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Flexible Spending Account

A flexible spending account (FSA) is an account in an employee’s name that reimburses the employee for qualified medical expenses or dependent care expenses. It allows an employee to fund the account with pre-tax dollars deducted from the employee’s paychecks. The employee can receive cash reimbursement up to the total value of the account for covered expenses incurred during the benefit plan year and any applicable grace period.

“Use-it-or-lose-it” Rule

Historically, the Internal Revenue Code (Code) required that money in an FSA be spent by the end of the plan year.  This rule, known as the “use-it-or-lose-it” rule, provided that any unused funds at the end of the plan year would be forfeited by the employee. This meant that, when an employee elected how much he or she would contribute to the FSA, the employee wanted to pick an amount that the employee would be likely to spend during the year.  The goal was to defer enough money to cover medical or dependent care expenses, but not so much that money would be left over and forfeited at the end of the year.

The Code now offers an employer two options to mitigate the “use-it-or-lose-it” rule.  A plan can provide for a grace period of 2 ½ months after the end of a plan year for employees to use their flexible spending account funds. So, for a plan year ending December 31, employees would have until March 15 to spend the remaining funds in their FSAs. There is no limitation on the amount of funds that can be spent during this grace period.

In the alternative, a plan may allow participants to carry over a certain amount of unused funds into the next plan year.  The amount that an employee can carry over from the 2023 plan year to the 2024 plan year is $610. Unlike a grace period, the carried over amount does not have to be spent within a certain timeframe.  The carried over funds can be spent throughout the following plan year.

The Code does not require a plan to offer a grace period or a carry-over provision.  Whether a plan offers either exception to the “use-it-or-lose-it” rule is up to the employer.  However, a plan cannot offer both options.  An employer must pick between the grace period and the carry-over option.

Types of Flexible Spending Accounts

There are two different types of FSAs: health care accounts and dependent care accounts. An employee can elect to have both types of accounts and contribute separate pre-tax dollars to each. These accounts are kept separate; for instance, an employee could not be reimbursed for dependent care expenses from his or her health care account.

1. Health Care Accounts

Health care FSAs reimburse employees for eligible medical expenses, up to the amount contributed for the plan year. The amount that an employee can contribute to an FSA is limited by the Code.

For 2023, the contribution limit is $3,050.

Click here to read more about the contribution limits.

A health care flexible spending account only reimburses employees for money spent on medical care, as defined under Section 213(d) of the Code. Section 213(d) of the Code defines “medical care” to include amounts paid “for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body.”

Examples of qualified medical expenses include deductibles and copayments for an individual’s health plan. Eye exams, eyeglasses, contact lenses, hearing exams, hearing aids, physical exams and smoking cessation programs are also covered. For a complete list of qualified medical expenses, visit the IRS website here.

2. Dependent Care Accounts

The second type of FSA is a dependent care account. This account can be used to pay for the care of dependent children under the age of 13 by a babysitter, day care center, or before- or after-school program. Care for a disabled spouse, parent, or child over the age of 12 is also eligible for reimbursement.

Many of the rules that apply to health care FSAs also apply to dependent care accounts, such as the “use it or lose it” rule. However, there are some important differences between the two types of accounts. For dependent care accounts:

      • The annual limit on contributions is higher.  For 2023, the contribution limit is $5,000.  However, in no event may an employee’s contribution exceed the employee’s earned income;
      • The American Rescue Plan Act temporarily raised the annual limit to $10,500 for taxable years beginning in 2021. However, plan years beginning in or after 2022, the contribution limit reverted back to $5,000;
      • Unlike an FSA, where an employer is required to advance funds to cover qualified medical expenses, if the employee’s salary deferrals to date of the expense are insufficient, dependent care expenses can only be paid from funds actually contributed by the employee; and
      • Dependent care expenses cannot be reimbursed until they are actually incurred. This can be an issue when childcare centers “pre-bill” for services, and employees are required to pay in advance.

For more information on FSA plan design and compliance, contact RMC Group today at 239-298-8210 or rmc@rmcgp.com.