What Is a Flexible Spending Account (FSA)?

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 is sometimes called a “flexible spending arrangement” and can be established by an employer for employees.

The account allows you to contribute a portion of your regular earnings before tax; employers also can contribute to employees’ FSAs. 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 also can be used to pay for the care of qualifying adults, including a spouse, who can't care for themselves and meet specific Internal Revenue Service (IRS) guidelines. A dependent-care FSA has different maximum contribution rules than a medical-related FSA.

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 a result, regular contributions to an FSA can reduce your annual tax liability.

The IRS limits how much can be contributed to an FSA each year. For medical expense FSA accounts, the annual contribution limit per employee is $3,050 for 2023.

If you are married, your spouse also can put aside up to the annual contribution limit through their employer. Employers can choose to contribute to an FSA, but they don't have to—if they do, their contribution doesn't reduce the amount that you are permitted to contribute. You aren't taxed on employer contributions.

For 2023, 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.

Pros and Cons of Flexible Spending Accounts (FSAs)

Besides their tax benefits, FSAs offer several advantages for account holders, but they don't cover all manner of medical or dental expenses. Here are some of their pros and cons.

Pros

• Reimburse medical care payments: The pretax funds contributed to an FSA can be used for this purpose, which is defined to include amounts paid for the diagnoses, cure, mitigation, treatment, or prevention of disease or ailments affecting any structure of the body.
• Pay spouses' and dependents' qualified medical expenses: FSA owners can use the account to cover these, along with their own medical costs.
  
• Cover many medical equipment purchases: 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.
• Reimburse amounts paid for insurance plan deductibles: FSAs are allowed to be used for this purpose, as well as to pay back the account holder for co-payments for medical services.

The Coronavirus Aid, Relief, and Economic Security (CARES) 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 these CARES provisions are permanent.

Cons

• Some procedures or health-related expenses aren't covered: Expenses for surgery for cosmetic purposes and for items or services that are just beneficial for general health, such as gym memberships, aren't reimbursable.
• Funds have a "use it or lose it" provision: Generally, you must use the money in an FSA within the plan year. But your employer may offer one of two options: a "grace period" of up to 2 1/2 more months to use the money in your FSA, or let you to carry over up to $610 per year to use in the following year, as of Jan. 1, 2023.
• Can't be used to pay for insurance premiums: Although FSAs can cover the costs of insurance deductibles they can't be used to pay for insurance coverage.

Special Considerations

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.

How Limited Purpose FSAs Work

A different type of FSA—a "limited purpose flexible spending arrangement" (LPFSA)—refers to a savings plan that can be used with a health savings account (HSA), which isn't allowed for a standard FSA. Contributions are made using pretax earnings.

A limited-purpose FSA is more restrictive because the arrangement is reserved for paying dental and vision expenses and sometimes other costs incurred in a high-deductible health plan (HDHP) after the plan holder meets the deductible.

The Bottom Line

A flexible spending account (FSA) lets you set aside a portion of your earnings before tax for medical and dental expenses. It's established by an employer for employees. Employers also can contribute to employees’ FSAs. 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 available for dependents' care.

There's a maximum contribution limit for individuals each year, and most of the money must be spent in the calendar year it's saved, so FSA account holders need to carefully plan their contribution amounts to avoid losing unused funds.