Does an FSA Reduce Your Adjusted Gross Income?

Flexible Spending Accounts (FSAs) are employer-sponsored benefit plans that affect an individual’s financial planning and tax obligations. Understanding how these accounts interact with Adjusted Gross Income (AGI) is key to maximizing their benefits. This article clarifies the nature of FSAs, details their impact on AGI, and differentiates between various FSA types and their tax implications.

Understanding Flexible Spending Accounts (FSAs)

A Flexible Spending Account (FSA) is an employer-sponsored benefit allowing employees to set aside pre-tax salary for qualified out-of-pocket expenses. These contributions reduce an employee’s taxable income, leading to tax savings. FSAs are typically offered as part of a cafeteria benefits plan.

There are two types: Health FSAs for medical costs, and Dependent Care FSAs for childcare or adult dependent care expenses. FSAs have a “use-it-or-lose-it” rule, requiring funds to be spent by the end of the plan year or forfeited. Employers may offer a grace period of up to 2.5 months or allow a limited carryover amount, such as up to $660 for Health FSAs in 2025, to the following plan year.

How FSA Contributions Affect Adjusted Gross Income (AGI)

Adjusted Gross Income (AGI) is a figure in tax calculations, representing your gross income minus specific deductions. These deductions are subtracted from your total income before AGI is determined. Your AGI determines your tax liability and eligibility for various tax credits and deductions.

Contributions to a Health FSA directly reduce your AGI because they are made with pre-tax dollars. The money contributed to a Health FSA is deducted from your gross pay before federal income, Social Security, and Medicare taxes are calculated. This lowers your reported gross income to the IRS, and thus your AGI.

For example, if an individual earns $60,000 annually and contributes $3,000 to a Health FSA, their taxable income for federal income tax purposes becomes $57,000. This reduction occurs at the source, meaning the $3,000 is never considered part of their taxable wages for income tax calculations. This direct reduction of gross income before AGI is a tax advantage. For 2025, employees can contribute up to $3,300 to a Health FSA.

Implications of a Lower AGI

A reduced Adjusted Gross Income (AGI) can lead to several tax outcomes for taxpayers. Since AGI is a starting point for calculating taxable income, a lower AGI often results in a lower overall tax bill. This can also place an individual in a lower tax bracket.

A lower AGI can increase eligibility for, or the amount of, certain tax credits. Many credits have AGI-based limitations or phase-outs. Reducing AGI can help taxpayers qualify for these credits or receive a larger credit amount.

A lower AGI can also impact the deductibility of certain itemized deductions. For instance, medical expense deductions are allowed for the amount exceeding a percentage of your AGI. A lower AGI means a smaller threshold to meet, making it easier to deduct qualifying medical expenses.

Distinguishing Health FSAs from Dependent Care FSAs

Both Health Flexible Spending Accounts (FSAs) and Dependent Care Flexible Spending Accounts (DCFSAs) offer tax advantages, but their impact on Adjusted Gross Income (AGI) differs. Health FSA contributions directly reduce an individual’s AGI because funds are withheld from gross income before taxes are calculated. This pre-tax treatment lowers the income reported to the IRS.

Dependent Care FSA contributions are also made with pre-tax dollars, reducing an employee’s taxable income for federal and payroll tax purposes. However, unlike Health FSAs, DCFSA contributions do not reduce AGI in the same direct manner for all tax calculations. Instead, the tax benefit of a DCFSA is realized through an exclusion from income, meaning the funds are not included in taxable wages.

The benefits of Dependent Care FSAs are often linked to the Child and Dependent Care Credit, a non-refundable tax credit that directly reduces a taxpayer’s final tax liability. You cannot claim the same expenses for both a DCFSA and the tax credit. The DCFSA provides an upfront tax saving by reducing taxable income, whereas the credit reduces the tax owed after AGI is determined.