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Your Guide To Navigating Employee Benefits: Flexible Spending Accounts

July 18th, 2024 by Blake Pinyan

Flexible spending accounts (FSAs) are a common benefit offered in employee packages. Understanding FSAs is crucial for making informed decisions about whether they fit your health and financial goals.

In this article, we’ll do a deep dive into the following:

  • Types of spending accounts and their associated purpose
  • Their tax features
  • Similarities and differences to Health Savings Accounts
  • Considerations

Types of flexible spending accounts

Health Care FSA

A Health Care FSA allows employees to contribute pre-tax dollars to an account used for qualified medical, dental, and vision expenses. This IRS publication outlines what qualifies as reimbursable expenses.

What can you use a Health Care FSA for?

  • Co-pays, deductibles, and co-insurance costs
  • Prescriptions
  • Medical equipment (crutches, etc.) and supplies (bandages, etc.)
  • Diagnostic devices (blood sugar kits, etc.)
  • Therapeutic services (acupuncture, etc.)
  • Dental and vision care

Key Facts:

  • Reimbursement Based: You are typically reimbursed for out-of-pocket health expenses after submitting receipts.
  • Annual Contribution Limit: For tax year 2024, the maximum contribution is $3,200, set by the IRS and subject to change annually.
  • Individual Accounts: FSA contribution limits are per person, not family. However, both spouses can have separate FSAs through their employers, allowing a combined total contribution of $6,400 for a family. For this case, expenses cannot be reimbursed through both spouses’ FSAs.

Funding Your FSA:

  • Salary Deferral: Contributions are made pre-tax through salary deductions. You choose a fixed amount or percentage of your paycheck to be directed to your FSA, up to the annual limit.
  • Election Period: You typically only have one chance per year to choose your contribution amount, during your company’s open enrollment period. Changing your contribution amount outside of open enrollment usually requires a qualifying event such as marriage, a new dependent, loss of coverage, loss of a dependent, or a change in your spouse’s employment.

Limited Purpose FSA

Limited Purpose FSAs (LPFSAs) are a specialized type of Flexible Spending Account offered by some employers. Unlike traditional Health Care FSAs, LPFSAs have a narrower focus, primarily covering dental and vision expenses. In some cases, they may also allow reimbursement for qualified post-deductible medical expenses.

Here’s what sets LPFSAs apart:

  • Limited Coverage: LPFSAs focus on dental and vision costs, with the potential to cover some post-deductible medical expenses as well.
  • Combined with HSAs: Health Care FSAs, you can have both an LPFSA and a Health Savings Account (HSA) for a powerful tax savings strategy. Expenses cannot be reimbursed through both your LPFSA and HSA for the same service.

Key Facts:

  • Matching Limits: Similar to Health Care FSAs, the annual contribution limit for LPFSAs is $3,200 in 2024, set by the IRS and subject to change annually. Spouses with separate LPFSAs can each contribute the maximum, allowing a combined household contribution of $6,400. These contributions are also made through pre-tax salary deductions.
  • Distribution: Funds are typically accessed via debit card or reimbursement.
  • Availability: LPFSAs are less common than traditional Health Care FSAs as not all employers offer them. They are often paired with high-deductible health plans to help manage out-of-pocket costs.

Examples of Eligible Expenses:

  • Dental: Co-pays, deductibles, office visits, X-rays, fillings, extractions, orthodontia, dentures, teeth grinding treatments and guards.
  • Vision: Co-pays, deductibles, office visits, eye exams, glasses/contacts and cleaning supplies, guide dogs, some eye surgeries.
  • Potential Medical Expenses: May cover qualified post-deductible medical costs, depending on the plan details.

Dependent Care FSA

A Dependent Care FSA helps working parents offset the cost of childcare. It allows you to set aside pre-tax dollars to pay for qualified care expenses incurred while you (and your spouse, if filing jointly) are working or actively seeking work. The IRS has a complete list of eligible and non-eligible expenses, but here are some examples.

