Flexible Spending Accounts: Use It Or Lose It

Q: Tax Playa, what is a flexible spending account (FSA), and how does it differ from an HSA or HRA?
Sharon, Arlington VA

A: An FSA is a tax-advantaged spending account for health care.  Money goes in every week out of your paycheck, and is used to pay for your out-of-pocket health care costs (copays, deductibles, eyeglasses, etc.).  The big limitation on these accounts is that whatever you put in must be spent by the end of the year (or, in some cases, a grace period until the next March), or you lose the money...

For more on FSAs, see IRS Publication 969, HSAs and Other Tax-Favored Health Plans.

First, let's clear up what FSAs are not.

1. FSAs are not HSAs.  HSAs (or "health savings accounts") are tax-advantaged savings accounts connected to a high-deductible health plan.  Whatever is not spent rolls over and grows like an IRA.
2. FSAs are not MSAs.  MSAs (or "medical savings accounts") are the ancestor of the HSA, and work in much the same way.
3. FSAs are not HRAs.  HRAs (or "health reimbursement arrangements") grow and build over the years, but are tax-advantaged accounts of the employer, and revert to the employer after you leave that job.

An FSA is established as a payroll deduction by your employer.  They are sometimes known as "Section 125 plans" or "cafeteria plans."  You decide how much money you want to deduct from each paycheck to go into the accounts.  The deduction is both pre-income tax and pre-FICA, so many people can save about $0.40 on the $1.00.

You can only change how much you want to go into the account over the course of the year if there is a change in your family or employment status.  There is no limit on the amount that you can contribute, but you must use up all of the money by the end of the year, or you lose it (meaning it reverts to the employer).  In some cases, your FSA plan will allow for a grace period of up to ten weeks after the end of the plan year (in the case of a calendar year this would be about March 15th).

You can use the money in your FSA for most out-of-pocket medical expenses (that is, those not already paid for by insurance, your employer, or another tax-advantaged method).  These normally include:

• co-payments for prescription medicines and office visits
• deductibles on your health care plan
• eyeglasses

For a complete list of allowed medical expenses, see IRS Publication 502, Medical and Dental Expenses.

You are allowed to coordinate an FSA with an HSA or HRA, but there are limitations:

1. HSA.  You are allowed to roll over unused balances from an FSA into an HSA if you do so by the end of the grace period or the plan year (depending on your plan).  If you have an FSA during the grace period, this does not disqualify you for HSA contributions.  You can maintain an FSA and an HSA at the same time if you only use the FSA for "other coverage" (accidents, disability, dental care, vision care, long-term care, or HDHP payments made after the deductible).
2. HRA.  You are allowed to use an FSA in conjunction with an HRA.  No double benefit is allowed (obviously) and the HRA plan has wide latitude to determine which account pays for which benefits.  An FSA can be used to pay for "other coverage" listed in (1).  An employer must be careful that an HRA not be the equivalent of an FSA.  As a side note, a discontinued HRA can be used in conjunction with an HSA to pay for "other coverage" or retirement benefits.

Comments

[John D. McCalpin, Ph.D.]

The interaction of medical FSA's with the itemization of medical deductions appears to have some subtleties that are not clearly explained in any IRS publications that I have found.

Consider the four combinations of using or not using FSA's and itemization of medical expenses.
(1) No FSA, no itemization: no tax deduction for medical expenses.
(2) With FSA, no itemization: up to ~$5000 (depending on employer) of medical expenses are (effectively) deducted from income.
(3) No FSA, with itemization: only medical expenses in excess of 7.5% of AGI can be deducted from income.
(4) With FSA, with itemization: appears almost identical to case without FSA, except AGI (used for computing 7.5% minimum) is reduced by FSA contribution.

For this last case, if expenses reimbursed by FSA cannot be declared as medical expenses (as clearly stated in Pub 969 page 14 and Pub 502, page 15), then the FSA's tax benefit of (effectively) deducting the *first* $5000 in medical expenses disappears, and is replaced by the standard "expenses - 7.5% of AGI".

This interpretation reduces the benefit of the FSA to a reduction in the AGI used to calculate the minimum medical expense level. For an income of $100,000 and an FSA contribution of $5,000, this reduces the "7.5% of AGI" from $7,500 to $7,125. For the 25% marginal tax bracket, this $375 increase in the amount of the medical expenses that can be deducted is worth a whopping $93.75 --- less than 1/10th of the value that the FSA would provide without itemization of medical expenses (25% of $5,000 = $1,250). The $93.75 tax reduction must also be weighed against the forfeiture of any unused balance in the FSA account (averaging $136 per employee in a recent survey).

Although one certainly does not expect to be able to deduct medical expenses more than once, it would be nice if the combination of the FSA with itemization did not destroy the value of the FSA. One would like to be able to deduct *both* the first $5,000 in medical expenses *and* the amount in excess of 7.5% of AGI, but I can't see any way to interpret the IRS publications in a way that would allow this benefit.

[Trevor Eyster]

I've been searching all over the web for an answer to this question:

As a 1099'er (Independent Contractor), am I eligible to participate in a Flexible Spending Account (FSA)? And if so, which administrators deal directly with individuals?

[Sara]

My company's open enrollment period for my health flexible spending account ended on November 15. I would like to increase my contribution for 2008 due to medical changes that have occurred since the deadline. I was told that a change to my election is not possible at this time because the open enrollment period has passed. Is this accurate even though we have not yet reached 2008? If so, are there any hoops that I can jump through that would allow me to change the election?