Flexible Spending Accounts: A Smart Tool to Save on Health and Dependent Care Costs

When it comes to managing your out-of-pocket health care and dependent care expenses, you may be overlooking one of the most effective tools available: the Flexible Spending Account (FSA). This employer-sponsored benefit allows you to set aside pre-tax dollars for qualifying expenses, saving you hundreds, or even thousands of dollars each year when used strategically.

A Brief History

FSAs were created under the Revenue Act of 1978 as a way for employees to pay for certain expenses with tax-free income. Over time, FSAs became a popular part of employer benefits packages, offering workers more flexibility in how they allocate part of their earnings toward medical and dependent care needs.

What Can You Use an FSA For?

There are two primary types of FSAs:

Health FSAs cover out-of-pocket medical, dental, and vision expenses. Common examples include copayments, deductibles, prescription medications, eyeglasses, contact lenses, and even some over-the-counter medications.
Dependent Care FSAs can be used for eligible childcare or adult daycare expenses, helping working parents and caregivers offset the high cost of dependent care.

Tax Advantages

The standout benefit of an FSA is its tax savings. Contributions are made on a pre-tax basis. This means the money you set aside is not subject to federal income tax, Social Security tax, or Medicare tax. For someone in a 25% tax bracket, contributing $2,000 to an FSA could mean $500 in tax savings.

However, there’s a catch. If you use FSA funds for non-qualified expenses, those withdrawals are considered taxable income, and you may face an additional penalty tax, typically around 20% on the misused amount.

Portability and Use-It-or-Lose-It

Unlike a Health Savings Account (HSA), an FSA is generally not portable. If you leave your job, you typically lose access to unused funds unless you have COBRA continuation rights for your FSA. Additionally, most FSAs are subject to the use-it-or-lose-it rule where funds must be spent within the plan year, although some employers offer a short grace period or allow up to $640 (2024 limit) to roll over.

Final Thought