I’ve gone in to great detail on health savings accounts (HSAs), but have paid little attention to their cousin, the flexible spending account, aka an FSA (oddly, the IRS refers to them as “flexible spending arrangements“, but I have never heard anyone else use that term).
HSAs are tax advantaged savings accounts that can be used to pay for eligible medical expenses. They are paired with high deductible health plans (HDHPs). Tax-free (pre-tax) contributions and withdrawals for qualified medical expenses, employer contributions, and growth through investments make them an outstanding option for those who are eligible.
And that’s the rub. In order to be eligible to contribute to an HSA, you must be currently enrolled in an HDHP. What if you are not enrolled in an HDHP? Then you should give some strong consideration to contributing to an FSA instead.
So, I thought I’d give a little Q&A format rundown of flexible spending accounts – their pros, cons, maximum contributions, eligible expenses, & just about anything else I figure people might be curious on. Open enrollment for health care and other employee benefits are is coming up shortly, so now is the time to figure out if an FSA is a good fit for you (and how much you should contribute).
What is an FSA?
Flexible spending accounts are a type of of tax-advantaged health care savings account that employees offer as a benefit of employment to employees. The main purpose and benefit of contributing to and using an FSA is that any contributions made are pre-tax dollars. However, any qualified medical expenses paid for using the FSA are tax-free dollars. So, you effectively pay no taxes on those expenses, by virtue of reducing your taxable income.
If you are in the 22% tax bracket, for example, any qualified expenses paid for by an FSA would essentially result in a 22% out-of-pocket savings.
Contributions to an FSA are voluntarily made by the employee or by the employer at their discretion. FSA accounts are not portable, meaning that the employer owns them and the employee cannot use funds beyond the end of the year if they leave the employer.
What are FSA Qualified Medical Expenses?
Expenses that are eligible to be paid for by HSAs are also eligible to be paid for by FSAs.
Common eligible expenses include dentist and doctor visits, procedures, and co-pays, prescription drug costs or co-pays, laser eye surgery, eye exams, contacts, eyeglasses, and chiropractor visits.
If you have any medical conditions that require special equipment or treatment, these expenses are typically covered as well.
For a full list of what medical expenses are covered by a flexible spending account, check out IRS publication 502. Update: as a result of the CARES Act, OTC medications and menstrual care products are now considered qualified medical expenses.
4 medical expenses that are not covered by FSAs that one might commonly believe are:
- Amounts paid for health insurance premiums.
- Amounts paid for long-term care coverage or expenses.
- You can’t pay off outstanding bills incurred prior to your plan year.
- Domestic partner and children of domestic partners are not eligible to participate in the healthcare FSA.
When you can Contribute to an FSA?
You must elect your FSA contributions at the beginning of the plan year. Then, your employer will deduct amounts periodically (generally, every payday), pro-rated to align to your annual election. You can change or revoke your election only if there is a change in your employment or family status that is specified by the plan.
What is the 2022 FSA Maximum Contribution?
The IRS set a maximum FSA contribution limit in 2022 at $2,850 per qualified FSA ($100 more than the prior year). As with other tax advantaged accounts, the maximum contribution is annually indexed to inflation.
Oddly, many employers might only offer that you can contribute at levels below the IRS maximum. This is unlike the 401K maximum contribution, where all employees can contribute up to the federal annual maximum.
There are some ways to get around the maximum. If you hold two or more jobs (with unrelated employers), you can elect up to $2,850 under each employer’s FSA plan (or up to each employer’s maximum allowed). If married, each of two spouses can contribute to their employer’s plan (effectively doubling the total contribution).
What are the Key Difference Between an FSA and HSA?
If you’ve had an FSA in the past or are considering one, you are probably wondering how FSAs differ from HSAs. There are a few key difference when comparing HSAs vs. FSAs:
- You own an HSA, your employer owns the FSA. In other words, you can take an HSA with you if you leave your employer, but you cannot do the same with an FSA. This is referred to as “portability” – HSAs are portable, FSAs are not portable.
- You can carry over 100% of HSA funds from one year to the next, FSA carryovers are much more limited.
- You can invest funds in an HSA, you cannot invest funds in an FSA.
- Contributions maximums between the two differ, but HSAs are higher, plan permitting.
Which is better? HSA features and benefits are superior to FSAs. However, FSAs are a solid benefit for those who are not eligible to contribute to an HSA.
The FSA Use-it-or-Lose-it Rule & Carryover Rule
The biggest downside to FSAs has historically been the so-called “use it or lose it” rule. This rule stated that you must use all of your annual contributions to an FSA by the end of that calendar year.
The challenge with the use-it-or-lose-it rule, was that you had to make your annual election before the start of the plan year. And if you overestimated your expenses, you would lose any unused contributions at the end of the year.
The IRS made re-evaluated the FSA “Use it or Lose it” rule, and now there are 2 changes that employers can implement (though it is not mandatory):
- A 2 month +15 day grace period: any unused funds contributed in a given year can be used in the first 2 months and 15 days of the following year.
- An FSA carryover rule: allowing an inflation-adjusted 20% carryover or rollover amount. For 2022, the carryover rule allows up to $570 in carryover funds (20% of the $2,850 maximum FSA contribution).
2022 Update: as a COVID-relief measure, Congress and the IRS approved new FSA rule changes for 2021 and 2022 that allow up to the maximum FSA contribution to be carried over into the subsequent year (2021 contributions to 2022). This rule is voluntarily implemented by employers (not mandatory). Without further legislation, FSA carryovers from 2022 to 2023 will revert back to the $570 maximum.
How Much Should you Contribute to an FSA?
This is the tricky part. You have to elect how much to contribute to an FSA before the calendar year begins. And you lose what you don’t spend. So, how much should you contribute to an FSA, so you cover most of your expenses without losing them at the end of the year? This will take a bit of predictive analysis.
The most common uncovered and qualified medical expenses you might have typically include:
- dental co-pays
- prescription drug co-pays
- prescription eyeglasses and/or contact lens
- eye exams or eye exam co-pays
- OTC medications
Use your estimated expenses in these areas as a base-line. Beyond that, add in any other predicted expenses for your family. If you have special medical needs that you are 100% sure you will have that exceed the maximum annual contribution your employer allows, then it makes a lot of sense to max out your FSA for that year.
Flexible Spending Account Discussion:
- What questions do you have about FSAs?
- Do you contribute to an FSA?
- How much do you contribute annually, and how do you calculate that amount?
- Have you ever been burned by the “Use it or Lose it” rule? How much did you lose?