You may have heard about this thing called a Flexible Spending Arrangement (FSA). You’ve heard it can somehow save you money on taxes, but don’t understand how it works or if it makes sense for your situation.
Worry no more! This article will get you up to speed on what I consider to be the most important points in regards to FSAs. Below is a quick outline, so if you want to skip around to a particular section, you can.
- Why should you care about how FSAs work?
- Who is eligible for an FSA?
- What are considered qualified medical expenses?
- How does using an FSA work logistically?
- How do you coordinate FSAs with other medical tax benefits?
- What are some best practices for using FSAs?
- Where can you find more in-depth information?
A quick, important note.
***This article talks specifically about Health FSAs, which can be used for “qualified medical expenses” (more on what those are later). There is another type of FSA called a Dependent Care Flexible Spending Arrangement that can be used to save taxes on “child and dependent care expenses.” We are not talking about those in this article. For more information on those, you can refer to IRS Publication 503, Child and Dependent Care Expenses.***
Let’s get to it.
Why should you care about how FSAs work?
The short answer is FSAs can save you money on taxes.
According to IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans, “A health Flexible Spending Arrangement (FSA) allows employees to be reimbursed for medical expenses. FSAs are usually funded through voluntary salary reduction agreements with your employer. No employment or federal income taxes are deducted from your contribution.”
The tax savings of FSAs are even better than other tax breaks available for medical expenses, such as itemizing your deductions. Below are some reasons why this tax break is so great.
Pre-FICA Taxes: You can save money on your federal taxes by contributing to an FSA. Some states also exempt FSA contributions, but not all. The real win for FSA, though, is that you can also save money on FICA (Social Security and Medicare) taxes. Even if you itemize your deductions, you still pay FICA taxes, so FSA contributions offer greater tax savings. For most people, the FICA tax savings will add up to 7.65% of your FSA contributions. Remember, that’s in addition to the income tax savings!
Note that if your earnings are over the Social Security Contribution And Benefit Base, you will likely not save the 6.2% Social Security taxes, and will only save on Medicare taxes. For 2019, the Contribution and Benefit Base is $132,900.
No Hurdle Rate: If you itemize your medical expenses, you only get to deduct the medical expenses that are greater than 10% of your Adjusted Gross Income (AGI). So if your AGI was $100,000 and you had $13,000 in qualified medical expenses, you would only get to deduct $3,000 ($13,000 – ($100,000 x 10%) = $3,000). There is no hurdle rate for your FSA contributions, so you start getting a tax benefit from the 1st dollar you contribute.
Excludable from Gross Income: Some tax deductions are called “below the line” deductions. This means that you still get the tax deduction, but they don’t help lower things like your AGI. Since FSA contributions don’t show up in your gross income, they are never counted towards your AGI or other line items on your tax return, which means they can help you avoid income phaseouts like rental real estate losses or IRA contributions.
No Reporting Requirements: According to Publication 969, page 16, “unlike HSAs or Archer MSAs, which must be reported on Form 1040 or Form 1040NR, there are no reporting requirements for FSAs on your income tax return.” No reporting requirements means your life is easier come tax time, which is something we can all appreciate.
Let’s look at an example to see just how valuable FSA contributions are. Let’s say you live in CA and have the following marginal tax rates:
- Federal Income Tax: 24%
- State Income Tax: 9.3%
- FICA Tax: 7.65%
- Total: 40.95%
If you contribute the maximum amount to your FSA ($2,700/year for 2019), that would save you $1,105 in taxes! Of course, not everybody should max out their FSA (more on that below), but that is a lot of potential tax savings.
Who is eligible for an FSA?
So FSAs sound great, right? They are. But it’s pointless if you aren’t eligible for one. So step #1 is to make sure you can, in fact, have an FSA. Below are the most common rules to determine your eligibility.
Type of Employment: Publication 969, page 16 states that “Health FSAs are employer-established benefit plans.” This means that, in order to open an FSA, your employer must offer it as an employee benefit. This is similar to a 401(k). The publication goes on to explicitly state “self-employed persons aren’t eligible for FSAs.” Sorry entrepreneurs.
Type of Health Insurance: Unlike HSAs, which require you to have a high deductible health plan (HDHP), the type of health insurance plan you have doesn’t matter for FSA purposes. You can have the most expensive plan your employer offers and still contribute to an FSA.
