What is a Health Flexible Spending Account?
A health flexible spending arrangement (FSA) is an account that is funded by voluntary salary deductions agreed upon with your employer. When you sign up for a health care flexible spending account, you are agreeing to set aside a certain amount of your salary or wages to pay your medical and dental expenses that are not covered by insurance. This total amount for the year is then deducted in equal portions from each one of your paychecks. The money goes into an account from which you can make withdrawals to pay for your out-of-pocket medical and dental expenses.
What Is the Tax Advantage?
The tax advantage is that the money that is deducted from your paycheck and that goes into a flexible spending account reduces your income subject to tax. The amount you contribute to your flexible spending account is not subject to employment taxes or federal income tax. You are using pre-tax earnings to pay for medical expenses, so the amount you can potentially save is your effective tax rate times the amount you contribute to the flexible spending account and use to pay medical expenses. When you withdraw funds from your FSA to pay qualified medical expenses, the withdrawals are also tax-free.
Your employer may also make contributions to your flexible spending account, as part of its benefits program. You are not subject to income tax on the contributions your employer makes to your FSA, except when your employer makes contributions to provide for coverage for long-term heath care insurance. In this latter case, you would be subject to tax on the employer contributions.
How Much Can I Contribute?
Flexible spending accounts are established by the employer, and can be offered as part of a cafeteria plan of benefits. The Internal Revenue Service (IRS) rules specify a maximum of $5,000 that an employee can elect to contribute to an FSA each year. But the employer plan can specify a maximum amount or a maximum percentage of an employee’s compensation that can be contributed to the FSA that may be less than $5,000.
What Types of Expenses Can I Pay From An FSA?
Funds from an FSA can be used to pay what the IRS refers to as “qualified medical expenses”. Qualified medical expenses are normally those that could be taken as an itemized deduction on Schedule A of Form 1040. But there is an exception for over-the-counter drugs, as noted below. If you use funds from your FSA to pay for medical expenses, the distributions from the FSA are tax-free, and therefore you cannot claim these same expenses as an itemized deduction.
Some of the types of expenses commonly paid with flexible spending accounts include co-payments and insurance deductibles, orthodontics and other dental care, eyeglasses and contact lenses, hearing aids and batteries, flu shots, laser eye surgery, chiropractor fees, fertility treatment or birth control, and alternative medical treatments such as acupuncture.
You cannot use funds from the FSA to pay for health insurance premiums, long-term care coverage or expenses, or expenses that are covered under another health insurance plan.
You can only take distributions from your FSA to reimburse you for qualified medical expenses incurred during the coverage period (the year). When you take a distribution, you will need to provide the FSA plan administrator with receipts or substantiation of the medical expenses for which you are requesting a distribution. These expenses must not have been paid or reimbursed under any other health coverage you have. And, distributions from the FSA are based on actual disbursements – the FSA cannot advance reimbursements for expected future expenses.
Over-the Counter Drugs
In September, 2003, over-the counter drugs were added to the medical expenses that can be paid from a health care flexible spending account. This is significant because normally health insurance plans do not cover most over-the-counter drugs. The U.S. Treasury Department and the Internal Revenue Service issued guidelines specifying that reimbursements for non-prescription drugs by an employer health care plan can be paid from an FSA and are therefore excluded from taxable income. The expense must be properly substantiated by the employee. And, you should check to be sure your employer plan includes over-the-counter drugs, because the IRS ruling does not make it mandatory.
The exclusion from income of medical expenses paid through a flexible spending account is broader than the itemized deduction for medical expenses, which does not include over-the-counter medications. So while reimbursement of the cost of non-prescription drugs can be excluded from income by paying for them through a flexible savings account, an itemized medical expense deduction could not be taken for these drugs.
One of the main drawbacks of a flexible spending account is the “use it or lose it” aspect. You cannot carry over the balance in your account from one year to the next, and you cannot get a refund for unused amounts. At the end of the year, any remaining balance in your account is forfeited and goes to your employer to cover future administrative expenses. So, you should try to estimate the amount you will need to contribute to an FSA to cover your medical expenses for the year that will not be covered by health insurance.
The amount that you want to have deducted from your salary and contributed to the FSA is determined at the beginning of each plan year. You can only change the amount, or revoke your choice, if there is a change in your employment or family status, that is specified in the plan.
Another drawback is that you have to keep receipts and file forms in order to withdraw funds from your flexible spending account. Normally you would have to send the receipt to the flexible spending plan administrator. But many companies are offering debit cards as an alternative. Instead of paying yourself and filing a claim for reimbursement, for example when you visit a doctor and have to make the co-payment, you use the debit card and the expense is charged directly against your flexible spending account.