Guide to flexible spending accounts (FSAs)

Flexible benefits are essential for attracting and retaining employees

With the cost of traditional benefits—like group health insurance—rising each year, many small to medium-sized employers wonder how they can offer competitive benefits that attract and retain employees, even in a tight labor market.

Offering flexible benefits is an excellent way to address the wants of your employees while bolstering your benefits package. One of the most popular benefits options for empowering employees is a flexible spending account (FSA). 

In this guide, we’ll show you how FSAs can help you offer various flexible benefits your employees desire. We’ll also compare them to popular alternatives to help you find the right benefits solution for your organization.

Topics covered in this guide include:

• What is a flexible spending account?
• Who is eligible for a flexible spending account?
• Types of FSAs
• Pros of FSAs
• Cons of FSAs
• FSA rules and requirements
• FSA alternatives
• Comparing FSAs to HRAs and stipends
• Offering an FSA alongside an HRA
• FSA FAQs

What is a flexible spending account?

A flexible spending account (FSA), also called a flexible spending arrangement, is a type of spending arrangement where employees can use tax-advantaged money for various expenses. 

The most popular form of FSA is a healthcare FSA. This medical reimbursement plan allows employees to use pre-tax dollars to pay for their qualifying medical expenses. This includes healthcare expenses such as doctor visit copays, vision expenses, and prescription drugs. FSAs don’t cover health insurance premiums. Any employee of an organization or agency that offers an FSA is eligible for an FSA.

Employee contributions to FSAs are made through payroll deductions, and employers can also make contributions. Unlike a health savings account (HSA), employees forfeit the FSA funds not used by the plan year's end. Annual limits are updated by the IRS each year.

Employees may withdraw FSA funds tax-free to pay for qualified expenses. Typically with a healthcare FSA, employees must submit a claim to their employer through their FSA with proof of their medical expenses. They'll get reimbursed if the expense isn’t covered by their group health insurance plan or HSA. 

Who is eligible for a flexible spending account?

Any employee is eligible to contribute to an FSA. Only employers can establish an FSA for their employees. FSAs can be offered alongside other employee benefits as part of a cafeteria plan.

You can’t use an FSA if you have a marketplace plan. Instead, you can establish an HSA, or the employer can offer a health reimbursement arrangement (HRA). 

You can’t participate in an FSA if:

• You are a 2% or more stakeholder in an S-corporation, LLC, LLP, PC, or partnership
• You're a business owner, and your business is a sole proprietorship 

Types of FSAs

There are many types of FSAs available for employees. This includes the healthcare FSA, dependent care FSA, the adoption assistance FSA, and the limited expense healthcare FSA (also called a limited-purpose FSA). 

We’ll break down the most common types of FSAs below.

Healthcare FSA

The most common type of FSA is a health FSA, also known as a medical FSA. A healthcare FSA allows employees to use pre-tax dollars for out-of-pocket medical expenses such as doctor visit copays, prescriptions, deductibles, and other eligible medical expenses. These eligible expenses are available in IRS Publication 502.

A healthcare FSA's maximum annual contribution limit is $3,050 for 2023, up from $2,850 in 2022. Additionally, if employers allow the funds to carry over, the maximum carryover amount increased to $610 for 2023. 

Limited-purpose FSA

A limited-purpose FSA allows employees to pay for qualified vision care and dental expenses. It doesn’t cover medical expenses, as it’s designed to pair with a health savings account (HSA). Annual contribution limits are the same as healthcare FSAs.

Dependent care FSA

A dependent care FSA, or child care HSA, allows employees to pay for employment-related dependent care services on a pre-tax basis. 

The maximum annual contribution limit is $2,500 for married couples filing separately and $5,000 for 2023 for single people and married couples filing jointly. This is unchanged from 2022.

Eligible dependent care expenses can include:

• After-school programs
• Babysitting due to work
• Nanny
• Preschool
• Nursery school

A dependent care FSA doesn’t cover tuition, and it is only available for depends under the age of 13.

Adoption FSA

With an adoption FSA, employees can set aside pre-tax money for expenses incurred while adopting a child. 

The maximum contribution limit for adoption assistance FSAs is $15,950 for 2023, up from $14,890 in 2022.

Commuter FSA

A commuter FSA allows employees to pay for employment-related commuter services on a pre-tax basis. There are two separate commuter FSAs available: the transit FSA and the parking FSA.

The annual contribution limit for commuter FSAs increased to $300 in 2023 from $280 in 2022.  

Pros of FSAs

Now that we’ve introduced FSAs and how they work, let’s cover their advantages.

1. Tax savings: Employees' contributions to their FSA through payroll deductions and employer contributions are taken out on a pre-tax basis. This means the money is deducted from your employees’ pay before taxes have been withheld. As a result, your employees’ taxable income is lowered.
2. No tax on qualified reimbursements: Employees who use their FSA for qualified expenses don’t pay taxes on those reimbursements, helping them save.
3. Full balance available on day one: Your employees’ full annual contribution is available on day one. Employees can withdraw funds from the FSA with an IRS-approved debit card or request reimbursement, even if they haven’t contributed to the account yet.
4. Use it or lose it: If employees don’t use their available funds, they lose them at the end of the year. This helps organizations save money compared to other accounts, like HSAs.

Cons of FSAs

There are many disadvantages to offering an FSA compared to other types of employee benefits. We’ll cover a few of these below.

