What Is a Flex Plan & How Does It Work?

A flexible spending account (FSA) is an employer-sponsored benefit program designed to help employees manage certain out-of-pocket expenses with pre-tax dollars. These plans offer a way to save money on healthcare and dependent care costs. This article explores the mechanics of flexible spending accounts, detailing eligible expenses, and how these plans operate.

Understanding Flexible Spending Accounts

A Flexible Spending Account (FSA) is a benefit offered by employers that allows employees to set aside money from their paychecks on a pre-tax basis. This dedicated fund is then used to pay for specific out-of-pocket health or dependent care costs.

Contributions to an FSA are deducted from an employee’s gross pay, which means the money is not subject to federal income tax, Social Security tax, or Medicare tax. This pre-tax treatment effectively lowers an individual’s taxable income, leading to tax savings. When qualified expenses are paid from the FSA, these withdrawals are also tax-free.

FSAs are distinct from health insurance. Employees typically fund these accounts entirely through payroll deductions, with the election amount usually determined during the annual open enrollment period. The availability of these funds generally begins on the first day of the plan year, regardless of whether the full amount has been deducted yet.

Types of Eligible Expenses

Flexible Spending Accounts are categorized by the types of expenses they cover, primarily focusing on healthcare and dependent care. Each type of FSA has specific rules governing what can be reimbursed, which are defined by the Internal Revenue Service (IRS).

A Health Care FSA (HCFSA) covers a broad range of medical, dental, and vision expenses that are not reimbursed by health insurance. Common eligible expenses include deductibles, copayments, prescription medications, and certain over-the-counter drugs and medical supplies. This also extends to items like eyeglasses, contact lenses, dental work, and even some medically necessary cosmetic procedures. IRS Publication 502 provides comprehensive guidance on what constitutes an eligible medical expense.

A Dependent Care FSA (DCFSA) is specifically designed to cover expenses related to the care of qualifying dependents, allowing the employee to work or look for work. Eligible expenses typically include costs for daycare, preschool, before- and after-school care, and summer day camps. For a dependent to qualify, they must generally be under the age of 13, or a spouse or other dependent who is physically or mentally incapable of self-care and lives in the employee’s home.

A Limited Purpose FSA (LPFSA) is a specialized type of HCFSA often used in conjunction with a Health Savings Account (HSA). This type of FSA restricts eligible expenses primarily to dental and vision care costs. This limitation allows individuals to contribute to both an HSA and an FSA simultaneously, providing tax advantages for specific healthcare needs while preserving HSA funds for broader medical expenses. Common ineligible expenses across all FSA types generally include health insurance premiums, long-term care premiums, and cosmetic procedures.

How Flexible Spending Accounts Operate

Employees typically initiate their FSA participation by making an election during their employer’s open enrollment period. This chosen annual contribution amount is then deducted from each paycheck in equal installments throughout the plan year. Once the election is made, it is generally irrevocable for the plan year unless a qualifying life event occurs, such as marriage, divorce, birth, or changes in employment status.

Reimbursement for eligible expenses involves submitting a claim to the plan administrator, with supporting documentation like receipts or an Explanation of Benefits (EOB) from an insurance provider. Funds can be disbursed via direct deposit, check, or through a dedicated debit card provided by the plan. The expense must have been incurred during the plan year for which the funds were elected, and the reimbursement is typically based on when the expense was incurred, not when it was paid.

FSAs have the “use-it-or-lose-it” rule, meaning any funds remaining in the account at the end of the plan year are forfeited. This IRS rule prevents FSAs from functioning as deferred compensation plans. However, the IRS allows employers to offer two exceptions to this rule, though an employer can only choose one or neither: a grace period or a carryover option.

The grace period allows employees an additional two and a half months after the end of the plan year to incur new eligible expenses using funds from the previous year’s balance. The carryover rule permits a limited amount of unused funds to be rolled over into the next plan year. For plan years beginning in 2024, the maximum carryover limit for a Health Care FSA is $640, increasing to $660 for 2025. Dependent Care FSAs do not typically have a carryover option but may offer a grace period.

Annual contribution limits for FSAs are set by the IRS and are subject to adjustment. For 2024, the Health Care FSA contribution limit is $3,200, rising to $3,300 for 2025. The Dependent Care FSA limit remains $5,000 per household, or $2,500 for married individuals filing separately, for both 2024 and 2025. If an employee leaves their job, the ability to use FSA funds typically ends on the termination date, though some plans may allow a short period to submit claims for expenses incurred prior to termination.