How a Flexible Spending Account Helps With Your Taxes

A Flexible Spending Account (FSA) is an employer-sponsored benefit that allows employees to set aside money from their paycheck to pay for certain out-of-pocket healthcare or dependent care costs. This arrangement helps individuals manage anticipated expenses for themselves, their spouse, and dependents. FSAs are designed to provide a financial advantage by allowing participants to use pre-tax dollars for eligible expenses, which can lead to notable savings on their overall tax burden. The funds contributed to an FSA are typically available at the beginning of the plan year, even before they are fully deducted from paychecks.

Tax Advantages of an FSA

Contributions made to a Flexible Spending Account offer significant tax benefits by reducing an employee’s taxable income. Funds are deducted from an employee’s gross pay before federal income taxes are calculated, effectively lowering the amount of income subject to taxation. This pre-tax treatment means participants do not pay federal income tax on the funds they contribute to their FSA.

Beyond federal income tax savings, FSA contributions are generally exempt from Social Security and Medicare taxes, collectively known as Federal Insurance Contributions Act (FICA) taxes. Since both employees and employers typically pay FICA taxes, this exemption provides an additional layer of tax savings for the employee.

Eligible Expenses

The tax benefit of an FSA is realized when the pre-tax funds are spent on expenses deemed “qualified” by Internal Revenue Service (IRS) rules. For a healthcare FSA, eligible medical expenses include a wide range of services and products that alleviate or prevent a physical or mental defect or illness. Common examples are doctor’s office visits, prescription medications, dental care, vision care, and copayments or deductibles for health insurance plans.

FSA funds can also cover specific medical equipment like crutches, supplies such as bandages, and diagnostic devices. Over-the-counter medicines and drugs generally require a prescription to be eligible for reimbursement. For a Dependent Care FSA (DCFSA), qualified expenses are those necessary for the participant and their spouse to work, seek employment, or attend school. These typically include childcare for children under 13 years old, preschool, summer day camps, before and after-school programs, and care for an adult dependent who is physically or mentally unable to care for themselves.

Managing Your FSA Funds

A distinguishing characteristic of Flexible Spending Accounts is the “use-it-or-lose-it” rule, which mandates that funds not used by the end of the plan year are generally forfeited. However, employers have options to mitigate this rule, though they can only offer one of two exceptions or none at all.

One common exception is a grace period, which allows participants an extended timeframe, typically up to two and a half months, to incur new eligible expenses after the plan year ends. For a calendar year plan ending December 31, this usually extends the spending deadline to March 15 of the following year. The other option an employer may offer is a carryover, which permits a limited amount of unused funds to be transferred into the subsequent plan year. For instance, the maximum carryover amount for health FSAs for the 2024 plan year is $640, increasing to $660 for the 2025 plan year.