Flexible spending account (FSA)

In short

A friend of mine once lost $400 from her paycheck account because she forgot it was there. Her story is a common one, and it is easy to avoid. A flexible spending account, or FSA, lets a worker set aside pay before tax to cover health costs. The yearly cap is the current figure, which the official source publishes each year, and the Internal Revenue Service publishes the current figure. The employer sets up the plan, so a worker can only join if the employer offers one. The worker picks a yearly amount during open enrollment, and that choice usually stays locked until the next one. Many plans have a use it or lose it feature, so check the plan's carryover or grace period rules early. Learn your own deadlines now, and the money works for you instead of against you.

The whole of it

What it is

I once watched my neighbor pay for his daughter's braces with a pile of receipts and a long sigh. He had never heard of an FSA, and nobody had told him. If you are holding an offer letter from an employer, you may have seen the term tucked in the benefits packet.

A flexible spending account is a benefit account run through an employer. The worker chooses an amount to set aside from each paycheck. That money comes out before income tax, which lowers the worker's taxable pay. Then the worker spends it on qualified medical costs, such as copays, prescriptions, and eyeglasses.

The word before matters here. It means the dollars skip income tax on the way in. They also skip it on the way out, as long as they pay for an approved expense. That double skip is the whole charm of the thing.

An FSA is not the same as a health savings account, or HSA. An HSA belongs to the worker and goes along when a job ends. An FSA belongs to the employer's plan, and the rules about leaving a job are different. Keep that in mind when comparing the two.

How it works

A friend of mine says the trick is to treat the FSA like a bus schedule. You pick the route early and then you ride it all year. The same goes here.

During open enrollment, the worker picks a yearly election. That is the total to be set aside for the year. The employer divides it across the paychecks and takes out an equal slice each time. The plan requires the worker to stay within the yearly cap, which is the current figure, which the official source publishes each year.

Here is a quirk that surprises people. The full yearly amount is usually available on day one, even though the paychecks arrive slowly. The employer fronts the money. The plan rules, not the worker, decide this, so read the summary plan description, which is the plan's own rulebook.

Then comes the spending. The worker pays for a qualified expense and either uses a special debit card or files a claim with a receipt. The plan administrator checks the claim and pays it back. Keep every receipt. Auditors and administrators both ask for proof.

Now the catch. Under the tax rules, an FSA generally cannot carry money forward without limits. A plan may offer one of two relief options, and only one of them. The first is a grace period of up to two and a half months after the plan year ends. The second is a carryover of a set amount, which is the current figure, which the official source publishes each year. A plan may offer neither. The employer decides, and the plan document spells it out.

The numbers, and where to find yours

A neighbor of mine kept guessing at her limit until she read one page. That page was the answer all along. The yearly cap and the carryover amount change from time to time, so this guide does not freeze them in place.

The current health FSA cap is the current figure, which the official source publishes each year. The current carryover maximum is the current figure, which the official source publishes each year. The Internal Revenue Service sets these figures each year through a revenue procedure and lists them on IRS.gov. Publication 969, called Health Savings Accounts and Other Tax Favored Health Plans, explains FSAs in plain terms.

Your own numbers live in two places. The first is your benefits portal, where the employer shows your election and your balance. The second is your plan document, which names the deadline, the grace period, or the carryover your plan allows. If you cannot find it, ask the benefits office. Asking is no shame.

A worked example

I once knew a teacher in Springfield named Maria Alvarez. She earns $52,000 a year and is paid every two weeks, so she gets 26 paychecks. Her family has a few known costs each year, and she wanted to cover them with pretax money.

She added up her expected bills. Two pairs of glasses cost $380. Prescription copays come to $540. Dental work not covered by insurance is about $480. Her total is $380 plus $540 plus $480, which is $1,400.

She elected $1,400 for the year. Her employer takes $1,400 divided by 26 paychecks out of each check. That is about $53.85 per paycheck. Her taxable pay drops from $52,000 to $50,600, since $52,000 minus $1,400 is $50,600.

Now the savings. Suppose, only as an example, that her federal income tax rate on that slice is 12 percent. Her real rate depends on her bracket, and the IRS publishes the brackets each year. Then 12 percent of $1,400 is $168. She also skips payroll tax, which is 7.65 percent for Social Security and Medicare. That is 7.65 percent of $1,400, or $107.10. The total saved is $168 plus $107.10, which is $275.10.

That means her $1,400 of care costs her about $1,124.90 after the tax break, since $1,400 minus $275.10 is $1,124.90. Her real rate may differ, because state tax and her bracket both matter. The math shows the shape of the benefit.

Maria spent $1,400 by December, so nothing was left over. She felt good about that. A small win. And she got there by adding up her bills first, which anyone can do.

Where it goes wrong

A fellow I know once left $600 in his account and lost it. It stung for months. The usual trouble is overestimating what a family will spend, because the unused balance may be forfeited under the plan's rules.

The second trouble is timing. The election is usually locked for the year. The plan can allow a change only after a qualifying life event, such as a marriage, a birth, or a loss of other coverage. A worker cannot simply cut the amount in July because the year feels different now.

A third trouble is leaving a job. When employment ends, the account often ends too, and the worker may lose access to any unspent funds. Claims for costs after the last day are usually not covered. The plan document names the exact cutoff, so check it before giving notice.

The fourth trouble is paperwork. The plan administrator may ask for an itemized receipt, not just a card slip. A claim with no proof can be denied, and the worker has to repay the money or the employer may report it as taxable pay. Keep your records tidy.

The last trouble is mixing up expense types. Not every health related purchase counts. Cosmetic items and general wellness spending often do not qualify. The IRS lists approved items in Publication 502, called Medical and Dental Expenses, and the plan may apply its own limits on top. When in doubt, ask the administrator before you buy.

Questions to answer before you leave this page

Does your employer offer an FSA at all, and when does open enrollment begin and end? What is the yearly cap, and have you looked up the current figure, which the official source publishes each year on IRS.gov to be sure? Can you list the care costs you already know are coming, such as glasses, copays, and prescriptions, and do they add up to a number you trust? Does your plan offer a grace period, a carryover of the current figure, which the official source publishes each year, or neither, and where in the plan document does it say so? What happens to your balance if you leave your job or change roles this year? Are you keeping receipts in one place, and do you know whether your card needs backup proof? If a life event comes along, such as a new baby or a change in coverage, do you know who to call about changing your election?