Why Do FSAs Have a Use-It-or-Lose-It Rule?

Flexible Spending Accounts (FSAs) serve as a valuable tool for individuals to manage healthcare costs by allowing pre-tax contributions for eligible medical, dental, and vision expenses. The “use it or lose it” rule is a defining characteristic of FSAs and shapes how participants must utilize their allocated funds.

Understanding the “Use It or Lose It” Rule

The “use it or lose it” rule dictates that any funds remaining in an FSA at the end of a plan year are generally forfeited to the employer if not spent on eligible expenses by the designated deadline. The standard timeline for spending FSA funds typically aligns with the employer’s plan year.

Funds within an FSA are intended for a broad range of qualified medical expenses, including deductibles, co-payments, prescription medications, and many over-the-counter items. The rule’s primary implication is that participants must carefully estimate their annual healthcare spending to avoid losing their contributions. It necessitates proactive planning and diligent tracking of expenses.

Regulatory Framework for FSAs

The “use it or lose it” rule is a fundamental requirement imposed by the Internal Revenue Service (IRS) to maintain the tax-advantaged status of Flexible Spending Accounts. FSAs are primarily governed by Internal Revenue Code Section 125, which outlines the rules for cafeteria plans, and Section 105, pertaining to health plans. These sections enable employees to contribute pre-tax dollars from their salaries into an FSA.

FSA contributions are exempt from federal income tax, Social Security, and Medicare taxes. Withdrawals for qualified medical expenses are also tax-free. The “use it or lose it” provision is designed to prevent FSAs from functioning as long-term savings or investment vehicles. This distinction ensures that FSAs remain spending accounts for current-year medical expenses, rather than accumulating tax-free wealth over time. The rule helps differentiate FSAs from other tax-advantaged accounts, like Health Savings Accounts (HSAs), which have different regulatory frameworks and allow funds to roll over year after year.

Exceptions and Flexibility

While the “use it or lose it” rule is a core component of FSA design, employers have the option to offer two specific exceptions that provide some flexibility. These exceptions are the grace period and the carryover option. An employer may choose to implement one of these two options, but they are prohibited from offering both simultaneously.

The grace period allows employees an additional two and a half months (2.5 months) beyond the end of the plan year to incur eligible expenses and use their remaining FSA funds. For instance, if a plan year ends on December 31st, a grace period would extend the spending deadline to March 15th of the following year. Alternatively, the carryover option permits employees to roll over a limited amount of unspent FSA funds into the next plan year. For example, the IRS allows up to $640 (for 2024) to be carried over, though this amount can be adjusted annually. It is important for individuals to verify with their specific plan administrator or Human Resources department which, if any, of these flexibilities are offered by their employer.

Strategies for Spending FSA Funds

To avoid forfeiting unspent funds, individuals can adopt several proactive strategies throughout the year. Regularly reviewing the remaining balance in an FSA and understanding eligible expenses is a beneficial first step. Many common healthcare items and services qualify, including doctor visits, prescription medications, and certain diagnostic tests.

Scheduling routine medical appointments, such as dental check-ups, eye exams, or physicals, towards the end of the plan year can help utilize funds effectively. Purchasing eligible over-the-counter items, such as pain relievers, first-aid supplies, menstrual care products, or sunscreen, is another practical approach. Many online FSA stores also offer a wide array of eligible products, making it convenient to spend down balances. If new prescription eyeglasses or contact lenses are needed, ordering them before the deadline can also be an efficient way to deplete remaining funds.