Flexible spending account Totally Explained

Everything about Flexible Spending Account totally explained

A flexible spending arrangement (FSA), or Flexible Spending Account, as they're commonly called, is one of a number of tax-advantaged financial accounts that can be set up through a cafeteria plan of an employer in the United States. An FSA allows an employee to set aside a portion of his or her earnings to pay for qualified expenses as established in the cafeteria plan, most commonly for medical expenses but often for dependent care or other expenses. Money deducted from an employee's pay into an FSA isn't subject to payroll taxes, resulting in a substantial payroll tax savings. The most common FSA, the medical expense FSA (also medical FSA or health FSA), is similar to a health savings account (HSA) or a health reimbursement account (HRA). However, while HSAs and HRAs are almost exclusively used as components of a consumer driven health care plan, medical FSAs are commonly offered with more traditional health plans as well. An FSA may be utilized by paper claims or an FSA debit card also known as a Flexcard.

Types of FSAs

Most cafeteria plans offer two different flexible spending accounts; one is for qualified medical expenses and the other is for dependent care expenses. A few cafeteria plans offer other types of FSAs, especially if the employer also offers an HSA. Participation in one type of FSA doesn't affect participation in another type of FSA, but funds can't be transferred from one FSA to another.

Medical expense FSA

The most common type of FSA is used to pay for medical expenses not paid for by insurance; this usually means deductibles, copayments, and coinsurance for the employee's health plan, but may also include expenses not covered by the health plan, such as dental and vision expenses and over-the-counter drugs. A medical FSA can't pay for health insurance premiums, cosmetic items, cosmetic surgery, or items that improve "general health". All items must be intended to treat or prevent a specific medical condition; this can be as significant as diabetes or pregnancy, or as trivial as skin cuts. Generally, allowable items are the same as those allowable for the medical tax deduction, as outlined in IRS publication 502

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The annual caps for a medical FSA varies by employer. Unlike dependent care FSAs, there's no IRS cap on medical FSAs, but employers generally limit the annual amount each employee may contribute, in order to reduce the risk of pre-funding. Should the employee leave or be terminated and thus no longer pay in to the plan, the employer doesn't recapture their pre-funding from the employee's payroll deduction.

Dependent care FSA

FSAs can also be established to pay for certain expenses to care for dependents that live with you while you're at work. While this most commonly means child care, it can also be used for adult day care for senior citizen dependents that live with you, such as parents. It can't be used for summer camps (other than "day camps") or for long term care for parents that live elsewhere (such as in a nursing home).
   The dependent care FSA is federally capped at $5,000 per year. While married spouses can each elect to have this amount deducted from their paycheck and applied to expenses, at tax time all withdrawals in excess of $5,000 are taxed. Unmarried couples can each deduct and use $5,000.
   Unlike medical FSAs, dependent care FSAs can't be "pre-funded"; employees can only receive reimbursement as funds are deposited into the FSA. Also, although FSA debit cards can be used with dependent care FSAs, they're subject to restrictive IRS requirements that generally require employees to pay the first child-care bill of each year by other means, among other things.
   While medical FSAs almost always favor the taxpayer, dependent care FSAs are a more complicated matter because they're a tradeoff between pre-tax deductions and tax credits, not itemized deductions. Enhancements to child tax credits in recent years have made them more attractive than dependent care FSAs for many taxpayers.
   If married, BOTH spouses must earn income in order for the Dependent Care FSA to work. The only exception is if the non-earning spouse is disabled or a student. If one spouse earns less than $5,000 then the benefit is limited to whatever that spouse earned. Many plan coordinators don't warn of this limit. This limitation can create a situation where the earning spouse sets up a Dependent Care FSA and dutifully sends in receipts to withdraw funds and then at tax time the FSA is effectively eliminated and all the work wasted. See IRS Form 2441 Part III for details.

Other FSAs

Though not as common as the FSAs listed above, some employers have offered adoption assistance through an FSA. Also, though medical FSAs can't reimburse for health premiums, some small employers without a health plan have established FSAs to reimburse their employees for individual health premiums.

FSA's coverage period

An FSA's coverage period ends either at the time the "plan year" ends for your plan or at the time when your coverage under that plan ends. Example: Loss of coverage due to a separation from the employer.
This means that if you're employed by a company from January through June and covered on their cafeteria benefits plan (including FSA) during that time, but don't elect and pay for continued coverage under that plan (for example COBRA). Your coverage period is defined only as January through June! Not January through December as one might think.
All covered expenses must be incurred (or be dated) between January and June of that year.

Methods of withdrawal from FSAs

In recent years, the FSA debit card was developed to eliminate "double-dipping" by allowing employees to access the FSA directly, as well as to simplify the substantiation requirement which required labor-intensive claims processing; the debit card also enhances the effect of "pre-funding" medical FSAs. However, the substantiation requirement itself didn't go away, and has even been expanded on by the IRS for the debit-card environment; therefore, withdrawal issues still remain for FSAs.
According to Celent, as of May 2006, there were approximately 6 million debit cards in the market tied to an FSA account, representing 25% of the FSA participating community. Celent projects that FSA cards will increase FSA adoption rates. The average card participation rate was around 20% as of May 2006. By 2010, it's projected this rate will increase to 85%.

