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What is a flexible spending account? Here are the basics

At a glance:

  • What is a flexible spending account?

  • How to set up a flexible spending account

  • Expenses that are eligible for reimbursement by a flexible spending account

  • How to use a flexible spending account

  • Summary of flexible spending accounts

Flexible spending accounts, offered by about 80% of large employers, allow you to save money on health and childcare expenses by putting aside before-tax dollars from your paycheck.

Although these accounts have been available in one form or another since the 1970s, only about 20% of eligible employees take advantage of this employee benefit.

When you sign up for a flexible spending account, you designate a certain dollar amount of your paycheck to be deducted by your employer on a pro-rated basis throughout the year. Then, those dollars are available to you to reimburse yourself for qualified health and childcare-related expenses.

The only catch is that the amount you can contribute is usually limited by your employer and you must spend the money you set aside within the calendar year you contribute it or a couple of months afterward. If you don't spend those funds, you lose them.

Like many employee benefits, FSAs can have a profoundly positive effect on your finances; and like employee benefits in general, you need to understand how they work so that you don't miss out on important opportunities to save money.

FSAs are offered by about 80% of large employers. (Graphic: Hannah Smart/Cashay)
FSAs are offered by about 80% of large employers. (Graphic: Hannah Smart/Cashay)

What is a flexible spending account?

A flexible spending account (FSA) is an employee benefit authorized by the IRS code that allows you to save before-tax dollars on certain healthcare and dependent care costs. To get one, your employer must offer this benefit and you must sign up, designating what amount of money you want to be deducted from your pay on a yearly basis.

Once you have funds in a dependent care flexible spending account, you can either directly use those funds to pay for qualified expenses or use those funds to reimburse yourself for qualified expenses you have already incurred. The entire amount you elect to contribute to a healthcare flexible spending account is available the first day of the plan year to pay for qualified expenses. Many employers provide debit cards that you can use to pay for healthcare or dependent care expenses when incurred.

Many healthcare expenses traditionally not covered by insurance companies, such as over-the-counter medications, prescription eyeglasses and hearing aids, are covered by FSAs. However, a doctor's prescription (or note) is now needed for over-the-counter medicines to be reimbursed through an FSA or HSA.

A big plus

Establishing an FSA carries a significant tax advantage — because you contribute to your FSA account with your pay before taxes are taken out, those dollars could ultimately be worth 30 to 40% more than the after-tax dollars that you would have otherwise used. Here's an example of how it works: if you contribute $1,500 to an FSA, you'll incur a tax savings of approximately $600.

The $600 is the 40% that your employer would have taken out of your pay otherwise to cover tax obligations such as Social Security and federal and state income taxes. (That's 7.65% Social Security, 28% federal, and 4% state in this example.) So, by participating in a flexible spending account, you have that extra $600 to spend on healthcare and dependent care expenses that you likely would have incurred regardless.

With that said, your savings will vary depending upon which tax bracket you fall into. The lower your tax bracket, the lower your tax savings will be.

Setting up a flexible spending account

Setting up a flexible spending account is easy. See your human resources department at work, which can provide you with the forms necessary to enroll. Your employer contracts with an insurance company, bank, or other FSA administrator who will actually administer the account, holding the funds you designate and providing you with either a debit card or reimbursement upon receiving receipts for qualified expenses.

Your employer may offer both types of flexible spending accounts — health care and dependent care — or only one. If both are offered, you may set up accounts for each type of expense.

You must do some homework

If you haven't had an FSA before, you need to estimate how much to contribute, because your employer will need you to designate an amount that you want deducted from your pre-tax pay this year.

It's better to be conservative the first year you contribute, because FSAs have a use-it-or-lose-it feature, whereby if you don't use the money within the year it is contributed — or during a short grace period afterward if offered by your employer — you lose the money. For the healthcare flexible spending account, the first $500 is exempt from this rule and you may carry over this amount if allowed by your employer. When deciding how much to contribute to a healthcare FSA, take a look at your medical expenses for the past year, which should give you a good idea of how much you are likely to spend.