Eligible Expenses:

  • Nanny/babysitter
  • Daycare/physical care
  • Preschool
  • After/before school programs
  • Summer camps (non-overnight)
  • Nursery schools
  • Household services for dependents (related to childcare)
  • Caregiver transportation
  • Fees/care deposits

Non-Qualifying Expenses:

  • Babysitting by siblings or children under 19
  • Private education/tutoring
  • Date night babysitting
  • Overnight camps
  • Music/sports lessons
  • Long-term care for elderly parents

Eligibility:

  • Dependent must be under 13 (or a disabled adult)
  • Dependent must live with you for more than 6 months of the year and be your financial dependent
  • For divorced parents, the parent with whom the child spends the most time qualifies

Contribution Limits (2024):

  • Individual filers: Up to $2,500
  • Married filers filing jointly: Up to $5,000

Key Facts:

  • Salary Deferral: Contributions are made pre-tax through salary deductions throughout the year.
  • Distribution: You can typically access funds via reimbursement, debit card, or direct payment to the care provider (depending on your FSA administrator).
  • Election Period: Changes to contributions can only be made during open enrollment unless a qualifying event occurs, such as:
    • Change in the number of dependents
    • Change in marital status
    • Significant change in care expenses (with proof)
    • Change in employment status
    • Change in residence
    • Dependent’s eligibility changes (e.g., child turning 14)
  • Combining with HSA: Similar to Limited Purpose FSAs, you can have both a Dependent Care FSA and an HSA. This allows you to maximize tax savings on childcare and other healthcare expenses.

Tax features

FSAs offer a tax-advantaged way to save for qualified healthcare and dependent care expenses.

Benefits of Pre-Tax Contributions:

  • Reduced Taxable Income: Similar to pre-tax 401(k) contributions, FSA contributions lower your W-2 box 1 wages, resulting in tax savings.
  • Tax Savings Increase with Bracket: Higher tax brackets see a greater tax benefit from pre-tax contributions. For example, at a 32% marginal tax rate, a $3,200 contribution in 2024 saves $1,024 compared to a 22% rate savings of $704. Combining an FSA with an HSA can maximize tax savings for both healthcare and dependent care.

Important Considerations:

  • No Double Dipping: Expenses reimbursed by an FSA cannot be claimed as itemized deductions on your tax return (Schedule A). Using your FSA over itemizing your medical expenses typically offers a greater tax advantage since most people take the standard deduction and there’s a 7.5% of income hurdle to cross for deducting medical expenses.
  • Distributions: Money you take out of an FSA needs to be used for qualified medical expenses to avoid taxation.

Dependent Care FSAs and the Child and Dependent Care Tax Credit (CDCTC):

  • CDCTC: A tax credit worth 20% – 35% of qualifying dependent care expenses (up to $3,000 for one dependent or $6,000 for two or more). Credits directly reduce your tax liability dollar-for-dollar, whereas deductions only reduce your taxable income at your marginal tax rate (10% – 37%). The CDCTC is a tax credit, and the FSA is a deduction.
  • No Double Dipping: You can’t use an FSA and claim the CDCTC on the same care expenses, but you can reap the tax benefits of both if your childcare costs are high enough.
    • Ex: A family with a 32% tax rate, two kids, and $11,000 in childcare costs could contribute $5,000 to their FSA, saving $1,600, and claim a $1,200 CDCTC for the remaining $6,000 of care costs, resulting in total tax savings of $2,800.
  • When care costs are lower: If care costs are at a level below the maximum FSA and CDCTC tax benefit, you’ll have to decide which tax benefit is of greatest value. For lower tax brackets, the CDCTC might be a better option since the credit percentage is higher for lower income levels and the deduction is less significant. Alternatively, the credit quickly declines from 35% to 20% when income approaches only $43,000. This element as well as the maximum amount of expenses that can be considered for the credit leads to higher tax bracket individuals finding more value in the deduction. Here are a few examples.
    • Lower Tax Bracket Ex: A family with a 12% tax rate, two kids, and $5,000 in childcare costs might find that CDCTC is a better choice as the credit would be at least $1,000 whereas the FSA would only save $600.
    • Higher Tax Bracket Ex: A family with a 32% tax rate, two kids, and $5,000 in childcare costs might find that FSA is a better choice as the deduction would be $1,600 whereas the CDCTC would only save $1,000.

Similarities and differences to Health Savings Accounts (HSAs)

Similarities

  • Account Purpose: Both accounts allow you to contribute money to cover qualified medical, dental, and vision expenses.
  • Tax-Advantaged Transactions: Contributions to both FSAs and HSAs are made with pre-tax dollars, lowering your taxable income. Additionally, qualified withdrawals from both accounts are tax-free.
  • Employer Contributions: Some employers may contribute to both FSAs and HSAs. Check your specific benefits plan for details on employer contributions.

