How Does a Flexible Spending Account (FSA) Work?

A Flexible Spending Account (FSA) is an employer-sponsored benefit allowing employees to set aside pre-tax money for eligible out-of-pocket healthcare or dependent care expenses. This arrangement provides a tax advantage by reducing an employee’s taxable income, as contributions are deducted from wages before taxes are calculated. The primary purpose of an FSA is to help individuals pay for certain expenses with tax-free funds, lowering their overall tax burden.

Understanding Different FSA Types

Employers offer various types of Flexible Spending Accounts, each designed for specific expense categories. The Healthcare FSA is common, intended for a broad range of medical, dental, and vision costs. Funds cover items such as deductibles, co-payments, and prescription medications.

The Dependent Care FSA (DCFSA) addresses expenses related to childcare or adult dependent care. This account is for care costs that enable the employee, and their spouse if applicable, to work or actively look for employment. Eligible expenses include daycare, preschool, or elder care.

A Limited Purpose FSA offers a restricted scope, primarily for dental and vision expenses only. This type of FSA is often used with a Health Savings Account (HSA) for individuals in a high-deductible health plan. Its limited scope allows participants to preserve HSA funds for broader medical expenses while benefiting from pre-tax savings on dental and vision care.

How to Set Up and Fund Your FSA

Flexible Spending Accounts are exclusively employer-sponsored, meaning individuals cannot establish one independently. Enrollment occurs during the annual open enrollment period, the primary opportunity to elect or re-elect participation for the upcoming plan year. During this time, employees decide their annual contribution amount.

Qualifying life events may allow for mid-year enrollment or adjustments to an existing FSA election. These IRS-defined events include changes in legal marital status (marriage or divorce), the birth or adoption of a child, a change in employment status, or a significant change in dependent care costs. Funds are contributed through pre-tax payroll deductions, with the total annual election amount divided evenly across paychecks.

Accessing and Using Your FSA Money

Accessing and using FSA funds involves understanding eligible expenses and reimbursement methods. For a Healthcare FSA, eligible expenses include co-pays, deductibles, prescription drugs, and certain over-the-counter medications if accompanied by a doctor’s note or prescription. Dental work, eyeglasses, contact lenses, and other vision care expenses are covered. Cosmetic procedures, insurance premiums, and dependent care for children over 13 (unless disabled) are not covered.

Dependent Care FSAs cover expenses such as daycare, preschool tuition, before- and after-school programs, and summer day camps for qualifying dependents. These expenses must be incurred to allow the account holder to work or seek employment. All expenses must be incurred after the FSA’s effective date.

There are two methods for accessing FSA funds after an expense. Many FSA plans provide a dedicated debit card, allowing for direct payment at the point of sale for eligible expenses. Some transactions may still require submission of additional documentation for verification.

Alternatively, individuals can pay for eligible expenses out-of-pocket and submit a reimbursement claim. This requires submitting a claim form with documentation, such as itemized receipts, an Explanation of Benefits (EOB), or a doctor’s note for specific over-the-counter items. The administrator reviews the claim and reimburses the employee.

Managing Unused Balances

The “use-it-or-lose-it” rule dictates that any money not used by the end of the plan year is forfeited. This highlights the importance of estimating annual expenses when making contribution elections.

Employers may offer exceptions to mitigate this rule. One common exception is a grace period, allowing an additional 2.5 months after the plan year to incur and use FSA funds. For example, for a plan year ending December 31, a grace period extends the spending deadline to March 15 of the following year. This provides extra time to spend remaining balances.

Another exception is a carryover, which permits a limited amount of unused funds to be transferred to the next plan year. For the 2024 plan year, the maximum carryover amount is $640, increasing to $660 for 2025. Employers typically offer either a grace period or a carryover option, but not both, or they may offer neither.