What Does FSA Mean in Business and How Does It Work?

A Flexible Spending Account (FSA) allows employees to set aside pre-tax money for specific expenses, typically as part of an employer-sponsored benefits package. These accounts help reduce taxable income while covering essential costs but come with rules on contributions, eligible expenses, and deadlines.

Types of FSAs

Flexible Spending Accounts come in different forms, each designed for specific expenses. Employers may offer one or more options depending on their benefits package. The type of FSA an employee selects determines what expenses qualify for reimbursement.

Healthcare

A Healthcare FSA (Medical FSA) covers qualified medical expenses not paid by insurance, including copayments, deductibles, prescription medications, and medical equipment. The IRS outlines eligible expenses in IRS Publication 502, which includes eyeglasses, dental treatments, and chiropractic care.

A key benefit is the uniform coverage rule, which makes the full annual election amount available at the start of the plan year, even if the employee has not yet contributed the full amount. However, changes to elections are generally only allowed during open enrollment or after a qualifying life event, such as marriage or the birth of a child.

Dependent Care

A Dependent Care FSA (DCFSA) allows employees to use pre-tax dollars for childcare or elder care expenses, including daycare, preschool, after-school programs, and in-home care services. These expenses must enable the employee (and spouse, if applicable) to work or look for work.

Unlike a Healthcare FSA, funds in a DCFSA are only available as contributions are made, meaning employees cannot access the full annual amount upfront. The IRS regulates these accounts under Internal Revenue Code (IRC) Section 129, which sets eligibility and contribution limits. To qualify, the dependent must be under age 13 or an adult who is physically or mentally incapable of self-care and resides with the employee for more than half the year.

Dependent care expenses must be substantiated with receipts and provider details, including the provider’s Taxpayer Identification Number (TIN) or Social Security number. Without this information, claims may be denied. These accounts are also subject to a “use-it-or-lose-it” rule, meaning unused funds at the end of the plan year are forfeited unless the employer offers a grace period.

Limited Purpose

A Limited Purpose FSA (LPFSA) is for employees with a Health Savings Account (HSA) who want to set aside additional pre-tax funds for dental and vision expenses, such as orthodontics, LASIK surgery, contact lenses, and eye exams.

Because IRS rules prohibit individuals from having both an HSA and a standard FSA, LPFSAs are restricted to dental and vision expenses. These accounts function similarly to Healthcare FSAs in terms of payroll deductions and reimbursements but are meant to supplement an HSA rather than replace it.

Employees expecting significant vision or dental expenses may benefit from an LPFSA while still maximizing their HSA contributions, which have higher limits and allow funds to roll over indefinitely. Since LPFSAs are subject to the same “use-it-or-lose-it” rule as other FSAs, careful planning is necessary to avoid forfeiting unused balances. Employers may offer a grace period or a carryover option, but these features vary by plan.

Eligible Expense Categories

Eligible expenses depend on the type of FSA an employee has. The IRS determines what qualifies, and these guidelines are subject to updates.

For medical-related FSAs, eligible expenses include doctor visits, prescriptions, and over-the-counter medications, such as pain relievers and allergy treatments, which became reimbursable without a prescription under the CARES Act of 2020. Other covered expenses include fertility treatments, smoking cessation programs, and weight-loss interventions prescribed by a physician. Transportation costs related to medical care, such as mileage, parking fees, and public transit fares, may also be covered.

Dependent Care FSAs reimburse services that provide care while the employee is at work. Summer day camps qualify, but overnight camps do not. Payments to relatives for caregiving are eligible if the caregiver is not the employee’s spouse or a dependent under age 19. Educational expenses, such as private school tuition for kindergarten and above, are not eligible.

Limited Purpose FSAs cover vision and dental expenses, including LASIK surgery, prescription sunglasses, and dental implants. Cosmetic treatments such as teeth whitening do not qualify. Orthodontic treatments, including braces and retainers, often require documentation to confirm medical necessity.

Contribution Limits

The IRS sets annual contribution limits for FSAs, adjusting them periodically for inflation. For 2024, the maximum an employee can contribute to a Healthcare FSA or Limited Purpose FSA is $3,200. Employers may set lower limits within this threshold. Dependent Care FSAs have a maximum contribution of $5,000 per household or $2,500 per spouse if married and filing separately.

Unlike 401(k) or HSA contributions, which can be adjusted throughout the year, FSA elections are generally locked in once the plan year begins. The only exceptions are qualifying life events, such as marriage, divorce, or the birth of a child, which allow mid-year adjustments. This makes estimating expenses carefully during open enrollment essential.

In 2024, the IRS allows employers to permit a carryover of up to $640 for unused Healthcare or Limited Purpose FSA funds into the next plan year. Alternatively, employers may offer a grace period of up to 2.5 months to use remaining balances, but not both. Dependent Care FSAs do not qualify for a carryover.

Funding and Reimbursement

FSA contributions are deducted from an employee’s paycheck on a pre-tax basis and deposited into the account throughout the year. Employers structure payroll deductions to ensure contributions stay within IRS limits. While Healthcare and Limited Purpose FSAs provide full access to the elected amount at the start of the plan year, Dependent Care FSAs require funds to be available before reimbursement is issued.

Reimbursement procedures vary by employer, but most FSAs require employees to submit claims with proper documentation, such as itemized receipts or Explanation of Benefits (EOB) statements from insurance providers. Some employers offer FSA debit cards, allowing participants to pay for eligible expenses directly without submitting claims manually. However, even with card transactions, administrators may request additional substantiation.

Unused Funds Options

FSAs operate on a “use-it-or-lose-it” principle, meaning any remaining balance at the end of the plan year is typically forfeited. However, employers may offer options to reduce this risk.

Some employers allow a carryover provision, permitting employees to roll over a limited amount of unused Healthcare or Limited Purpose FSA funds into the next year. For 2024, the IRS set the maximum carryover at $640. Alternatively, employers may offer a grace period of up to 2.5 months, giving employees extra time to incur eligible expenses. Dependent Care FSAs do not qualify for a carryover and are subject to stricter forfeiture rules. Employees should review their plan documents to determine which option applies.

Tax Handling

FSAs provide tax advantages by allowing employees to contribute pre-tax dollars, reducing their taxable income. This lowers federal income tax, Social Security tax, and Medicare tax liabilities. Employers also benefit, as FSA contributions are exempt from payroll taxes.

Reimbursements from an FSA are not taxable as long as they are used for qualified expenses. Dependent Care FSA contributions must be reported on IRS Form 2441 when filing a tax return. Employees should maintain accurate records to avoid potential tax issues.