What Is a Flexible Spending Account?

As employers cut back on benefits or require employees to contribute more, establishing a flexible spending account (FSA) gives employees a valuable benefit at little cost to the employer.

A flexible spending account (FSA) is a tax-favored program offered by employers that allows their employees to pay for eligible out-of-pocket medical and dependent care expenses with pre-tax dollars. Typically at the beginning of each plan year, employees decide how much they want to contribute. They contribute pre-tax dollars via payroll contribution to their accounts. Maximum contribution amounts adjust yearly with inflation. For 2016, employees can contribute up to $2,550 (unchanged from 2015) toward a medical FSA, and up to $5,000 for dependent care.

Employers can offer two types of FSA:

1. Medical FSAs allow employees to spend their funds on eligible medical expenses that are not covered by their major medical plan. Eligible expenses can include dental work, vision care, chiropractic care, psychological care, and more.
2. Dependent care FSAs let employees pay for eligible day care expenses they and their spouses need in order to work, look for work or attend school full-time. Eligible expenses include care for children under age 13 or anyone you can claim on your federal tax return who is physically or mentally incapable of self-care.

For employees, an FSA gives an immediate discount on these expenses that equals the taxes they would otherwise pay on those earnings. FSAs appeal to many younger employees, who like the cost savings they represent for day care expenses.

FSAs also help employers. Because they reduce employees’ taxable income, they’ll reduce your payroll and FICA tax liability. You can also deduct any administrative costs as a business expense.

Caveats: Employees

FSA elections are only effective for one benefit period. Employees who miss the annual open enrollment season must wait until the next one. Experiencing a “qualifying life event,” such as marriage, divorce, birth or adoption of a child, will allow them to contribute outside of open enrollment season.

FSAs have always operated on a “use it or lose it” basis, with employees forfeiting any funds left at the end of the plan year. That changed a bit with the Affordable Care Act, which allows plans to permit employees to roll over up to $500 into the following year.

Plans also have the option of adding a 2½ month grace period. The grace period allows employees to apply FSA funds from the prior year’s contributions to expenses incurred within the grace period.

Plans can offer either a rollover or a grace period, but not both.

Caveats: Employers

Although FSAs won’t cost you anything in premiums, just a bit in administration, they do have a couple of pitfalls.

First, rules governing these plans give employees immediate access to their entire election amount, which could leave employers responsible for the shortfall. For example, an employee could elect to contribute $100 per month, or $1,200 per year. In January, with only one month’s contribution made, he has $1,200 of dental treatments. If he submitted it to the plan for reimbursement, the plan would have to pay the entire amount. The employer would pay the shortfall.

Employers also run the risk that employees will leave the company before their salary deduction contributions match the funds they’ve already withdrawn from their FSA.

On the positive side, a FSA adds another layer to your benefits program, allowing employees to select the type of FSA and contribution amount that best suits their situation. As employers trim their benefits due to increasing medical costs, funds from an FSA can help ease the sting.