What is a Flexible Spending Account and How Does an FSA Work?

When it comes to health insurance, there is lots of jargon and plenty of acronyms. Many people have heard of FSAs but may not actually know — what is a flexible spending account, exactly?

Whether you’re an employer trying to understand the benefits you’re offering to your team, or an employee trying to determine what benefits will suit your needs, it’s worth exploring what an FSA brings to the table. Let’s dive in.

What Is an FSA?

A healthcare flexible spending account, or HCFSA — or most commonly known as FSA — is an account that eligible employees allocate pre-tax money to throughout the year. They then use funds in that account to pay for certain out-of-pocket health care costs.

An employee elects how much money they want to allocate, and then the money is deducted from that employee’s paycheck over the duration of the year. Because it’s pre-tax income, there can be significant savings when using FSA funds over money from your checking account.

Unlike the HSA and the HRA, which are both designated for higher out-of-pocket costs (typically, high-deductible health plans), FSAs are available for use with most types of health insurance plans.

Before the Affordable Care Act (ACA) was enacted, employers selected the maximum annual election. However, after the ACA took effect, the IRS set an annual FSA maximum limit. The IRS can modify that limit every year to adjust for cost of living. In 2024, the annual limit will be raised to $3,200.

Common Account Features of a Flexible Spending Account:

• Funds can be used for deductibles, copays, medication, and other healthcare-related out-of-pocket costs.

• The employer owns the account — if you leave the company, you can’t take the account with you.

• All money deposited is untaxed.

• For ease of use, most FSA accounts come with a debit card.

• Employees can spend the money in the account before it’s fully funded.

How Does an FSA Work?

Healthcare FSAs can cover medical, dental or vision expenses that you would otherwise pay for out-of-pocket, including co-pays and deductibles. Health insurance premiums are not eligible expenses. For a full list of qualified expenses please visit IRS Publication 502.

With the Healthcare FSA, there is a 2024 limit of $3,200 that you can set aside pre-tax. Healthcare FSA funds are tied to your employer's plan, that means even if you have already contributed to an FSA with a previous employer, you are still eligible to contribute the full amount with your new employer for the remainder of the year. You can elect to participate in an FSA during open enrollment or if you experience a qualifying life event, and you must select a contribution amount at that time. You cannot make any changes or opt-out of the FSA later in the year.

How FSA Spending Works

If employees elect to receive the annual maximum at the beginning of the year, they'll immediately have access to that full amount of money to cover health care costs. In the event that they need to spend it all in January, they can. That's because the company owns the account and is fronting employees the money. Each time money is withheld, the company gets repaid a little more.

Employers should note that the company owns not only the money, but also the liability. For example, say an employee has to pay $50 every paycheck to cover their FSA. They might use the entire amount by March, then resign in June. The employee would only have paid half of the total value of the FSA, meaning that the company pays out the rest. Companies cannot take the remaining balance out of the employee’s last paycheck. 

On the employee side, the FSA has a risk element of "use it or lose it" associated with it. Unlike an HSA, which the employee owns, the amounts in FSAs are forfeitable. If you don’t use the full amount you’ve elected to contribute by the end of the calendar year, the rest is forfeited and goes back to the employer.

That said, companies are permitted to include a carryover provision or a grace period for their FSAs. As of 2023, the carryover provisions will permit employees to carryover up to $610 in unused FSA amounts from the previous calendar year. A grace period allows employers to include a period of up to two and a half months when the employee can continue to use FSA funds for health care services during that time. Regardless of what the employer chooses, any remaining balances in FSAs at the end of that period will be profit for the company.

Can a Healthcare FSA Cover Expenses by Dependents?

Yes, a Healthcare FSA can cover expenses for qualifying dependents, even if they are not currently covered under your employer-sponsored health insurance plan. Qualifying dependents include:

• Spouse

• Qualifying child

• Qualifying relative

FSA Advantages and Disadvantages

On the employee side, once the plan starts, all the money for the year is available for use. This is obviously an advantage because if employees need access to all the money on the first day of the plan, it's available. However, if the employee were to use the money on the 1st and then quit on the 2nd, the employee wouldn’t have to pay into the plan. Naturally, this is a disadvantage for the employer because they would have to foot the bill.

On the other hand, an advantage for the employer is that any money left over—after the $610 rollover, if applicable—can be added to the company’s bottom line for use on plan-related expenses. This is a disadvantage for employees because they had the money for the FSA withdrawn from their paychecks, resulting in them funding the FSA and not being able to use it all for their out-of-pocket health care costs.

However, overall, both employers and employees can benefit from FSAs. Employees can save on their taxes by contributing to an FSA and reducing their taxable income. And employers can add this benefit, at relatively low cost, to help with recruiting and retaining employees.

What is a Dependent Care FSA?

A Dependent Care flexible spending account, (DCFSA), is an account that eligible employees allocate pre-tax money to throughout the year that can be used to reimburse themselves for the work-related cost of care for a qualifying dependent. For a full list of qualified expenses please visit IRS Publication 503.

A qualifying dependent is broadly defined as:

• A tax dependent of yours who is under age 13, or

• Any other tax dependent of yours, such as an elderly parent, who is physically or mentally incapable of self-care and has the same principal residence as you

• A spouse who is physically or mentally incapable of self-care and has the same principal residence as you

To qualify for a Dependent Care FSA, one must be “gainfully employed”. Gainful employment usually means working or looking for work. If an employee is single, they may be reimbursed for expenses incurred due to gainful employment. If they are married, generally both the employee and the spouse must be gainfully employed or looking for work to be reimbursed for expenses.

The IRS can modify the annual limit every year to adjust for cost of living. For 2023, employees may contribute up to $5,000 per year to a DCFSA if they are married and filing a joint return, head of household, or if they are a single parent. If an employee is married and filing separately, they may contribute up to $2,500 per year per parent.

How DCFSA Spending Works

If employees elect to receive the annual maximum for Dependent Care FSA at the beginning of the year, they will only have access to funds as they contribute. Unlike FSAs, which are front-loaded, employees are only able to make claims up to the amount they’ve contributed to date. This eliminates the risk and liability for employers to pay out more than the employee contributes. 

On the employee side however, the DCFSA still has a risk element of "use it or lose it" associated with it. Like HCFSA, the amounts in DCFSAs are forfeitable. If you don’t use the full amount you’ve contributed by the end of the calendar year, the rest is forfeited and goes back to the employer.

How to Set Up an FSA

For employers, setting up an FSA, whether it be healthcare or dependent care, doesn’t require any outside organizations, but it can be helpful to work with a Third Party Administrator (TPA) that knows the rules of FSAs in and out. Once you identify who you want to work with, you’ll need to then determine the following:

• How much money will you offer? As an employer, you can set the maximum an employee can contribute to an FSA as long as the amount does not exceed the annual limit set by the IRS.

Will there be any grace period or carryovers? You can offer a grace period of up to 2.5 months. Or, instead, will you permit carryovers?

How Justworks Can Help Manage Employee FSAs

If you offer your employees access to health insurance through Justworks, you can offer FSAs through Justworks, too. You can manage this benefit within the Justworks platform, and employees can easily access their FSA as well. Once they set up their contributions, Justworks will simply deduct the employee’s contribution to the FSA while processing payroll.

Learn more about offering employee health benefits through Justworks, and get started today.