If you anticipate large expenses coming up in the current year, such as orthodontic expenses for a child or new prescription glasses for yourself or your spouse, you might want to allocate a higher amount to your healthcare flexible spending account. In the case of a dependent care FSA, consider how many children you will have in daycare in a given year, whether they will be receiving childcare full-time or part-time, and whether there are any circumstances under which alternative childcare would be available — from a relative, for example — that would be less expensive.

If you roll over the $500 maximum into a non-limited healthcare flexible spending account the next year, you will be barred from participating in a health savings account (HSA) in that next year. This is to ensure that your rolled over funds get used. However, those who have HSAs should take notice of the rule.

(Photo: Getty Images)
When deciding how much to contribute to a healthcare FSA, take a look at your medical expenses for the past year. (Photo: Getty Images)

The contribution limits

There is a contribution limit of $2,750 per year for health FSAs.

For a dependent care FSA, the IRS allows you to contribute up to $5,000 a year if you are married and filing a joint return or if you are a single parent; or $2,500 per year if you are married and filing separately. If you enroll in and use funds from a dependent care FSA, you must file IRS Form 2441 when filing your income taxes.

You may have some reimbursement options

If your health care FSA plan administrator offers options in terms of reimbursement, choose the method that is the most convenient for you. Typical options include debit cards, credit cards, and stored value cards as well as a traditional reimbursement account.

Typically, debit, credit, and stored value cards are more convenient than traditional reimbursement accounts because they are set up with documentation systems that meet IRS standards, so you generally don't have to provide receipts to your FSA administrator to document your expenses.

With a traditional reimbursement account, you must provide receipts to your FSA administrator before you can receive funds from your account.

What expenses are eligible for reimbursement by a flexible spending account?

Both medical and dependent care flexible spending accounts cover a wide range of expenses. For medical FSAs, all expenses that you can generally take as itemized medical and dental expenses on your tax return are qualified FSA expenses. Qualified expenses include a wide range of medically related costs, such as the following:

  • acupuncture

  • birth control pills

  • chiropractic treatment

  • contact lenses

  • dentures

  • fertility treatment

  • laser eye surgery

  • lodging to obtain medical care

  • psychoanalysis and psychiatric care

  • smoking cessation treatment programs

  • vasectomies

  • X-rays and other diagnostic tests

Acupuncture needles are applied on Sarah Taylor's back during an acupuncture treatment at the Children's National Medical Center in Washington, Monday, Dec. 10, 2018.  Over and over, the 17-year-old struggled to make doctors understand her sometimes debilitating levels of pain, first from joint-damaging childhood arthritis and then from fibromyalgia.  "It's very frustrating to be in pain and you have to wait like six weeks, two months, to see if the drug's working," said Sarah, who uses a combination of medications, acupuncture and lots of exercise to counter her pain. Children's National Medical Center is testing an experimental device that aims to measure pain according to how pupils react to certain stimuli. (AP Photo/Manuel Balce Ceneta)
Acupuncture is a qualified expense. (Photo: AP Photo/Manuel Balce Ceneta)

Exceptions

Exceptions may include amounts paid for health insurance premiums, long-term care insurance premiums or expenses, and expenses that are covered by another health plan. Other ineligible expenses are health club dues, medicines and drugs bought from other countries, hair transplants, and unnecessary cosmetic surgery.

For more information on allowable health care FSA expenses, see IRS publication 502, Medical and Dental Expenses. This publication refers to those medical and dental expenses allowed as itemized deductions, but also outlines those that are qualified health FSA expenses. The major exception is over-the-counter medications, which are a qualified FSA expense.

Qualified expenses for a dependent care FSA

For a dependent care FSA, expenses that cover the care of a dependent child under 13 or a dependent adult while the taxpayer is either working or actively looking for work, are covered.

