In the late 1960s, as inflation and other factors increased the cost of employer-sponsored health benefits, employers began instituting annual deductibles and coinsurance on their health benefits plans, and/or excluding coverage for certain medical items that were legally allowed to be covered by IRS regulations (e.g. vision, dental, alternative medicine). Excluding these medical expenses effectively almost doubled the employee cost for these items on an after-tax basis. To respond to this dilemma, in the 1970s the IRS created Flexible Spending Accounts (FSAs) to allow employees to pay pre-tax dollars for medical expenses and dependent (child) care expenses not covered by their employer-sponsored health plan.
Under these plans, employees are able to set aside a certain amount of their taxable gross wages each year as a non-taxable FSA allowance to pay for out-of-pocket qualified health and dependent care expenses. This results in a savings to the employee, as they are allowed to avoid paying taxes on this money that is set aside for these expenses. These savings are equal to the taxes the employee would have paid on the money designated for a FSA plan each year, and can be several hundred dollars (depending on the amount set aside in a FSA).
The FSA designated dollars are then used to pay for medical expenses that aren't covered by a health plan; like co-pays, deductibles, dental and vision care, dependent daycare and thousands of other medically-related items. FSA debit cards are issued to employees and are a convenient way to access these funds.
One significant disadvantage to using an FSA is that funds not used by the end of the plan year are forfeited to the employer, known as the "use it or lose it" rule. This means the employer can keep funds that haven't used by the end of the year, so it is important to figure out how much you should be setting aside in the account each year.
If you end the plan year with FSA dollars left, the Internal Revenue Service (IRS) allows a maximum 2.5-month grace period in the new year to spend those funds (check your individual plan for specifics). For example, in 2020, since the limit on health FSA salary reduction contributions was $2,750, the carryover limit was increased to $550. The carryover limit is increased as increases are made to the FSA contribution limit.
Are Flexible Spending Accounts worth it? Yes, as long as you have somewhat predictable medical expenses each year, and/or dependent care expenses. You can expect to save around 20- 25% in taxes on every dollar you put in. As your income and contributions rise your savings increase.
How much should I put in it? If your medical expenses are regular and
reoccurring (like disposable contact lenses and prescription medication)
you should consider contributing at least that amount to your FSA
account. An easy way to help determine how much you should be
contributing would be to keep track of your medically-related and
dependent-care-related expenses each year.