What is an FSA?
Tax-advantaged benefits with strict time limits
Summary: Flexible Spending Accounts are tax-advantaged employee benefits to pay for health expenses, dependent care costs, or adoption costs. Employees may elect during open enrollment to make contributions to fund FSAs, but unspent funds may be forfeited after the end of the year.
FSAs cover a few types of benefits
Flexible Spending Accounts, or FSAs, are employee benefits programs that provide tax-free reimbursement for specific types of expenses incurred by employees during the year.1
There are FSAs for health care costs.2 These are usually called Health FSAs (HFSAs).
FSAs for dependent care costs.3 These are usually called Dependent Care Assistance Programs (DCAPs), or less often called DCFSAs.
And FSAs for adoption costs.4 These are usually called Adoption Assistance Programs (AAPs), or less often called AAFSAs.
FSA funding and elections
FSAs are normally funded by employees. During open enrollment, the employee elects to convert taxable salary into a pre-tax FSA balance. When the plan year starts, the employee’s salary & wages are reduced by an amount that will equal the full-year balance of the FSA.
So if the employee elects $3,000 in contributions and the payroll schedule is 24x per year, each paycheck will be reduced by $125 (3,000/24=125). You save taxes on the part of your salary diverted into the FSA, so that $125 is tax-free.
As a general rule, the FSA election must be made before the start of the plan year.5 Employees hired during the plan year can make elections for the current year, of course. Most FSA elections cannot be revoked or changed unless you have a life event or change in status.6
Those life change events might include:
marital status (marriage, separation, divorce, death of spouse),
dependents (childbirth, adoption, death of dependent),
employment status (starting a job, leaving a job, starting or ending a leave of absence, changing worksite),
dependent becomes ineligible,
change in residence, or
an adoption proceeding opens or closes.
The employment and residence events include changes in the job or home of a spouse or dependent, as well as the employee.
Other life events that permit mid-year election changes include:
court orders (divorce decree, separation order, QMCSO child medical support order)7
Medicare or Medicaid eligibility,8 or
significant changes in cost or coverage.9
If you do a mid-year election change, the change needs to be consistent with the life event that allowed the change.10 The life event is not a blank check to make election changes.
Use it or lose it – FSA forfeitures
FSAs expire every year, and any money you do not spend during the year is forfeited. In this way, FSAs are not like HSAs or 401(k)s, since those accounts store money that you own, but FSAs are notional and are not accounts that you own. If you leave your employer, then your participation in the FSA may also end, with unspent funds (eventually) forfeited. There are some limited exceptions to FSA forfeitures.
FSAs can permit run-out periods, meaning a period after the plan year ends but where expenses can still be submitted.11 The expenses submitted during the run-out period must have been incurred during the plan year. The run-out period is especially important for expenses incurred in the last few weeks of the plan year (e.g. December).
FSAs can have grace periods, meaning a period of up to 2 and a half months after the end of the plan year when new qualified expenses can be incurred.12 The grace period has to be part of the written cafeteria plan document. The grace period can be followed by a run-out period, allowing some time for the recently incurred expenses to be reimbursed.
Health FSAs can have limited carryovers, allowing up to $500 to be carried over to the next year, but HFSAs that allow carryovers cannot allow grace period expenses.13 This was a modest change from 2013 to stop punishing employees for leaving modest remainder balances in their HFSAs.
FSAs can also have spend-down periods, meaning a period after the employee separates from employment when new qualified expenses can be incurred.
During the initial period of the covid-19 pandemic, the IRS loosened the FSA rules to allow generous expense periods, carryovers, and grace periods.14
FSA limits
The limit for DCAPs (DCFSAs) is $5,000.15 However, employees with a tax filing status of married filing separately (MFS) have a DCAP limit of $2,500.
The limits for the other FSA types are inflation-adjusted.16 For HFSAs, the annual limit is $3,050 in 2023. If the HFSA permits carryovers, the 2023 carryover limit is $610. For AAPs (AAFSAs), the limit is $15,950.
FSA expenses
HFSAs must be spent on health care expenses.17
DCAPs (DCFSAs) must be spent on dependent care expenses.18
AAPs (AAFSAs) must be spent on adoption expenses.19
FSA expenses must be incurred during the plan year. But if there’s a grace period, expenses can also be incurred up to 2.5 months after the end of the year.
Expenses can’t be reimbursed from another source if they’ll be paid by the FSA. They also cannot be deducted if they are paid by the FSA. Either of those would result in a doubling up on the benefit, which is not permitted.
Legal formalities
Sometimes ERISA
Health FSAs will normally be ERISA health plans.20 Of course, this is not true if the health FSA is offered by a non-ERISA employer, like a government or church.21 Dependent care FSAs and adoption assistance FSAs are normally not ERISA benefit plans.22
Usually cafeteria plan
FSAs are normally provided through an employer cafeteria plan, which allows the employee to make pre-tax contributions to fund the FSA.23 The cafeteria plan rules are the source of many of the most significant FSA features: uniform coverage throughout the year, 12-month plan year, no deferral of compensation, annual forfeiture of unspent balances, limitations on mid-year election changes, and others. It also means that HFSAs, DCAPs, and AAPs will always be governed by a written plan document.
Never HCE discrimination
All 3 types of FSA have nondiscrimination rules that prevent them from favoring highly compensated employees and executives over other employees. First, because they all share the cafeteria plan nondiscrimination rules.24 Second, because they each have individual nondiscrimination requirements.25
Health FSAs must meet the general health plan nondiscrimination provisions. Dependent care FSAs (aka DCAPs) have a series of four specifically tailored nondiscrimination tests. Adoption assistance FSAs directly rely on nondiscrimination tests created for educational assistance programs.26
Conclusion
So the basic story is FSAs save you money on taxes, but be careful because you can also lose money if you don’t spend it all.
Prop. Treas. Reg. § 1.125-5(a)(1)
Prop. Treas. Reg. § 1.125-2(a)(2)
Prop. Treas. Reg. § 1.125-4(c)
Prop. Treas. Reg. § 1.125-4(d)
Prop. Treas. Reg. § 1.125-4(e)
Prop. Treas. Reg. § 1.125-4(f)
Prop. Treas. Reg. § 1.125-4(c)(3)
Prop. Treas. Reg. §1.125-1(f)
ERISA § 3(1) (ERISA definition of ‘employee welfare benefit plan’ applies to any employer program that provides medical, surgical, hospital, sickness, accident, or disability benefits to employees)
ERISA § 4(b)(1) & (2) (ERISA exceptions for governmental plans and church plans)
ERISA § 3(1) (ERISA definition of ‘employee welfare benefit plan’ does not apply to employer programs that provide the sort of benefits typically provided by DCAPs and AAPs). However, note that ERISA has a specific rule that day care centers are ERISA welfare benefit plans. If a DCFSA narrowed the choice of dependent care providers to a single provider, then the DOL might interpret it as functionally providing a day care center. See ERISA Advisory Opinion 1993-25A.
§ 105(h) (HFSAs); § 129(d)(2) (DCFSAs); § 137(c)(2) (AAFSAs)