How do flexible spending accounts (FSAs) for health care expenses work?
A health care FSA is an employer-sponsored account used to reimburse employees for qualifying health care expenses.
Health care FSAs are benefit plans established by an employer to reimburse employees for qualified health care expenses, such as copayments and certain prescription drug costs. FSAs are usually funded through salary reduction agreements in which the employee agrees to receive lower monetary compensation in exchange for equivalent contributions to an FSA. For example, an employee who elects to reduce his or her monthly paycheck by $200 would receive, in return, a $2,400 annual contribution to his or her FSA.
The key benefit of FSAs is that these contributions are not subject to income or employment taxes, which could mean significant tax savings for the account holder. An employee contributing $200 a month to an FSA would save $360 in federal income taxes if he or she were in the 15 percent tax bracket ($2,400 × 0.15 = $360) and an additional $184 dollars from reduced Social Security and Medicare payroll taxes ($2,400 × 0.765 = $183.60). Because the federal income tax savings depend upon the employee’s income tax rate (which rises with income), the benefit of using an FSA is greater for higher-income workers. For example, the income tax savings for an employee in the 35 percent tax bracket with the same $2,400 annual contribution would be $840 ($2,400 × 0.35 = $840).
An important attribute of FSAs is that the entire value of an employee's FSA account must be made available at the beginning of the year. For example, if the same employee discussed above incurred a $3,000 medical expense in March, he or she could use the full $2,400 annual FSA contribution to help pay for that cost, even though only $600 would have been contributed into the account by March.
In 2013, the Internal Revenue Service (IRS) instituted a contribution limit for health care FSAs. The limit is adjusted yearly for inflation; in 2017, it is $2,600 per year per employer. Generally, employees must use the money in a FSA within the plan year, although employers may also offer one of two options:
- Provide a grace period of up to 2.5 months into a new plan year to use FSA money from the preceding plan year.
- Allow the employee to carry over up to $500 per plan year to use in the new plan year.
The Bureau of Labor Statistics estimates that about 43 percent of all civilian workers had access to an FSA in 2016 (Bureau of Labor Statistics 2016, 2785). As a whole, high-income employees and employees in larger firms are more likely to have access. Only about 1 in 10 low-income workers had access to a FSA in 2015 compared with about 7 in 10 workers at the top of the earning scale (figure 1).
Employees in larger firms (500 or more workers) are about three times as likely to have access than employees in smaller firms (99 or fewer workers), with 74 percent of the former reporting access versus 23 percent of the latter in 2016 (figure 2). Larger firms are typically better able to handle the complexity and administrative costs of offering FSAs, and low-income jobs often do not offer health insurance, thus eliminating access to flexible benefits, such as FSAs, for such workers.
More specific data on exactly who uses FSAs and how much federal tax revenue they cost are difficult to obtain because employees are not required to report FSA elections on federal income tax returns, and few surveys ask specifically about FSA participation.
 Allowable expenses are discussed in the IRS publication Medical and Dental Expenses (IRS 2016).
 Contributions to a FSA also are not subject to the employer portion of payroll taxes. The $2,400 reduction in the employee’s earnings credited to his or her Social Security accounted could slightly reduce the employee’s eventual Social Security benefit.
 Only individuals eligible for employer-provided major medical coverage can be offered the FSA. The IRS stipulated this new restriction in 2013 with Notice 2013-54.
Bureau of Labor Statistics. 2016. National Compensation Survey: Employee Benefits in the United States, March 2016. Washington DC: US Department of Labor.
IRS (Internal Revenue Service). 2016. Medical and Dental Expenses (Including the Health Coverage Tax Credit) for Use in Preparing 2016 Returns. Publication 502. Washington, DC: Internal Revenue Service.
Joint Committee on Taxation. 2008. Tax Expenditures for Health Care. JCX-66-08. Washington, DC: Joint Committee on Taxation.
IRS (Internal Revenue Service). 2016. “Revenue Procedure 2016-55.” Washington, DC: Internal Revenue Service.
———. “Application of Market Reform and Other Provisions of the Affordable Care Act to HRAs, Health FSAs, and Certain Other Employer Healthcare Arrangements.” Notice 2013-54. Washington, DC: Internal Revenue Service.
Rapaport, Carol. 2013. Tax-Advantaged Accounts for Health Care Expenses: Side by Side Comparison. RS21573. Washington, DC: Congressional Research Service.