Flexible Spending Accounts: Use It or Lose It

FSA ERISA benefits lawyerFlexible Spending Accounts, or FSAs, allow employees to make tax-advantaged contributions towards their health care costs for the year. The FSA is distinct from the employer’s ERISA-governed health insurance plan; but the two operate closely. The employer’s insurer may even administer the FSA. The employee, and possibly the employer as well, contributes each year which may then pay for qualified medical expenses. If the funds are not depleted at the year’s end they become subject to “use it or lose it”.

How FSAs work

Each plan year the employee elects a particular dollar amount he or she wants to set aside to the FSA for qualified medical expenses (for medical FSAs). The IRS, under the Affordable Healthcare Act (aka Obamacare), sets the current cap at $2,500 for FSA contributions. The employer will then deduct a portion of each paycheck through the year to fund the employee’s FSA elected contribution. The employer may make a contribution as well. The employee may then use the FSA funds through the year to pay for qualified medical expenses. There are also dependent care FSAs which work the same way but used for dependent care only.

The benefit to the employee is that the employee can set aside money for medical expenses on a tax-advantaged basis. The employee’s FSA contributions are not subject to employment taxes (medicare and social security) so the employee obtains a roughly 7% tax break on those funds. Then the distributions are tax-free from income tax so long as they paid for qualified medical purchases. If you have predictable medical expenses during the year, it can be very lucrative to avoid taxation on that income by cycling it through an FSA to pay for those medical bills.

Qualified medical expenses

It is important to understand what are qualified medical expenses for an FSA. Qualified medical expenses include treatment from qualified medical physicians and cover a wide array of treatments. Certain home improvements to accommodate a medical condition or disability may also be covered. Before 2011, FSAs could be used to pay for any over the counter (OTC) medications. The Affordable Care Act terminated that opportunity. Now OTC medications are only qualified expenses if a doctor prescribes them.

The use it or lose it rule

Probably the most important rule when dealing with FSAs is the “use it or lose it” rule. When you elect a contribution for a plan year, you lock in to making that contribution on a per-paycheck basis regardless of whether you end up needing all of that money for medical expenses (in certain qualifying events, like childbirth, you can raise your contribution for the year). Under the “use it or lose it” rule, an employee must either exhaust the FSA balance each plan year (or the plan year plus up to 2.5 months, as the plan permits) or the remaining balance is forfeited to the FSA plan and may be used by the employer to pay for the plan’s administrative costs and funding requirements.

This “use it or lose it” rule creates a certain financial risk for employees. Employees want the tax advantage; but a common complaint is employees get caught by the “use it or lose it” rule by surprise. Unfortunately, not understanding this rule will not avoid its application. Employees also often believe there is some loophole to the “use it or lose it” rule that will allow them to get back their money. That is not the case (although the federal regulators are considering eliminating the rule for certain kinds of FSAs). Employees also sometimes confuse FSAs, which are subject to this rule, and other similar arrangements, like Health Spending Accounts (HSAs), that are not subject to the rule. An FSA cannot convert to another type of account to avoid the rule.

Back in the day…

Prior to 2011, it was common for people to use their FSA contributions as they needed through the year with little fear of running into the “lose it” side of the rule. This is because employees could use the remaining funds to buy OTC medications at the end of the plan year to exhaust their account balances. The Affordable Care Act closed off this option, which makes it harder for employees to find ways to exhaust their balances for non-health care costs. A key problem with permitting OTC medications was that it was very difficult to determine whether the employee was buying OTC medication or other consumer goods, so it was easy for the employees to use the funds for whatever they wanted. The Act closed off the OTC medication option in part to eliminate that abuse of the FSA system.

Now employees need to be more careful about planning their FSA contributions. There are still many elective and preventative care options to exhaust an FSA balance; but it’s no longer as easy as taking a trip to CVS or Kroger and buying all the Robitussin. Employees need to thoroughly understand how their FSA works and plan appropriately. Speaking with a CPA or CFP to make some financial planning would be a great way to accomplish that objective.

The FSA design was a strange concept. It didn’t turn out exactly as planned. Fortunately, more effective programs that do not suffer from the “use it or lose it” rule have become more common. However, many employers offer FSAs; so it is important that employees understand how they work.

Employee benefits and Flex Spending Accounts

Flexible spending accounts may be one of the employee benefits you receive as part of your compensation. You should review the terms of any benefit plan or account available through your job. With the ACA most families rely upon their employment relationship for health care. That can include ERISA-governed health care plans and flexible spending accounts. The combination of benefits can help you maximize access to health care for your family. If you have questions about employee benefits or other issues with your job then you should speak with employment attorneys. Attorneys specializing in employment law understand the complicated labor and employment laws that govern your job. Learn more by contacting an employment attorney right away.

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