How Does a Flexible Spending Account (FSA) Work?

A Flexible Spending Account (FSA) helps manage out-of-pocket healthcare or dependent care expenses using pre-tax dollars. This employer-sponsored benefit allows individuals to set aside a portion of their salary before taxes are deducted, reducing their taxable income. Funds accumulated in an FSA can then be used for eligible expenses, leading to potential tax savings.

What is a Flexible Spending Account

A Flexible Spending Account is an employer-sponsored benefit where employees contribute pre-tax money for specific expenses. Contributions are not subject to federal income, Social Security, or Medicare taxes, reducing taxable income. Funds withdrawn for eligible expenses are also tax-free, providing a dual tax advantage. Eligible employees whose employers offer the plan are typically able to participate.

There are three primary types of Flexible Spending Accounts, each designed for distinct purposes. A Health Care FSA is utilized for qualified medical expenses for the employee, spouse, and dependents, covering items such as deductibles, co-payments, and prescription medications. A Dependent Care FSA, conversely, is specifically for eligible dependent care expenses, which include costs for childcare or adult daycare that enable the account holder and their spouse to work or attend school. Finally, a Limited Purpose FSA is a specialized health care FSA that restricts eligible expenses to dental and vision care only, and it is typically offered alongside a Health Savings Account (HSA) to allow participants to maximize tax benefits.

Funding and Spending FSA Money

Employees contribute to their Flexible Spending Account through regular payroll deductions, with the elected annual amount divided evenly across pay periods. The Internal Revenue Service (IRS) sets annual contribution limits for these accounts, which can vary by FSA type. For the 2025 plan year, the maximum employee contribution for a Health Care FSA is $3,300. For a Dependent Care FSA, the maximum contribution limit is $5,000 for individuals or married couples filing jointly, and $2,500 if married filing separately.

FSA funds become available at the beginning of the plan year, even if the full elected amount has not yet been deducted from paychecks. Participants can access their funds primarily through an FSA debit card, which allows for direct payment at the point of sale for eligible expenses. Alternatively, individuals can pay for eligible expenses out-of-pocket and then submit claims for reimbursement, typically requiring an itemized receipt detailing the service or product, the date of service, and the cost.

Common eligible expenses for a Health Care FSA include co-pays for doctor visits, prescription drugs, dental procedures, and vision care like eyeglasses and contact lenses. The IRS Publication 502 provides a detailed list of qualified medical expenses. For a Dependent Care FSA, eligible expenses typically cover care for a qualifying dependent under age 13 or a disabled dependent, such as daycare, preschool tuition, or before/after-school programs, enabling the account holder to work.

Important Rules for Your FSA

A fundamental rule governing Flexible Spending Accounts is the “use-it-or-lose-it” provision, which generally dictates that any unused funds remaining at the end of the plan year are forfeited. This rule emphasizes the importance of carefully estimating anticipated expenses when making annual election decisions. Employers, however, have options to mitigate this forfeiture and offer more flexibility to participants.

Two exceptions to the “use-it-or-lose-it” rule are the grace period and the carryover option. A grace period allows participants an additional two and a half months after the plan year ends to incur new eligible expenses and use the previous year’s funds. For example, for a plan year ending on December 31, the grace period would typically extend until March 15 of the following year. The carryover option, on the other hand, permits a specific amount of unused Health Care FSA funds to be rolled over into the next plan year. For 2025, the maximum carryover amount for a Health Care FSA is $660. Employers can choose to offer either a grace period or a carryover, but not both.

Changes to FSA election amounts are generally not permitted during the plan year once the annual election has been made. However, exceptions are allowed if a qualifying life event (QLE) occurs. These events, defined by the IRS, include changes in legal marital status (such as marriage, divorce, or death of a spouse), changes in the number of tax dependents (like birth or adoption of a child), or significant changes in employment status for the employee or their spouse that affect benefit eligibility. For Dependent Care FSAs, a change in a child care provider or a significant change in the cost of care can also be a qualifying event for a mid-year adjustment. Financial hardship alone does not qualify as an event to change an FSA election.

FSA When Changing Employment

When an employee leaves their job, the status of their Flexible Spending Account changes. For a Health Care FSA, any remaining balance is usually forfeited upon employment termination. However, some employers may offer a limited continuation of coverage through the Consolidated Omnibus Budget Reconciliation Act (COBRA) for the Health Care FSA.

This COBRA extension for a Health Care FSA is usually limited and complex, often allowing the employee to use the remaining funds only for expenses incurred up to the end of the plan year in which the qualifying event (employment termination) occurred, and only if the account is “underspent” (more has been contributed than reimbursed). For Dependent Care FSAs, funds can only be used to cover expenses incurred on or before the date of employment termination. It is important for individuals to consult their employer or plan administrator for specific details regarding their FSA upon job separation.