified expenses related to medical and dental costs.

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 before they are made subject to payroll taxes.
  • 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.

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 significantly lower your annual tax liability.

The IRS limits how much can be contributed to an FSA account per year. For medical expense FSA accounts, the 2020 limit per employee is $2,750 (it was $2,700 in 2019). If you are married, your spouse can also put aside that limit through his or her 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.

Advantages and Disadvantages of Flexible Spending Accounts (FSA)

The funds from an FSA can be used toward the payment of certain authorized dental, vision, and medical expenses, including for dependents and spouses. Funds in the account may also be used to cover deductibles and co-payments when medical services are rendered. Unfortunately, the money may not be used to pay for insurance premiums.

Medical equipment purchases, such as diagnostic devices, bandages, and crutches, can be covered by FSAs. As to drugs, it used to be that prescription medications and over-the-counter drugs that had been prescribed by a doctor were covered, as well as insulin, whether prescribed or not. However, the CARES (Coronavirus Aid, Relief, and Economic Security) Act, signed into law by the president on March 27, says that you may now use your FSA to pay for over-the-counter drugs, including those needed for quarantine and social distancing, without a doctor’s prescription. The act also expands the use of FSA funds to menstrual care products, and both of these provisions are permanent.

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, employers can offer a grace period of up to two-and-a-half months to finish using that funding.

If that option is not taken, employers might let you roll over $500 per year of unused funds from your account. Neither option is required, but only one may be offered.

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.