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 employees to contribute a portion of their 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 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 the employee's 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 2.5 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 the employee's earnings before taxes, lowering their taxable income. As such, regular contributions to an FSA can significantly lower an employee's 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 an individual is married, their spouse can also put aside that limit through their employer. Employers can choose to contribute to an FSA, but do not have to—if they do, the employer contribution does not reduce the amount that the employee is permitted to contribute.

Advantages and Disadvantages of Flexible Spending Accounts (FSA)

The funds from an FSA can be used towards 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.

Prescription medications, over-the-counter drugs that have been prescribed by a doctor can be paid for through money from an FSA. This includes receiving reimbursements for insulin. Medical equipment purchases, such as diagnostic devices, bandages, and crutches can be covered by FSAs.

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 workers carry over $500 per year of unused funds from their accounts. Such options do not have to be offered by an employer. If they are, the employer can only offer one of these options.

When the year end or the grace period expires, any funds that remain in the FSA are lost. This compels FSA holders to try to carefully plan out the amount of money that will go into the account and how they will spend it over the course of the year.