Flexible Spending Accounts (FSAs) are an employer-established health benefit that allows employees to use pre-tax dollars for out-of-pocket medical expenses, dependent (child) care expenses, and adoption expenses.
Depending on your individual income tax bracket, employees save a combined 18% - 50% federal, state, and local income and wage taxes on medical expenses funded through an FSA. Employees also receive the intangible benefits of having funds for anticipated out-of-pocket medical expenses available through forced payroll savings.
There are three types of Flexible Spending Accounts: Health FSAs, Dependent Care FSAs, and Adoption FSAs.
1. Health FSA
The most common type of FSA is a Health FSA, also known as a Medical FSA. A Health FSA allows employees to use pre-tax dollars for out-of-pocket medical expenses such as doctor co-pays, prescriptions, deductible expenses, and other eligible medical expenses. The maximum annual contribution limit for Health FSAs is $2,550 (2015).
For example: An employee elects to contribute pre-tax wages to an FSA in the amount of $200/month. On the first day of year, the employee receives a $2,400 FSA allowance for medical expenses. The employee has access to the full $2,400 on the first day of the plan year. The employee may use their FSA to pay (or be reimbursed) for qualified medical expenses.
2. Dependent Care FSA
A Dependent Care FSA, or Child Care FSA, allows employees to pay for employment-related dependent care services on a pre-tax basis. The maximum annual contribution limit for Dependent Care FSAs is $5,000 (2015).
Unlike a Health FSA, with a Dependent Care FSA funds are only available that have already been contributed through payroll deduction. In other words, the full year’s election is not available on day one of the plan year.
For example: With a Dependent Care FSA, an employee elects to contribute pre-tax wages to a Dependent Care FSA in the amount of $400/month in 2015. The employee has access to the funds that have accumulated in the FSA via payroll deductions (Ex: $400 on January 1). The employee may use their FSA to pay (or be reimbursed) for qualified dependent care.
3. Adoption FSA
A lesser known FSA option is an Adoption FSA. With an Adoption FSA, employees can set aside pre-tax money to use on expenses incurred while adopting a child.
Tip: In this guide on Flexible Spending Accounts, we focus on Health FSAs.
To better understand how Health FSAs are used, here is a summary of key features:
FSAs must be established by the employer.
FSAs are usually 100% employee funded, but an employer may contribute.
The maximum annual contribution is $2,550 (2015), with annual inflation increases.
FSA contributions are made with pre-tax payroll deductions.
FSA funds may be used on any unreimbursed medical care expenses, as defined by the IRS (see Publication 502). Health insurance premiums are not an eligible expense.
If the employer allows, a maximum of $500 FSA funds may be carried over year to year. Otherwise, the funds are “use it or lose it.”
FSAs are tied to employment, and are not maintained if the employee no longer works for the employer.