Employee Benefits: Should I Sign Up for a Flexible Spending Account?

Learn what an flexible spending account is and whether you need one.

If you’ve recently started a new job or are reconsidering your employee benefits during open enrollment, you might be wondering whether you should start a flexible spending account (also called a flexible spending arrangement), or FSA. There are two types of FSAs: FSAs for health care and FSAs for dependent care.

FSAs are funded through pretax contributions, typically through withholdings from your paychecks. You can then use the money to pay certain health care or dependent care expenses throughout the year. Although these accounts offer significant tax advantages, they aren’t right for everyone. Below, we explain what these accounts are and how they work.

What Is a Flexible Spending Account?

An FSA is an employment benefit that allows you to set aside money, tax free, to pay certain expenses. If your employer offers an FSA, you can decide whether to participate. As long as you use the money to pay for qualified medical or dependent care expenses, you won’t have to pay taxes on it. This can result in significant savings. Some employers contribute to employee FSAs; others don’t.

There are two types of FSAs:

  • A health FSA can be used to pay qualifying health care expenses—basically, anything you could deduct as a medical expense on your tax return.
  • A dependent care FSA can be used to pay certain costs associated with childcare or dependent adult care.

Who Can Open an FSA?

FSAs are available only as an employment benefit. Self-employed people, people who are out of the workforce (such as stay-at-home parents), or retired people may not open an FSA. These are private benefit plans, which means employers get to decide whether to offer an FSA and rules for participation.

Contributions to an FSA

You must determine, at the start of every year, how much you want to contribute to either or both of your FSAs. You may contribute a maximum of $2,650 to your health FSA in 2018; this amount is subject to adjustment each year. For dependent care FSAs, the maximum contribution is $2,500 if you are single or married filing separately from your spouse; for joint filers, the maximum contribution is $5,000 combined.

You’ll need to think carefully about how much money to contribute, however. Unlike other employer-based savings programs (like 401ks), FSAs are “use it or lose it” plans. If there is money left unspent at the end of the year, you might have to forfeit it (see below).

Spending the Money in Your FSA

As long as you spend money only on covered expenses, your withdrawals from your FSA are not taxed. For health care FSAs, you may use your funds to cover qualified medical expenses: expenses you could deduct on Schedule A of your tax return. These expenses include the costs of health care (including copays), dental care, vision care, prescription drugs, and more. IRS Publication 502: Medical and Dental Expenses provides detailed information on which expenses qualify.

For dependent care FSAs, you can use your money to pay for care for:

  • your child who is under the age of 13
  • your spouse who is unable to care for himself or herself, or
  • another dependent who lives with you and is unable to care for himself or herself (including an older child or a parent).

The care must be necessary to allow you to work. For children under 13, regular K through 8 school expenses are not covered, but you can use FSA funds to pay for day care, nursery school, preschool after-school programs, summer day camps, babysitting and so on. (See IRS Publication 503: Child and Dependent Care Expenses, to learn more about what’s covered.)

For health FSAs, the entire amount that you decide to contribute is available to you for covered expenses at the start of the year. For example, let’s say you decide to contribute $1,200 for the year, with your employer withholding $50 from your paycheck twice a month. On January 5, you spend $750 on a new pair of glasses. You can charge the whole amount to your FSA, even though the actual balance in your account is only $50.

If You Don’t Spend Down Your FSA

The big disadvantage to an FSA is that they are “use it or lose it” benefits. If you end up with a surplus in your account, you might have to forfeit it to your employer. Your employer can—but does not have to—soften this harsh result a bit by adopting one of these two provisions (it cannot adopt both):

  • a grace period, by which you can have up to two-and-a-half months in the new year to spend down your previous year’s FSA money, after which your employer gets whatever is left in your account, or
  • a provision that allows you to carry over up to $500 of unused funds into the new year. Any amount that remains unspent at the end of the new year is forfeited to your employer.

These rules make it really important to accurately estimate your healthcare or dependent care spending at the beginning of the year.

If You Leave Your Job

If you quit or are fired from your job, your FSA will terminate (unless you extend the benefit through COBRA.) The money left in your FSA reverts to your employer—but, in an interesting wrinkle, so does some financial liability. Let’s return to our glasses example: If you charge $750 against your annual $1,200 FSA amount, but you quit on January 25, you will have contributed only $100 to your FSA. Your employer will have to pay the remaining $650.

As you can see, the rules for FSAs can be complicated, but you can save on taxes if you use them carefully. Read your employer’s plan documents and talk to your benefits advisor to figure out the best strategy for you and your family.

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