Flexible spending accounts, or FSAs, are special savings accounts offered through some employer benefit plans. They allow the account holder to pay for certain out-of-pocket medical and dependent care costs with tax-free money.
However, “tax-free money” is a phrase that’s not used too often in personal finance articles—at least not legitimate ones.
So it’s no surprise that FSAs come with a decent number of rules and regulations, which limit the application of this special, tax-favored savings vehicle.
For instance, FSA rules cap the amount of money that can be placed in the account each year ($2,750 for 2021), and also dictate which types of expenses qualify for an FSA distribution.
Still, FSAs can be a powerful tool for taking care of unavoidable medical costs that frequently wreak havoc on American finances, even with the rules that keep them in check.
Flexible Spending Account Explained
We’ve covered flexible spending accounts in depth elsewhere on our site, but as a quick refresher, FSAs are savings programs offered through employers—which means that self-employed people, like freelancers, aren’t eligible.
(Psst: if that’s you, buying a healthcare plan on the market might be an option to consider, though you may also be able to get coverage through an employed spouse’s plan.)
FSAs are also sometimes called flexible spending arrangements, and there are a few sub-types, such as dependent care FSAs (DCFSAs) and limited purpose FSAs (LPFSAs).
However, for the purposes of this article, the focus will be on the account rules that govern plain old healthcare FSAs, whose funds can be used to cover you, your spouse, and your dependents.
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Flexible Spending Account Rules: An Overview
FSA contributions work similarly to employer-sponsored retirement plans, like 401(k)s: a certain amount of wages is withheld each pay period and contributed to the account.
The account holder elects how much to withhold at the beginning of the plan year—and, importantly, they may not be able to change it unless there’s a change in employment or family status. That means it’s important to think the decision through carefully!
But unlike a 401(k), the funds placed into an FSA aren’t just tax-deferred—they’re actually tax-free. That means they aren’t included in the account holder’s total taxable income, and taxes aren’t due when distributions are made, either… which is pretty darn rare and special.
How Much Can I Contribute to My FSA?
The government certainly wants to keep collecting taxes, so there are strict limits to how much money can be stashed into a tax-free savings account.
In 2021, account holders may contribute up to a maximum of $2,750 per year to their FSAs. Employers may also place limits on the amount an employee can elect to be contributed, up to this federal cap.
Unused Funds: FSA Rollover and Reimbursement Rules
Another powerful limit on the usability of FSAs is the fact that, generally speaking, unused FSA funds are forfeited.
In other words, FSAs are “use it or lose it” accounts; the money that isn’t used for qualified expenses by the end of the plan year can’t be rolled over into the next.
Thus, account holders may want to be cautious to avoid over-contributing to the plan and carefully estimate how much they think they’ll actually need to spend on out-of-pocket health expenses.
However, there are some exceptions that may be accessible, depending on the employer’s policy choice. They may allow for a “grace period” or a carry-over option—one or the other, but not both, and they’re not legally required to offer either.
• The grace period option allows account holders to use their FSA funds for an additional two and a half months after the plan year to pay for qualified medical expenses.
• The carry-over option allows account holders to roll over up to $500 of unused funds into the account for use the next plan year, though the employer may specify a lower dollar figure. Carryover doesn’t affect the maximum allowable contribution for the next year’s plan.
Changes to FSA Plans Due to COVID-19
Due to the COVID-19 pandemic, the IRS issued new guidance regarding FSA plans. Employers have the option to extend the grace period for 2019 funds through the end of 2020. Generally, those funds would have expired under the typical two and a half month grace period. For 2020, individuals are also able to make prospective adjustments to their FSA.
This includes revoking a contribution, adjusting the amount contributed, or making a new election.
What Can a Flexible Spending Account Be Used For?
Given the contribution limits and forfeiture rules of flexible spending accounts, FSA account holders usually want to be careful about calculating how much money they might actually be able to use—otherwise, significant amounts of their paycheck might end up right back in their employers’ hands.
And although many medical expenses qualify, not all of them do. For instance, non-prescription medications, with the notable exception of insulin, cannot be paid for with funds from an FSA.
