What Happens If I Use My FSA Incorrectly?

A Flexible Spending Account (FSA) helps cover medical and dependent care expenses with pre-tax dollars, but improper use—such as submitting ineligible expenses or failing to follow plan rules—can lead to financial and administrative consequences. Mistakes may result in denied reimbursements, unexpected tax liabilities, or restrictions on future participation. Understanding these risks can help you avoid costly errors and make the most of your FSA.

Rejected Claims

FSA claims are often denied when expenses don’t meet IRS eligibility requirements under Section 213(d) of the Internal Revenue Code. Cosmetic procedures, general wellness items, and non-prescription drugs without a doctor’s note are common ineligible expenses. Even if an item seems health-related, it must align with the plan’s specific guidelines to qualify for reimbursement.

Documentation errors also lead to claim denials. Itemized receipts must include the provider’s name, date of service, description of the expense, and amount paid. A credit card statement or a receipt missing key details can result in automatic rejection. Some plans require an Explanation of Benefits (EOB) from an insurance provider to confirm that the expense wasn’t covered elsewhere.

Timing issues can also prevent reimbursement. FSAs operate on a use-it-or-lose-it basis, meaning expenses must be incurred within the plan year or applicable grace period. Claims for services outside the allowed timeframe won’t be reimbursed. Additionally, missing submission deadlines can forfeit reimbursement eligibility.

Taxable Amounts

If an FSA is used for non-qualified expenses, the IRS treats those funds as taxable income. Since FSA contributions are made pre-tax, improper use negates this benefit, subjecting the misused funds to regular income tax. For example, an employee with a 22% tax rate who spends $500 on ineligible items would owe $110 in federal income tax, plus any applicable state taxes.

Employers must ensure compliance with IRS rules and typically report improper FSA use as taxable income on an employee’s Form W-2. This can increase taxable wages at year-end, potentially pushing the employee into a higher tax bracket. Misused FSA funds are also subject to payroll taxes, including Social Security and Medicare (FICA), which add another 7.65% in combined employee contributions.

If an employer fails to properly account for ineligible FSA expenses, they risk IRS penalties. Audits can uncover misreporting, leading to fines and back taxes for both the employer and employee. Employers may need to amend payroll tax filings and issue corrected W-2 forms, creating administrative burdens and potential late payment penalties.

Possible Withholding from Pay

Employers may recover misused FSA funds from an employee’s paycheck, especially if an expense was reimbursed and later deemed ineligible. Because FSAs provide the full elected amount at the start of the plan year, employers bear the financial risk of early distributions. Many companies have payroll deduction policies allowing them to recoup ineligible reimbursements through wage withholding.

The authority to withhold pay depends on federal and state wage laws. Under the Fair Labor Standards Act (FLSA), deductions cannot reduce an employee’s earnings below the federal minimum wage. Some states, such as California and New York, impose stricter restrictions, requiring explicit employee consent. Unauthorized deductions could lead to wage theft claims or labor law violations. Many employers outline these policies in benefits enrollment documents, specifying that improper FSA claims may be offset through payroll deductions.

If an employee leaves the company with a negative FSA balance, recovery becomes more complicated. Employers typically cannot deduct outstanding amounts from a final paycheck unless state law permits it or the employee has agreed to such deductions. Instead, they may issue a repayment demand, report the amount as taxable income, or, in extreme cases, pursue legal action. Some businesses write off small balances, but repeated misuse can lead to stricter oversight of FSA claims.

Plan Suspension or Termination

Repeated misuse of an FSA can result in suspension or termination from the plan. Employers must administer FSAs in compliance with IRS regulations under Section 125 of the Internal Revenue Code and have discretion in handling misuse. If an employee continually submits ineligible expenses or fails to provide required documentation, the employer may suspend their ability to submit claims until the issue is resolved. Suspension periods vary but often last until the employee repays misused funds or demonstrates compliance with plan rules.

Widespread misuse within an organization can jeopardize the entire FSA program. FSAs must comply with IRS non-discrimination testing to ensure highly compensated employees do not disproportionately benefit. If an employer fails these tests due to improper claims or administrative errors, the tax-advantaged status of the plan could be at risk, potentially making all participants’ contributions taxable. To prevent this, some employers impose stricter controls, such as requiring pre-approval for certain expenses or limiting reimbursement methods.

Potential Regulatory Penalties

Improper FSA use can trigger IRS and Department of Labor (DOL) penalties. FSAs fall under Section 125 of the Internal Revenue Code, which mandates strict compliance with plan rules. If an employer allows improper reimbursements or fails to enforce eligibility requirements, the IRS may declare the entire plan noncompliant. This could result in all employee contributions losing their tax-exempt status, leading to retroactive taxation and penalties for the employer.

The DOL also enforces compliance under the Employee Retirement Income Security Act (ERISA) if an FSA is considered a welfare benefit plan. Employers that mismanage FSAs or misreport taxable amounts may face audits, fines, or legal action. In cases of willful noncompliance, penalties can include excise taxes under IRS Section 4980D, which imposes fines of $100 per affected employee per day until the issue is corrected. Employers must maintain accurate records and ensure plan documents align with IRS and DOL regulations to avoid scrutiny.

Future Plan Ineligibility

Employees who repeatedly misuse their FSA may face restrictions on future participation. While federal law does not prohibit re-enrollment after misuse, employers can set eligibility criteria. Some companies bar employees from enrolling in the next plan year if they have a history of submitting fraudulent or excessive ineligible claims. Others may require additional documentation or pre-approval for future reimbursements.

Even if an employer does not impose direct restrictions, repeated misuse can affect participation in other tax-advantaged benefits. Many companies bundle FSAs with Health Savings Accounts (HSAs) or commuter benefits, and a history of noncompliance may lead to increased scrutiny across all pre-tax programs. Additionally, if an employee’s misuse results in IRS penalties or employer audits, it could impact their standing within the company, potentially affecting promotions or job security. Employers may also adjust plan designs to mitigate risk, such as reducing reimbursement flexibility or requiring stricter substantiation for claims.