Differences

  • High-Deductible Health Plan (HDHP) Requirement: Contributing to an HSA requires enrollment in an HDHP, which has higher annual deductibles and out-of-pocket maximums compared to traditional plans. In 2024, individual HDHPs require a minimum deductible of $1,600, while family plans require $3,200. HDHPs also set maximum out-of-pocket limits, which are $8,050 for individuals and $16,100 for families in 2024 (subject to annual adjustments). FSAs, on the other hand, can be used with any type of health insurance plan.
  • Contribution Limits and Timing: FSA contribution limits vary by account type (Health Care, Limited Purpose, Dependent Care) and are set annually by the IRS. Contributions for Health and Limited Purpose FSAs are also typically made as a lump sum at the beginning of the year. HSAs generally have higher contribution limits and allow contributions throughout the year via payroll deductions. Additionally, HSAs offer a $1,000 catch-up contribution for those age 55 or older, which FSAs do not.
  • Investment Ability: Contributed funds in an FSA are for current healthcare expenses and cannot be invested. In contrast, HSAs allow you to invest the money for future medical needs, growing your savings over time.
  • Use-It-or-Lose-It: Unused FSA funds are typically forfeited at the end of the year (with some exceptions for grace periods or limited carryover amounts). This can be a drawback if you underestimate your healthcare expenses. HSAs, on the other hand, function more like a savings account, allowing unused funds to roll over year-to-year. The FSA rollover limit for 2024 is $640 according to the IRS.

Considerations

Here are some key considerations when deciding whether an FSA is right for you and managing your FSA effectively.

Choosing Between HSAs and FSAs:

As you now know, you cannot contribute to both an HSA and a Health Care FSA. If your employer offers both, you’ll need to choose one. We’ve covered the similarities and differences between the two, but the primary factor is your health insurance plan.

  • High-Deductible Health Plan (HDHP): If you choose an HDHP with a higher deductible and lower monthly premium, an HSA is generally considered the better option. However, HDHPs carry higher out-of-pocket risks.
  • Low-Deductible Health Plan (LDHP): If you prefer an LDHP with a lower deductible and higher monthly premium, FSAs offer tax benefits on contributions and tax-free withdrawals when used for qualified medical expenses.

Funding Considerations:

FSAs have a “use-it-or-lose-it” feature, which can be challenging because medical expenses are often unpredictable.

  • Contribution Strategy: As best as you can, we generally recommend contributing to an FSA to the extent of your anticipated medical expenses. Maxing out an FSA may not be wise if you’re young and healthy, and don’t expect any major medical expenses. You’d still get the tax benefit, but risk losing unused funds especially if your employer doesn’t offer any rollover to the next plan year. Predicting dependent care costs is often easier than general healthcare costs. However, it’s still important to be mindful of your contribution amount since there’s no rollover options for Dependent Care FSAs.

Leaving Your Employer:

  • Health Care and Limited Purpose FSAs: These accounts are typically front-loaded by your employer at the beginning of the year, with the cost gradually deducted from your paychecks. If you’ve used all your funds before leaving mid-year, you usually don’t need to repay anything.
  • Unused Funds and COBRA: If you leave mid-year with unused funds, enrolling in COBRA to continue your plan can be expensive. Choosing a new plan or forgoing COBRA typically results in losing unused FSA funds. If you plan to leave your employer, try to spend down your FSA funds beforehand.
  • Dependent Care FSAs: Unused funds in a Dependent Care FSA are typically forfeited upon leaving your employer, which makes it wise to use up any remaining funds before your last day of employment.

Conclusion

FSAs can be valuable tools within an employee benefits package. They allow you to contribute pre-tax dollars to cover qualified medical and dependent care expenses, reducing your taxable income and potentially saving you money. However, it’s crucial to understand the key differences between FSAs and HSAs, especially the “use-it-or-lose-it” nature of FSAs.

At Anchor Bay, we help our clients determine if FSAs align with their overall financial plan. Because individual circumstances vary, professional guidance can be essential in making informed decisions about FSAs and other benefits options.

Remember, being intentional with your choices is key when navigating your employee benefits. Consider all the options available and their potential impact on your financial well-being.