FSA funds are also ineligible to be used for health insurance premiums or long-term care coverage and expenses, which may affect those with chronic illnesses or disabilities.
There are, however, a wide range of procedures and healthcare services that FSA funds can be used to cover, including dental expenses.
In basic terms, any treatment that would qualify for a medical expense tax deduction can be covered by FSA funds; the full list of which can be found in IRS Publication 502 .
From acupuncture and alcoholism to birth control pills and psychological counselling, many services do count as qualified medical expenses.
Along with being the right kind of medical expense, services paid through FSA funds must be applied to the right people in order to be covered. Eligible beneficiaries include:
• The account holder
• Their spouse
• Dependents claimed on their tax return
• Children age 26 and under
Keep in mind, too, that FSAs generally work in conjunction with other types of health benefits and coverage, and funds can’t be used to reimburse services that are covered under other health plans.
It might be a valuable exercise to write out all of the expected medical expenses you’ll face as a family at the beginning of the plan year in order to decide how much to contribute, including additional coverages, in order to avoid overcontribution. While nobody can predict the future, some routine expenses can be foreseen—and a little bit of planning might save a lot of forfeited funds in the end.
Taking Distributions from an FSA
The process for taking distributions from an FSA may vary based on the plan. In some cases, distributions are made from an FSA to reimburse the account holder for medical expenses they’ve incurred. Some FSAs also have a debit, credit, or stored value card that can be used to pay directly for qualifying expenses.
In order to take a distribution, the account holder may have to provide a written statement from the doctor or medical service provider that specifies the medical expense incurred, as well as a statement documenting that the expense hasn’t been covered by any other health plan. In other situations, a receipt may be sufficient documentation in order to be reimbursed.
FSA reimbursements are only available for verifiable medical expenses that have already been incurred, rather than expenses the account holder plans to incur in the future. (In other words, you can’t write to the FSA and tell them you’re going to the doctor next month.)
Finally—and importantly—FSA participants must be able to use the entire benefit (that is, the total amount of money they pledged to contribute to the plan) even if those monies haven’t yet been contributed. There is some opportunity for roll-over, depending on the plan rules. Some FSAs allow account holders to carry over up to $500.
For example, if you decide to contribute $2,000, but get hurt midway through the year when only $1,000 has been deducted from your pay, you’ll still be able to use up to $2,000 worth of tax-free FSA coverage for qualified expenses. Pretty cool, huh?
Is a Flexible Spending Account Worth It?
A flexible spending account can be a helpful tool, but it’s not the only option for footing medical bills.
For one thing, $2,750 might not even scratch the surface of some fairly basic medical procedures. Take, for example, a simple natural birth, one of the most fundamental human experiences — which, according to Fair Health Consumer , would set back an uninsured person living in Portland, OR more than $20,000. Although that cost varies depending on location, it’s clear to see that additional coverage is necessary for most.
Furthermore, although the tax-free nature of FSAs is attractive, the prospect of forfeiting parts of a paycheck is definitely not—and there are other ways to save cash for medical expenses and other emergencies which offer not just flexibility, but growth.
For example, the average savings account earns 0.50% APY in interest, and up to 0.80%, per the latest FDIC rate cap information, which isn’t a huge return, but is more than the 0% you’ll earn on an FSA. That said, the value of tax-free dollars could easily eclipse the interest rate if the funds in the FSA are actually used.
While an FSA can be a beneficial tool, especially for those who know they’ll spend a decent amount out of pocket on healthcare, a SoFi Checking and Savings® account can add additional help in this instance; there are no account fees and account holders can earn cashback while they save and spend.
The Vaults system allows you to set money aside for specific savings goals—including medical expenses as well as more exciting objectives like vacations or home renovations. The tax benefits of the FSA can make them an appealing and useful tool. But if you’re not sure you’ll use the funds saved in an FSA, SoFi Checking and Savings could be an alternate solution. Those that will definitely use funds saved in an FSA may consider using SoFi Checking and Savings as a complementary tool to work toward other saving goals.
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