1. Contribution limits: FSAs have annual contribution limits for how much employers and employees can contribute each year
2. Limited rollover: A drawback of FSAs for employees is a limited annual rollover for unused funds. Employers can only allow up to $610 to roll over each year. However, they must eliminate grace periods if they choose to do so. 
3. Not portable: While beneficial to employers, another drawback for employees is that, unlike HSAs, funds are tied to employment. Employees who leave your organization can’t use their funds after the plan year.
4. Limited qualified expenses: Compared to other types of health benefits, a healthcare FSA has a more limited selection of qualified expenses. For example, an FSA can’t reimburse employees for their health insurance premiums. 

FSA rules and requirements

FSAs can be an extremely valuable benefit to your employees. However, there are rules and regulations you must follow to stay compliant. 

If an FSA is offered alongside a cafeteria plan, it is subject to IRS Code Section 125. However, if an FSA isn’t offered through a cafeteria plan, it is subject to Section 105 instead.

Employer contributions

If an employer decides to contribute to an employee’s healthcare FSA, the IRS allows an employer match separate from employee contribution limits. An employer can contribute up to $500 to a healthcare FSA no matter if the employee contributes. Starting at $501, employers can only match dollar-for-dollar contributions. 

Employers can also limit how much they want to contribute to an FSA. For example, suppose an employee contributes $1,000 to a healthcare FSA. In that case, an employer can decide to either match that and contribute $1,000 or cap contributions at any dollar amount they choose, such as $500.

You must include employer contributions to long-term care insurance through an FSA in an employee’s income. 

Employee contributions

Employees contribute to their FSA by electing to have money voluntarily withheld from their pay through a salary reduction agreement. Employees don’t pay federal income tax or employment taxes on their contributions. 

Your employees can choose their contribution amounts at the beginning of the plan year. Then, you can deduct the amounts periodically in accordance with the annual election. Employees can change or revoke elections only if there’s a change in employment or family status specified by the plan or during your benefit’s open enrollment. 

Distributions

Employees are reimbursed for qualifying expenses incurred during the plan year. Employees are eligible for the maximum reimbursement under your plan at any time during the plan year, regardless of how much you or your employee contributed. These distributions aren’t counted as taxable income for payroll taxes or federal taxes. 

You can’t reimburse employees for health insurance premiums, long-term care coverage, or any medical expenses covered under another plan, such as health insurance or an HRA.

Any reimbursements made for non-qualifying expenses are considered taxable income.

A third-party administrator must substantiate all FSA expenses. An FSA debit card is also a popular feature for automatically substantiating purchases.

Grace period and carryover funds

Employers can allow unused healthcare FSA funds to carry over into the following year. The IRS caps the carryover for unused funds at $610 for 2023. If employers choose not to have a carryover balance, they can set up a two-and-a-half-month grace period for employees to use their remaining FSA funds.

However, employees can’t choose to have both a grace period and a carryover balance. They must choose one or the other, or neither.

Tax reporting

Unlike HSAs, employees don’t need to report FSAs on their income tax returns to the IRS. You also don’t need to report FSAs on Form 1040. 

Non-discrimination testing

FSAs, like other employee benefits, are subject to non-discrimination testing. This allows you to show that your benefits plan complies with federal non-discrimination laws for highly-compensated employees, officers, and owners.

ERISA requirements

Since an FSA falls under ERISA, employers must file Form 5500 with the IRS to report their plan information each year. You’ll also need to offer COBRA for qualified employees.

All FSAs must have plan documents and provide employees with a summary plan description (SPD).

Alternatives to flexible spending accounts

If you’re looking for affordable and personalized employee benefits, you can also offer your employees a health reimbursement arrangement (HRA) or employee stipend. 

HRAs

An HRA allows employers to reimburse employees, tax-free, for their qualifying medical expenses. Unlike an FSA, you can reimburse employees for their individual health insurance premiums, vision care and dental expenses, and out-of-pocket medical expenses. 

You can provide an HRA as an alternative to traditional group health insurance plans, saving you money while giving your employees more freedom over their health plans. A qualified small employer HRA (QSEHRA) and individual coverage HRA (ICHRA) are excellent opinions for providing your employees with health benefits.

If you use or plan to use an FSA to supplement your group health plan, a group coverage HRA (GCHRA), also known as an integrated HRA, is designed to supplement your group health policy, such as a high deductible health plan (HDHP). 

Determining which HRA is best for your organization depends on the level of flexibility and control you want over your benefit.

Employee stipend

Instead of offering an FSA for dependent care, adoption, or commuter benefits, you can provide your workers with an employee stipend. An employee stipend is a sum of money employees can use for the expense categories you choose. For example, you can offer a monthly allowance for commuter benefits such as mass transit passes or a wellness stipend for gym memberships and mental health resources.

Employee stipends are completely customizable to your organization’s needs for any expense you can think of. While some fringe benefits, such as commuter benefits, are tax-free up to the IRS annual limit, others are taxable. 

Learn more about each HRA

Offering an FSA alongside an HRA

If you’re interested in both FSAs and HRAs for your organization, you can offer both benefits at the same time! This can be an excellent way to optimize your tax savings and flexibility. However, there are rules you’ll need to follow to ensure your benefits are compliant.

When offering an FSA and HRA:

• The same expenses can’t be reimbursed for both accounts
• Unless otherwise specified in your plan documents, your employees must use their available HRA allowance first before they can use their FSA
• You can’t offer an FSA alongside a QSEHRA
  • A QSEHRA can’t be combined with any traditional health plan. The IRS considers an FSA a group health plan.

Frequently asked questions about flexible spending accounts