FSA 101—What’s a Flexible Spending Account & How Does It Work?

A health FSA is special way to save money for medical expenses. Image © GrenouilleFilms/E+/Getty Images

A health Flexible Spending Account is a special savings account that helps you pay for medical expenses your health insurance doesn’t pay for, as well as your health insurance deductible, copays, and coinsurance. There are tax advantages to having an FSA, so there are also lots of rules about who can have one, how it’s set up, and how it can be used. Here’s how it works.

Your Flexible Spending Account Is Owned by Your Employer

An FSA is an account tied to your job; it’s set up by your employer.

Even though the FSA account may have your name on it, technically, your employer owns the account and all of the money in it. However, your employer uses the money in your FSA to pay for your out-of-pocket medical expenses.

How Money Gets Into Your Flexible Spending Account

Even though your employer owns the account, you’re usually the one putting money into it. During open enrollment each year, you tell your employer how much money you’d like to contribute to your FSA that year. IRS rules limit your contribution to no more than $2,500 per year, but you can contribute less than that if you prefer.

Your employer then deducts enough money from each of your paychecks throughout the year to result in the yearly contribution you chose. The money your employer deducts, known as a payroll deduction, goes straight into your FSA. It’s deducted from your paycheck before your income taxes are figured so you don’t pay income taxes it.

In addition to the money you put into your FSA through payroll deductions, your employer can put money into your FSA. However, most employers don’t contribute to their employee’s FSAs.

What Can Flexible Spending Account Money Be Used For?

In general, you can use your health FSA money to pay your health insurance deductible, copays, or coinsurance.

You can also use it for some medical expenses your health insurance doesn’t cover like first aid kits, hearing aids, hearing aid batteries, contact lenses and contact lens cleaning solutions. Kids need braces? You can use your FSA money to pay the orthodontist. Want vision correction surgery? You can use your FSA money for that, too.

As a rule of thumb, you can’t use your FSA money to pay for purely cosmetic procedures like face lifts and liposuction. Additionally, you’re only allowed to use your FSA to pay for over-the-counter medications (like Tylenol and aspirin) if you have a doctor’s prescription for these non-prescription medications.

You can use your FSA money for anything that the IRS considers an “eligible expense.” For more specifics about what qualifies as an eligible expense and what’s prohibited, see IRS publication 502.

How Do You Access Your FSA Money?

There are two common ways you access the money in your FSA. First, your employer may give you a debit card to pay for FSA eligible expenses.

For example, when you go to a doctor’s appointment and the office staff wants to collect your copayment, you would pay the copayment using your FSA’s debit card. These debit cards are generally “smart enough” not to allow you to spend the money in your FSA for things that aren’t FSA eligible expenses.

Rather than providing a debit card, some employers require you to pay your medical expenses up front and then reimburse you for those expenses using the money in your FSA. In this case, when the doctor’s office staff collects your copayment, you’ll pay for it yourself and save the receipt. You’ll then submit the receipt to your employer. Your employer will take money out of your FSA to reimburse you. Some employers send this reimbursement money to you as a check in the mail; some add the reimbursement to your next paycheck; some deposit the reimbursement money into a bank account of your choosing.

What Are the Advantages of an FSA?

  • You save on taxes. Since your FSA contribution is deducted from your paycheck before your payroll taxes are calculated, your income looks smaller so you pay less in payroll taxes. Unlike an IRA or 401K, you don’t even pay income taxes on that money when it comes out of the FSA. The money you put into an FSA and then use to pay for eligible medical expenses is tax free.
  • It’s easier to budget. An FSA makes it easier to come up with the money for big medical expenses like your health insurance deductible. Here’s why. Let’s say your health insurance deductible is $1,200 so you choose to contribute $1,200 to your FSA this year. In January, your employer takes $100 out of your paycheck and puts it into your FSA. Early in February, you get sick and wind up owing your entire $1,200 health insurance deductible in February. Even though you’ve only put $100 into your FSA so far, you’re allowed to take out the entire $1,200…before you’ve even put it all into the account. You can pay your deductible in full even though you haven’t saved enough money yet.
  • Quitting? It’s like a loan you don’t pay back. If you quit or lose your job before the year is up, you don’t have to make up the difference between what you’ve contributed into your FSA and what you’ve spent from it. Learn more about this in “What Happens to My Flexible Spending Account When I Lose My Job?
  • No tax filing hassles. Unlike other types of tax-advantaged savings accounts used to pay health care expenses (HSAs and HRAs) you generally don’t have to address your FSA contributions or the money you take out of your FSA when you file your federal income tax returns.

What Are the Disadvantages of an FSA?

Even though an FSA can help you out with taxes and budgeting for health care expenses, it’s not without problems. Here’s what to beware of.

  • Use it or lose it…kind of. If you don’t spend all of the money in your FSA each year, some or all of that money is forfeited to your employer. IRS rules allow your employer to rollover up to $500 of the money remaining in your FSA at the end of the year into an FSA for the next year. However, your employer doesn’t have to roll this money over. Even if your employer chooses to roll unused funds over, since the IRS limits the rollover to $500, you’ll forfeit anything more than $500 remaining in the account at the end of the year. As an alternative to rolling over up to $500, your employer may allow a grace period of a several weeks for you to “use up” any unused funds left over in last year’s FSA. However, once again, your employer isn’t obligated to do this.
  • You’re locked in. Once you make your contribution election during open enrollment, you can’t change your mind until next year’s open enrollment. That money comes out of each paycheck all year long even if you later decide you’re contributing too much or your paycheck is too small to meet your monthly obligations. The only way you’re allowed to change your contribution amount before the next open enrollment period is if you have a qualifying event. These are usually things like getting married, divorced, having a baby, or having a change in your employment status.
  • Lower Social Security benefits. Since your FSA contributions come out of your paycheck before your social security taxes are calculated, you pay slightly less in social security taxes each year. However, since the amount you’ll eventually collect in social security benefits is based on your earnings, making your earnings appear lower could potentially result in slightly decreased social security benefits. If you’re concerned about this, your financial or tax advisor can help you figure out if your decreased earnings might affect your social security benefits.
  • Your money won’t grow. If you were saving hundreds or thousands of dollars outside of an FSA, you’d probably invest the money in something that would allow it grow or collect interest. However, since the FSA is technically owned by your employer, you can’t invest or get interest on your FSA money. By putting your money into an FSA, you’re losing the opportunity to invest it elsewhere. You have to weigh whether the tax and budgeting advantages of the FSA outweigh the lost investment opportunity.


IRS Notice 2013-71
IRS Publication 969

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