Plan year grace period

In 2005, the Internal Revenue Service authorized an optional 2½ month grace period that employers can use in their plans, allowing use of the funds for 2½ months after the end of the plan year.

Advantages and disadvantages of all FSAs

An FSA allows money to be deducted from an employee's paycheck pre-tax and then spent on qualified expenses.
For an example of potential tax savings associated with a flexible spending account, a person in the 28% Federal marginal tax bracket and an example 4% state tax (along with FICA taxes of typically 7.65%, for a total tax of almost 40%), could deduct $2,000 and put that money into an FSA for health care. This would result in almost $800 in tax savings.

Example 1: No FSA Account with Fixed Medical Expenses
$NET_INCOME = $INCOME * (1 - $TAX_RATE) - $MEDICAL_EXPENSES

Income = $50,000
Tax Rate = 40%
Medical Expenses = $2,000
Net Income = $28,000
Example 2: Fixed Medical Expenses Reserved in an FSA Account
$NET_INCOME = ($INCOME - $MEDICAL_EXPENSES)(1 - $TAX_RATE)

Income = $50,000
Tax Rate = 40%
Medical Expenses = $2,000
Net Income = $28,800 There is a straight-line savings of $800, IF you spend everything in the FSA account AND you need everything you purchase.
Example 3: Minimum FSA Account Spending Threshold to Realize Savings
$MEDICAL_EXPENSES * (1 - $TAX_RATE)

Tax Rate = 40%
Medical Expenses = $2,000
Threshold = $1,200 As long as you spend at least this amount from an FSA account, every additional dollar spent improves your Net Income.

If this example person hadn't utilized the FSA and instead itemized their deductions, they likely wouldn't have been able to deduct this $2,000 expense because it wouldn't have met the 7.5% of Adjusted Gross Income threshold needed to be able to deduct it on their federal tax return. Even if the expenses had met the 7.5% threshold, only the part in excess of 7.5% would count as an itemized deduction; and itemized deductions are only beneficial if they exceed the standard deduction, which is hard to meet unless you've home mortgage interest or large charitable contributions. Finally, expenses for over-the-counter drugs can't be deducted or counted towards the 7.5% threshold, but they can be paid for by the FSA.

Pre-funding

One very important advantage of medical FSAs is that they're "pre-funded" by the employer: If you set aside an amount per year in a medical FSA (as in the earlier example), the entire amount is available for your use immediately--either at the start of the plan year (commonly January 1) or after the first contribution to the FSA is received by the FSA vendor, depending on the plan--even though you only contribute to the FSA in small increments throughout the year (for example, 1/26 of the annual amount if you're paid biweekly).
You don't continue to contribute to the plan upon termination of your employment. Thus, you could use the entire amount on day one of the plan year, terminate your employment on day two of the plan year, and contributions would have been none or negligible (for example, perhaps 1/26 in the case of biweekly contributions). The "free" money isn't taxable. The reason for this is that the IRS views these plans for tax purposes as insurance policies.

Over-the-counter drugs & medical items

Another very powerful medical FSA feature that has been introduced in recent years is the ability to pay for over-the-counter (OTC) drugs and medical items. In addition to substantially expanding the range of "FSA-eligible" purchases, adding OTC items made it easier to "spend down" medical FSAs at year-end to avoid the dreaded "use it or lose it" rule.
However, substantiation has again become an issue; generally, OTC purchases require either manual claims or, for FSA debit cards, submission of receipts after the fact. Most FSA providers require that receipts show the complete name of the item; the abbreviations on many store receipts are incomprehensible to many claims offices. Also, some of the IRS rules on what is and isn't eligible have proven rather arcane in practice. The recently-developed inventory information approval system (IIAS), which separates eligible and ineligible items at point-of-sale and provides for automatic debit-card substantiation, should eliminate these issues and make medical FSAs very attractive for OTC purchases.

Use it or lose it

One major drawback is that the money must be spent within the coverage period as defined by the benefits cafeteria plan coverage definition. This coverage period is usually defined as the period that you're covered under the cafeteria plan during the "plan year". The "plan year" is commonly defined as the calendar year.
   Any money that's left unspent at the end of the coverage period is forfeited back to the company; this is commonly known as the "use it or lose it" rule.
   A second requirement is that all applications for refunds must be made by a date defined by the plan. If funds are forfeited, this doesn't eliminate the requirement to pay taxes on these funds if such taxes are required. For example, if a single person elects to withhold $5000 for child care expenses and gets married to a non-working spouse, the $5000 would become taxable. If this person didn't submit claims by the required date, the $5000 would be forfeited but taxes would still be owed on the amount.
   Also, the annual contribution amount must remain the same throughout the year unless certain qualifying events occur, such as birth of a child or death of a spouse.

Further Information

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