As a successful, young professional, you may have access to a Flexible Spending Account (FSA) through your employer. These savings accounts are used to set aside pre-tax dollars for certain approved expenses. They’re typically offered as an option in a Section 125 cafeteria plan.
FSAs have developed a bit of a bad image, because of one particular feature. So, let’s review the basics of FSAs and how you can utilize them as a potentially valuable employee benefit.
Flexible Spending Accounts originate from Section 134 of the Revenue Act of 1978. This law provides tax-favorable treatment of flexible spending accounts for medical expenses, dependent care expenses and, occasionally, for other expenses. These accounts allow employees to defer salary on a pre-tax basis into an FSA. This means you’re reducing your taxable income and thus avoiding income tax on the amount you defer into the FSA.
Types of Flexible Spending Accounts
While there are several forms of FSAs offered by employers, we’ll focus on the two most common types. You may be able to participate in one or both.
Health Flexible Savings Account
The Health FSA (or medical expense FSA) or is usually offered alongside a traditional employer-sponsored health insurance plan. This FSA is used to pay medical, dental and vision expenses not paid by your health insurance. These expenses can include co-payments, deductibles and co-insurance related to your health insurance plan. You can also use the Health FSA to pay for over-the-counter prescriptions when purchased with a doctor’s prescription. You can pay for medical devices such as crutches, glasses, and dental braces. You can use your health FSA to pay for medical services such as chiropractic visits, Lasik eye surgery and physical therapy. The full list of eligible expenses can be found in IRS Publication 502.
Dependent Care Assistance Programs (DCAP)
Your employer may offer a Dependent Care Assistance Program (or DCAP) to pay for expenses for dependent care. Qualifying expenses include childcare for children under the age of 13, and day care for an individual who (a) is incapable of self-care, (b) lives with you for more than half of the year and (c) is your spouse or dependent. The Dependent Care Assistance Program can also be used to pay for a nanny, pre-school and summer camp. The full list of eligible expenses can be found in IRS Publication 503.
In 1984, the Internal Revenue Service issued a ruling that requires employees to establish an annual deferral amount for an FSA. Later, in 2013, the IRS capped the amount employees an defer into a Health FSA at $2,500. The IRS indicated that the amount would increase annually for inflation. The limit for a Health FSA in 2020 is $2,750. It will remain at that level in 2021. It is possible for both partners in a household to fund their own Health FSAs.
The limit for a Dependent Care Assistance Program in 2020 is $5,000 per family. That limit also remains the same in 2021.
Changing Deferral Amounts
The amount you defer can be changed during the year, in the event of marriage, divorce, birth or adoption of a child, or death.
The least attractive feature of FSAs and DCAPs is that unused funds within an FSA are generally forfeited at year-end. This “use it or lose it” nature of the account has forced many employees into a mad scramble in December to use dollars remaining in their FSAs.
Thankfully, under the Affordable Care Act, an FSA plan may permit an employee to carry over up to $550 to the following calendar year. However, this doesn’t apply to all plans. Employers aren’t required to offer this carry-over.
If an employer doesn’t offer a carry-over opportunity, it can still offer a grace period for the spending of dollars in an FSA or DCAP, allowing you to claim expenses incurred in early 2021.
But, employers cannot offer both a carry-over and a grace period.
CARES Act Changes
Because of the disruption caused by the COVID-19 pandemic, the IRS published guidance in May 2020 that grants employers additional flexibility in the administration of their FSA and DCAP plans.
The IRS will permit employers to allow their workers to make mid-year changes to their FSA and DCAP elections. They can revoke an existing deferral election and stop making contributions to the plan. They can make new elections, if they didn’t previously make an election to participate, and they can increase or decrease the amount of an existing deferral election.
The IRS also granted an extended grace period for deferrals made in 2019. That grace period would normally have expired March 15, 2020. However, it has been extended to December 31, 2020. If an employer adopts the extended grace period, unused amounts in Health FSAs and Dependent Care Assistance Programs can be reimbursed until the end of 2020.
The recent $2 trillion CARES Act has expanded Health FSA coverage to include over-the-counter drugs that aren’t prescribed by a doctor, and menstrual care products.
Do you have questions about your workplace benefits, or about building a robust plan for your financial future? Contact us today to see how our team at Springwater Wealth can help you.
Get Professional Help
FSAs and DCAPs can be important employee benefits for young professionals and their families. But you need to manage them carefully to avoid costly mistakes.
If you have questions about how to integrate a Health Flexible Spending Account or a Dependent Care Assistance Program into your overall financial plan, consider working with a CERTIFIED FINANCIAL PLANNER™ (CFP®).