How Does an FSA Work?
- Ben Luthi
- 6 min read
Let’s face it, medical bills can get expensive fast, even if you don’t have chronic health issues. An FSA or Flexible Spending Account gives you the chance to set aside money before taxes. You can save these funds or use them to pay for qualified medical expenses. The benefits of an FSA include tax savings, front-loaded accessibility, and convenience.
But not everyone qualifies for an FSA, and some aspects of the plans may be less than appealing for some. If you have consistent health care costs, here are some ways an FSA may be able to help.
Front-loaded, pre-tax accounts, offered by your employer
An FSA is a pre-tax health account, and it's sometimes referred to as a Medical FSA or Healthcare FSA. You can use the funds in this account to pay for eligible medical expenses.
You can only get a Flexible Spending Account through an employer. The Society for Human Resource Management states 63% of companies offered FSAs in 2018. If your employer offers an FSA and you’re eligible to contribute, you can use it to save money on a pre-tax basis.
Then you can use that money to pay for qualified medical expenses throughout the year. The tax savings will depend on how much you contribute and your effective tax rate. Who wouldn’t want to keep even a little extra money in their pocket, rather than giving it to Uncle Sam?
Unlike similar health accounts, FSAs are front-loaded, which means you decide how much to contribute from each paycheck during the upcoming plan year. Once the plan year begins, you’ll receive the total of all your expected contributions from the get-go.
Here’s an example of how this works:
Let’s say you decide to set aside $100 per paycheck, and you’re paid two times a month. That’s a total of $2,400 over the course of a year. But you’ll receive that full amount at the beginning of your plan year.
That said, FSAs also have a “Use it or Lose it” policy. The rule says you must use all the money in your FSA within the same plan year that you make the contributions. Otherwise, you may have to give up the remaining amount. That said, employers may choose one of two options to provide some leniency with the rule.
First, they can give employees a grace period of up to two-and-a-half months. During this time, employees can incur new expenses and use the previous year’s funds to cover them. The second option allows participants to carry over a small amount of funds, a limit which is set by the IRS each year.
Because of the “Use it or Lose it” rule, an FSA may not be the best fit for someone who doesn’t incur medical expenses often. You must choose how much you want to contribute to the account during open enrollment. As a result, it's essential to have a good idea of your upcoming expenses, so you don't overfund the account.
Finally, FSAs are not portable, so if you leave your employer, you can’t take your FSA funds with you. But, if you leave your job and used more FSA funds than you contributed for the year, you don’t have to repay the difference.
How to add money to your account
After you’ve determined your contribution amounts, you’ll put money into the account through paycheck deductions. The IRS sets contribution limits each year for FSAs.
Unfortunately, there’s no higher limit if you’re on a family plan. But if you have a spouse or partner, both of you can save up to the annual limit of an individual FSA.
Remember, you’ll decide how much you want to contribute with each paycheck at the beginning of the plan year. So you’ll want to plan ahead. Also, if you carry over FSA funds from the previous plan year, that won’t count toward your contribution max.
You may be able to make changes during the year if certain events occur. Some qualifying life events include marriage, divorce, or having a baby. If any of those things happens, you’ll have 30 days to update your contribution amount.
Your employer may also choose to contribute to your FSA. They can do a dollar-for-dollar match, or $500 max. The limit is whichever option is greater. If you plan to set aside less than $500, the most your employer can contribute is $500. But if you contribute more than that, you can get a match of up to the FSA maximum contribution limit.
How to use your flexible spending account (FSA)
You’ll typically have two options for using your FSA funds to pay for eligible expenses:
- Debit card: Most FSA providers give you a debit card tied to the account. When you need to pay for a qualified medical expense, use the card as you would any other debit card.
- Reimbursement: If you choose to pay for your health care costs out of pocket with debit or credit cards, you can request for reimbursement. Make sure you keep your receipt. You’ll need to upload it through your online account or mobile app to receive the money.
You can’t use your FSA funds for everything, even if it is health-related. For example, if your health insurance already covers the cost, you can’t double-dip. Cosmetic surgery is also a no-no. Most in-person doctor visits, prescriptions, dental, and vision care are qualified expenses.
Check the IRS website or What’s Eligible for a full list.
How does an FSA compare to other health accounts?
Your employer may offer more than one option for tax-advantaged health savings. They can offer a Health Savings Account (HSA) or a Health Reimbursement Arrangement (HRA).
If your employer offers more than one type of health savings plan, find out which ones you’re eligible for. Then read all the terms to compare your options to decide which is the best for you. Here’s a quick summary of each:
Health Savings Account (HSA)
An HSA allows you to set aside pre-tax dollars for eligible health care costs. HSAs are only available for people enrolled in a High Deductible Health Plans (HDHPs). HSA contribution limits are set annually by the IRS and differ for individual and family plans. You can add $1,000 more in catch-up contributions if you’re 55 or older.
There’s no “Use it or Lose it” rule, and HSA plans are portable. If your employer does offer an HSA, it may choose to make contributions on top of yours. Finally, unlike an FSA or HRA, you can invest your HSA funds.
Health Reimbursement Arrangement (HRA)
You can only get an HRA through an employer, and the company owns the account. Some employers may even choose to offer an HRA instead of health insurance plans. The primary difference between the two is that only an employer can make contributions to an HRA.
Contribution limits will vary based on the type of HRA you have. Any money your employer contributes is not considered income on your tax return. Your employer will get to decide which expenses are eligible. They also determine whether you can carry over unused funds at the end of the year.
NOTE: A healthcare FSA is different from a Dependent Care FSA. A Dependent Care FSA allows you to pay for qualified care expenses that will enable you to work. You can also get tax benefits from a Dependent Care FSA, but many of the rules differ from a health FSA.
The last and most important FSA tip
FSAs are best to use for expected qualified health expenses. Do your best to plan each year and review your expected expenses to maximize the tax savings. The last thing you want to do is lose money at the end of the year. But with the right strategy, FSAs are a great tool to save money on annual health savings.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.