These include adult daycare, after-school care, in-home or outside-of-the-home daycare, au pair or nanny fees or salary, day camp, emergency daycare, preschool tuition, and elder care. Ineligible expenses include kindergarten or elementary school tuition, overnight camp, boarding school, and convalescent home expenses for elderly or disabled dependents.

While overnight camp expenses are generally not allowable, those expenses that are incurred for the daycare portion of the overnight camp are eligible for inclusion. You can deduct childcare expenses while you are actively looking for work if you have earned income for the year. You can also use dependent FSA funds to pay a non-parent relative to care for a child or disabled or elderly dependent.

If you or your spouse is employed part-time, dependent care expenses must be allocated between days worked and days not worked, and only expenses from days worked are eligible for reimbursement from your FSA. For a list of qualified child and dependent care expenses eligible for dependent care FSA spending, see IRS Publication 503, Child and Dependent Care Expenses.

Employee Joyce Chandler (L) looks on as Antonin Bohac, who works at a lead mine for The Doe Run Company, encourages his 2-year-old son, Sawyer to eat while dining at the Bixby Country Store in Bixby, Missouri, U.S. November 17, 2016.  Picture taken November 17, 2016. To match Special Report USA-LEAD/TESTING    REUTERS/Whitney Curtis
Dependents must either be a child or a qualifying relative. (Photo: REUTERS/Whitney Curtis)

Most companies allow you to use your FSA funds for qualified expenses incurred by you, your spouse, and your dependent children. Your spouse must be a person to whom you are legally married as permitted under applicable state law. "Dependents" generally must be either:

  • a child (son, daughter, stepchild, etc.) who lives with you more than half of the year and who is 18 years or younger for the entire calendar year (or under age 24 and a student for the entire year) or is permanently and totally disabled, or

  • A "qualifying relative" who lives at the same principal place of residence as you for the entire year and receives at least half of his/her financial support from you. In addition, the relationship between you and the qualifying relative cannot be in violation of local law.

This means that your FSA funds may not be used for qualified medical expenses incurred by a domestic partner unless the domestic partner meets the definition of a "qualifying relative." If the domestic partner is not a "qualifying relative," you cannot pay for his or her medical expenses with FSA funds.

Using a flexible spending account

When funding your health or dependent care flexible spending account, be careful not to fund too generously, as IRS rules forbid you to carry funds over from one year to another beyond $500.

Your employer may require you to spend the remainder of your funds by the end of the calendar year in which they were contributed, or may allow you a two-and-a-half month grace period after the end of the calendar year to spend saved funds.

Dependent care FSAs

If you have a dependent care FSA, you must submit receipts for qualified expenses to your FSA plan administrator. Once those are processed, the administrator will reimburse you, either through a check or direct deposit, for those expenses. IRS rules do not permit the plan to provide funds for expenses that have not yet been incurred.

For health FSAs, many plans provide a credit, debit, or stored value card whereby you can access your funds on the spot for qualified expenses. If you aren't provided with such a card, you generally must submit receipts for qualified expenses and then will be reimbursed by your plan administrator.

Summary of flexible spending accounts

Flexible spending accounts are a potentially valuable employee benefit that allows you to save money on your health and dependent care expenses. Most employees are thrilled to learn that they can cut these costs by up to 40%.

A wide variety of expenses qualify for health FSA reimbursement, including over-the-counter medications (with a doctor's note or prescription), prescription glasses, and other expenses — expenses that traditional healthcare coverage often does not cover.

If you have dependent children or dependent disabled or elderly relatives, you can use a dependent care FSA to pay for qualified expenses such as adult daycare, preschool tuition, and day camp costs.

To top it off, accessing benefits is easy with most FSAs — you can use debit or credit cards with many plans, while others will reimburse you through checks or direct deposit after receiving proof that you paid the qualified expenses. Still, only a small percentage of employees take advantage of FSAs, a fact that necessitates greater educational efforts to promote them.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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