Flexible Spending Accounts: Benefits, Types, and Drawbacks

Introduction to Flexible Spending Accounts

A flexible spending account (FSA) is a tax-advantaged financial account offered to employees in the United States through a cafeteria plan. This plan allows employees to set aside a portion of their pre-tax salary to pay for expenses covered under the plan. FSAs typically cover medical expenses but also address dependent care needs (Ferenczy, 2007). Because the money contributed to the plan is not subject to income tax, FSAs generate significant payroll tax savings for both employees and employers. However, any funds not used by the end of the plan year are forfeited, which can represent a loss for the employee.

Most companies offer a medical expense FSA that allows employees to set aside money for health care costs. Unlike FSA funds, funds held in a health savings account (HSA) are not lost at the end of the plan year. Employees may access their FSA funds using an FSA debit card. Within a cafeteria plan, two primary types of FSAs are typically offered: qualified medical expense accounts and dependent care expense accounts (Ferenczy, 2007). Different cafeteria plans may offer different FSA structures, particularly when the employer also offers an HSA. An employee may participate in more than one type of FSA simultaneously; however, funds may not be transferred between FSA accounts.

Types of FSAs: Medical and Dependent Care

Under a medical expense FSA, funds are used to pay for medical and dental expenses not covered by insurance. The Patient Protection Act permits employers to set a maximum yearly election amount for their employees (Garman & Forgue, 2012). Employers may also provide FSA debit cards to participating employees, enabling them to pay for eligible expenses at the point of sale — including purchases at pharmacies and qualifying grocery stores. These vendors are generally restricted from allowing the card to be used for expenses that fall outside the plan's eligible categories.

Under a dependent care FSA, an employee may use funds to cover expenses related to caring for qualifying dependents. Eligible dependents include children under the age of 13 and children who are physically or mentally incapable of self-care, regardless of age. The plan may also cover adult dependents — such as parents or grandparents — who reside with the employee (Garman & Forgue, 2012). The dependent's care expenses are claimed through the employee's federal tax return. However, this plan does not cover long-term care for dependents who live outside the employee's home, such as parents residing in nursing facilities.

Conclusion

The plan's main disadvantage is that all funds must be spent within the coverage period — that is, during the plan year. Any funds remaining after the plan year ends are generally applied toward administrative costs or retained by the employer and are not available to the employee in future years (Ferenczy, 2007). Organizations considering FSA adoption should weigh this limitation alongside the tax savings and administrative benefits the plan provides.

References

Ferenczy, I. H. (2007). 2006 — Employee benefits in mergers and acquisitions. New York, NY: Aspen Publishers.

Garman, E. T., & Forgue, R. E. (2012). Personal finance. Australia: South-Western Cengage Learning.