Also Have an HSA: Publication 969, page 4 states that “an employee covered by an HDHP and a health FSA or an HRA that pays or reimburses qualified medical expenses generally can’t make contributions to an HSA.” This means that you usually must choose between an HSA and an FSA (more on how to decide later in this article, but the key point is that you usually can’t have both).
Notably either you or your spouse having an FSA invalidates you from contributing to an HSA. So, even if you and your spouse are on separate insurance plans, if your spouse has an FSA, it means neither of you can contribute to an HSA. Refer to IRS Rev. Rul. 2004-45 for more detail on this.
There is an exception that allows you to have what’s called a “limited purpose FSA” and still contribute to an HSA. The FSAs can only reimburse you for dental and vision expenses, so they are much more limited in scope, hence the name.
Highly Compensated Employee: Lastly, there are no income phaseouts with regards to contributing to an FSA, which is great. However, “certain limitations may apply if you are a highly compensated participant or a key employee.”
That gets pretty complicated and is beyond the scope of this article, but shouldn’t apply to most of you reading this. That said, it’s good to know, and if you think this may apply to you, you should talk with your HR department and/or benefits provider.
What are considered qualified medical expenses?
Again, according to Publication 969, page 16, “generally, distributions from a health FSA must be paid only to reimburse you for qualified medical expenses you incurred during the period of coverage.”
In order to be a qualified medical expense, the expense must be incurred by:
- Your spouse
- Your dependent(s)
- Your non-dependent child, but who is under age 27
But what exactly is a qualified medical expense? Publication 969, page 16 says “qualified medical expenses are those specified in the plan that generally would qualify for the medical and dental expenses deduction. These are explained in Pub. 502.”
IRS Publication 502, Medical and Dental Expenses, page 2 goes onto explain further that “medical expenses are the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and for the purpose of affecting any part or function of the body.” Many of these expenses are listed in Publication 502. The publication also lists expenses that are explicitly not qualified.
However, there are a couple notable differences. Publication 969, page 17 states that you can’t receive distributions from your FSA for health insurance premiums, or amounts paid for long-term care coverage or expenses.
How does using an FSA logistically work?
Let’s now walk through some of the logistics of an FSA, so you can understand how they work in practice. We’ll walk through the following 3 areas:
- End of Year
Deposits: For 2019, you can contribute up to $2,700 to your FSA. That doesn’t mean that you must contribute that amount though. You can contribute anywhere from $0 up to $2,700.
According to Publication 969, “at the beginning of the plan year, you must designate how
much you want to contribute. Then, your employer will deduct amounts periodically (generally, every payday) in accordance with your annual election.” So make sure you don’t miss your open enrollment period, which is your time to choose your FSA contribution amount.
Publication 969 also states “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.” So make sure that you are very certain with the amount you decide to contribute, since you likely won’t be able to change it.
Withdrawals: Publication 969 states “Generally, distributions from a health FSA must be paid only to reimburse you for qualified medical expenses you incurred during the period of coverage.” Usually this means you pay for the expense out of pocket, and then get reimbursed. However, you may be able to have your healthcare provider bill your FSA directly.
Publication 969 also states “you must provide the health FSA with a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expense.” The documentation required can be a pain, but the tax savings can be worth it!
Hopefully your FSA will provide you with a debit/credit card. This can make reporting much easier. Publication 969 states “if the use of these cards meets certain substantiation methods, you may not have to provide additional information to the health FSA.” This usually means the vendor has an Inventory Information Approval System (IIAS). Not all vendors have this though, so you may still need to provide documentation, even if you have a debit/credit card.
Publication 969 states “you must be able to receive the maximum amount of reimbursement (the amount you have elected to contribute for the year) at any time during the coverage period, regardless of the amount you have actually contributed.” This is very beneficial since you have access to funds even before you’ve contributed them!
End of Year: Publication 969 states “FSAs are generally ‘use-it-or-lose-it’ plans. This means that amounts in the account at the end of the plan year generally can’t be carried over to the next year.” This is why it is so important to be careful when choosing how much to contribute to your FSA.
Publication 969 also states “however, the plan can provide for either a grace period or a carryover… A plan may allow either the grace period or a carryover, but it may not allow both.” These are exceptions to the ‘use-it-or-lose-it’ nature of FSAs. These 2 exceptions are completely optional though, so your plan does not have to allow either one of these.
The grace period can be up to 2.5 months, and the carryover amount may be up to $500. Make sure to check your specific plan to see if it has 1 of these exceptions.
How do you coordinate FSAs with other medical tax benefits?
