Personal Finance

What Is a Flexible Spending Account?

Health care spending encompasses all types of out-of-pocket costs—and they can add up quickly. The average household spent $4,968 on health care in 2018, according to the U.S. Bureau of Labor Statistics. This spending goes beyond just health insurance premiums, and covers everything from medical services to drugs to medical supplies.

For those who have kids, child care costs are another huge expense. A typical working family that pays for child care for children under 5 years old spends 10% of their average income to have their children cared for, according to the Center for American Progress.

A flexible spending account (FSA) is one way to potentially reduce your health care and dependent care spending. Funded with pretax earnings, an FSA is a special type of account that can be used to pay for a wide variety of qualified costs. One of the biggest advantages of an FSA is that you won't pay taxes when you use these funds as intended. FSAs do come with certain restrictions, however. Here's a comprehensive overview of how they work to help you determine if an FSA is right for you.

How Does a Flexible Spending Account (FSA) Work?

The only way to enroll in an FSA is through your employer. Not all employers offer this benefit, but if yours does, it could serve as a tax-friendly way to cover certain health care and dependent care expenses.

Once you enroll, you'll choose how much you want to contribute to the account each month or pay period, and that amount will be automatically deducted as a pretax salary reduction. When you need to use the funds, you won't pay taxes on withdrawals as long as they are used to pay for qualified expenses. What constitutes a qualified expense? The rules vary depending on the type of FSA you have. Employers typically offer one or more of the following:

  • Health FSA: You can use these funds to pay for a wide variety of qualified medical expenses not covered by your health plan. These can include insurance deductibles, medical devices, certain prescriptions and more. Contributions are capped at $2,750 per year, though your employer may have a lower limit, so be sure to check with your benefits coordinator.
  • Limited-purpose FSA: These FSAs are designed specifically for medical expenses related to vision and dental care. Contribution limits are also set at $2,750.
  • Dependent care FSA: Parents and other caregivers can use funds in this type of account to cover child care or elder day care bills. The contribution limit is $5,000 for individuals or married couples filing jointly; $2,500 for a married person filing separately.

Once you've set your FSA contribution amount, you generally can't change it unless you experience a qualifying life event (such as the birth of a child or a change in marital status). Otherwise, you'll have to wait for the following open enrollment period. New federal guidelines are providing more FSA flexibility in light of the coronavirus pandemic, however: During 2021, you can modify your contribution rate whenever you like.

You may have two options when using FSA funds. Many plans provide an FSA debit card to pay for expenses (though it's still wise to hang on to your receipts in case your plan administrator needs to substantiate a charge). Alternatively, you may need to cover these costs upfront then submit a claim to get reimbursed afterwards.

Pros and Cons of Using an FSA

There are benefits and drawbacks to using an FSA. Here are some important things to consider when deciding if this type of account makes sense for you.

Pros

  • It makes health care and child care more affordable. You fund an FSA with pretax dollars and aren't taxed when you use that money to pay for qualified expenses. As such, you're reducing the amount of money you're required to pay Uncle Sam.
  • It's convenient. Having an FSA creates a pool of money you can use specifically for eligible expenses. This can make budgeting a little easier because you're relying less on your take-home pay to cover these costs.
  • Your employer might contribute to your FSA or match a portion of the contributions you make. They aren't required to do so, but they may choose to offer FSA contributions as an employee benefit.

Cons

  • FSAs are structured as a "use it or lose it" benefit. If you have leftover money in your FSA at the end of the plan year, you may not be able to keep all of it for future use. Your employer may offer a grace period of up to two and a half extra months to use the funds, though they aren't required to do so. Alternatively, they may allow you to roll over up to $550 into the following year. For these reasons, it's important to be careful not to overfund your FSA.

One important note: Thanks to legislation passed at the end of 2020, employers have the option of allowing FSA participants to rollover all unused funds from 2021 into 2022. Check with your employer to see if that option is available to you.

Who Is Eligible for an FSA?

FSAs are only offered by employers. If one is available to you through work, it should be outlined in your employee benefits package. Your human resources department can provide more information regarding your employer's offerings.

Employees can typically enroll in their company's FSA during onboarding as a new hire (assuming there's no waiting period to do so; every company is different) or during the annual open enrollment period. Traditionally, participants who experience a qualifying life event can also change their FSA contributions without waiting for open enrollment.

What Is the Difference Between an FSA and an HSA?

A health savings account, or HSA, is also funded with pretax dollars and can be used to cover qualified medical expenses. It's similar to an FSA, but there are some key differences.

If your employer doesn't offer an FSA, you can open an HSA on your own through some banks, credit unions or organizations that manage IRAs. The only catch is that you must have a high deductible health plan (HDHP) to qualify for an HSA. In 2021, an HDHP for an individual is one with a deductible that's at least $1,400. That number jumps to $2,800 for families.

HSAs can also be used as investment vehicles. Depending on where you open your HSA account, you might be able to invest the money and enjoy tax-free growth. You won't pay taxes on HSA funds used for eligible expenses, but if they are otherwise used, you'll need to include them in your taxable income and pay a 20% penalty.

Here are some other ways an HSA differs from an FSA:

  • You can rollover 100% of your HSA funds. Unlike an FSA, you can keep any unused funds that are left in your HSA at the end of the year. What's more, your account will follow you even if you leave your job. This isn't usually the case with FSAs.
  • Once you turn 65, you can use HSA funds for more than just medical expenses. Tapping an HSA to cover non-qualified expenses ordinarily results in a 20% penalty. But once you turn 65, that penalty is waived. That means you can use those funds to pay for all sorts of expenses, not just medical costs.
  • You may take a tax hit for HSA withdrawals made down the road. If you do use HSA funds for non-medical expenses after you turn 65, you'll be taxed on the amount spent. This, in turn, can increase your tax liability. It's a detail that could disrupt your financial game plan, especially in retirement.
  • You can use an HSA to pay for lots of different health-related items. The list of qualified medical expenses for HSAs is more vast compared with FSAs. It includes everything from sunscreen and over-the-counter pain medication to air purifiers and feminine hygiene products.

Can a Flexible Spending Account Affect Your Credit Score?

A flexible spending account will not have a direct effect on your credit score. Just like a checking, savings or investment account, your FSA balance and account activity don't show up on your credit report. That said, if FSA contributions are stretching your budget and making it difficult to meet your other financial obligations, that can impact your credit score in a negative way. Adjusting your contributions may be all you need to set things right.

Having an FSA may actually help your credit if it makes it easier to pay your medical bills and prevent them from being sent to collections—where they could wreak havoc on your credit score. You can check your credit score and credit report for free with Experian, making it that much easier to keep your credit going strong.