Tax Benefits of Flexible Spending Accounts

Last week, we discussed the tax benefits of health savings accounts, tax-advantaged savings accounts specifically designed for individuals with high-deductible health plans (HDHPs). But for those who do not have an HDHP, there are other options when it comes to paying for medical expenses. Enter flexible savings accounts, or FSAs, which can help cover the cost of health care expenses, all while saving you money during tax time. Here’s an overview of flexible spending accounts, including what they are, how they work, and their tax benefits that can save you money. 

What is a Flexible Spending Account (FSA)? 

Like a health savings account (HSA), a flexible spending account (FSA) is a tax-advantaged savings account used to pay for qualified medical expenses. In addition, FSA contributions are made with pre-tax dollars, which means these contributions are not included in your taxable income, thus reducing your tax liability for the year. Unlike an HSA, contributions made to your FSA do not carry over to the next year and instead use a “use it or lose it” policy. This essentially means that any funds that are unspent by the end of each plan year are forfeited to your employer. However, your employer may offer some exceptions to this rule. For example, some employers might give you an additional grace period of an extra 2.5 months to use the funds or allow up to $610 to carry over into the following year. 

In 2023, the IRS allows you to contribute up to $3,050 to your FSA if you’re a single person. If you are married, your spouse may also contribute the same amount through their own employer. Although they are not required to, your employer may also contribute to your personal FSA. While an FSA can cover things like medical deductibles, first aid supplies, eyeglasses, contact lenses, some dental expenses, copayments, some prescriptions drugs, and coinsurance, all FSA-eligible expenses are determined by the IRS. Unlike HSAs, FSAs are typically owned by the employer or the FSA administrator. When you leave your job, you generally lose access to your FSA. 

How Does an FSA Work? 

During your employer’s open enrollment period, you have the opportunity to sign up for an FSA. You’ll need to decide how much money you want to contribute to the account for the upcoming plan year. For example, you can designate a certain dollar amount for your FSA, up to the IRS limit. Once you’ve enrolled in the FSA, your chosen contribution amount will be deducted from your paycheck on a pre-tax basis. As you incur eligible medical expenses throughout the plan year, you can access the funds in your FSA to pay for them. Your employer will provide you with a payment card, which is similar to a debit card, or reimbursement procedures to access the funds. You are liable for paying back your account if the benefits card is unintentionally or knowingly used for ineligible costs. Any unspent funds in your FSA at the end of the plan year may be forfeited.  

Pre-Tax Contributions 

While contributions to your FSA are not tax-deductible like those of an HSA, they are deposited pre-tax, which lowers your total tax liability. For example, if your annual salary is $50,000 and you contribute $3,000 to your FSA, your gross income would then be $47,000. Any taxes owed, whether they are federal, state, or local, would be based on the gross amount. Because these funds are not taxed, you cannot claim a tax deduction for your contributions. However, FSA participants have an average 30% tax savings on the total amount they contribute to their account.  

FSAs vs. HSAs 

HSAs and FSAs are both popular tools for managing healthcare expenses, but they have some key differences. Not everyone qualifies for an HSA, but FSAs are generally available to employees who work for an employer that offers this benefit. The contribution limits for HSAs are typically higher than those for FSAs. In 2023, the maximum annual contribution for individuals with self-only HDHP coverage is $3,650, while for family coverage, it’s $7,300. Individuals aged 55 or older can make an additional $1,000 catch-up contribution. FSAs have lower contribution limits, with the maximum annual contribution limit of $2,850 per individual in 2023. This limit applies to each employee and is not based on family coverage. HSAs offer the advantage of rollover, while FSAs follow a “use it or lose it” policy, with some exceptions. Contributions to both accounts are made with pre-tax dollars, reducing your taxable income. Withdrawals for qualified medical expenses are generally tax-free for both accounts. 

If you’re thinking about getting an HSA or FSA, you should consider your specific circumstances, healthcare needs, and employer offerings to determine which option is best suited for you.  

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