The many types of tax benefits related to medical costs can make it difficult to know how they interact with one another. The general rule-of-thumb is that you can’t “double dip.” By this, I mean you generally can’t receive a tax benefit for a medical expense if you’ve already received a different tax benefit for that same expense, or were already reimbursed for it. Below are some examples.
Itemized Deductions: The Instructions for Schedule A state “you can’t deduct amounts that have already been excluded from your income; so, don’t include on line 1 insurance premiums paid by an employer-sponsored health insurance plan (cafeteria plan) unless the premiums are included in box 1 of your Form(s) W-2. Also, don’t include any other medical and dental expenses paid by the plan unless the amount paid is included in box 1 of your Form(s) W-2.”
Publication 969, page 17 also states “you can’t deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are equal to the reimbursement you receive from the FSA.”
So if you use FSA funds for a medical expense, you cannot also itemize that expense, and vice versa.
Other Health Plans: Publication 969 also states “you can’t receive distributions from your FSA for… amounts that are covered under another health plan.” So if a medical expense is paid for by your health insurance plan, a Health Reimbursement Account (HRA), or other health plan, you cannot also use your FSA funds for that same expense.
Health Savings Accounts (HSAs): As stated earlier, you generally cannot contribute to an HSA while having an FSA (unless it’s a limited purpose FSA). You also cannot use the same medical expense to qualify for tax-free withdrawals from both accounts. Remember, no double dipping!
What are some best practices for using FSAs?
Don’t forget common expenses: Some websites/stores help by making it easier to identify which purchases are FSA eligible and which are not. For example, the Amazon FSA Store, Walgreens FSA Shop, and FSAstore.com are great for medical shopping. You can purchase things like sunscreen, first-aid kits and pregnancy tests.
Contribute the right amount: You usually only get one chance during the year to choose how much to contribute to your FSA, and usually that money is lost at the end of the year. Those rules make it incredibly important to choose an appropriate contribution amount. Try to budget out what your medical expenses will be as best you can, and don’t forget to revisit your contribution amount during each open enrollment period.
HSA or FSA: Many employees can choose both an HSA or an FSA as part of their employee benefits. But remember, you usually can’t contribute to both at the same time. Here are some points to help you make your decision.
- Pros for HSAs
- HSAs allow for larger contribution amounts ($3,500 for self-only coverage in 2019) vs. only $2,700 for FSAs.
- HSAs allow unused amounts to be rolled over, while FSAs generally do not.
- HSAs allow you to invest your money while FSAs always stay in cash.
- HSAs can be opened at any company you choose, while FSAs must be through the company your employer chooses.
- HSAs allow you to adjust your contribution amounts freely throughout the year, while FSAs only allow you to adjust contributions once per year (or when you have a “change in your employment or family status that is specified by the plan”).
- Pros for FSAs
- FSAs can work with any health insurance plan, while HSAs require you to have a high-deductible health plan (HDHP).
- FSAs usually don’t require any Federal tax reporting, but HSAs do.
Overall, I think HSAs clearly win this battle. But remember, you must have an HDHP to use an HSA. So if an HDHP doesn’t make sense in the 1st place (which is a whole different article, but usually means you are very healthy and don’t go to the doctor often), then you may consider using an FSA instead.
Know your plan: Each FSA will follow the same general rules, but plans can and do vary. Some have debit/credit cards, some have carryovers or grace periods, etc. Make sure to read up on your plan and ask questions ahead of time so you don’t get surprised after it’s too late.
Where can you find more in-depth information?
This article covers a lot of information, but it’s near-impossible to write about everything related to FSAs. If you really want to dive deeper, below are some resources for you.
- Your employer: Each FSA can have its own nuances. If you want information specific to your plan, you should consult your specific plan document, HR team, and/or benefits provider.
- IRS Publication 969: This document is titled “Health Savings Accounts and Other Tax-Favored Health Plans” and discusses FSAs in more detail. As the name implies, it also discusses other common types of tax-favored health plans.
- IRS Publication 502: This document is titled “Medical and Dental Expenses” and goes into more detail on what expenses generally are/aren’t eligible.
- Instructions for Schedule A: This document provides instructions for itemizing your deductions, and can help if you are itemizing medical expenses.
Wrapping it all up
Health FSAs can help you save money on taxes for medical expenses you would incur anyways. FSAs have pretty strict rules, so it’s important you understand how they work in order to maximize their value.
This article should cover a lot of the more common FSA questions I’ve encountered, and give you a solid base to understand if an FSA is right for you, and how to benefit from one.