There’s often nothing more damaging to your finances than an expense you aren’t prepared to cover. It can send you spiraling, forcing you to take out more debt than you can afford.
There’s one area in particular where those costs can easily skyrocket, saddling you with tens of thousands in unpaid bills: health care. Talk to just about anyone in dire financial straits, and chances are they’ve been hit with an unexpected medical bill at some point in their lives. These days, it’s not even a sudden doctor’s visit that can result in onerous medical costs. More and more Americans have been saddled with high deductible health plans these days, sending out-of-pocket health care expenses ever higher.
But it’s not enough to just purchase a health plan anymore if you want to cover all your health care expenses. That’s where a designated health care spending account like a Flexible Spending Account can be useful. An FSA functions similarly to a regular savings account, but every contribution you make is tax deductible and must be used for certain eligible medical expenses.
Here’s everything you need to know about what a flexible spending account is, how it works, and whether or not one is right for you.
What is a flexible spending account?
A flexible spending account (FSA) is a designated savings account provided by employers that allows people to save ahead for medical expenses. However, an FSA can only be used for specific medical expenses.
The most important thing to understand about flexible spending accounts is that the contributions you make to them are tax-deductible. That means you can take money out of your income before taxes to set aside for medical costs, which can mean a big savings depending on your tax bracket.
Flexible spending account rules
In order to maximize your FSA benefit, you want to be sure you understand all of the flexible spending account rules involved and which expenses are eligible.
Here are a few to keep in mind:
Once you decide how much to save in your FSA, that’s it. When it’s open enrollment time, users can decide if they want to contribute to their flexible spending account and how much. After that window closes, their contributions are set in stone.
You can only change your contribution amount more than once per year if you experience a qualified event:
- Getting married, divorced, legally separated, or becoming a widow or widower. These have to be legal status changes. If you’re separated but still legally married, you can’t use that as a qualifying event.
- Having a child, adopting, losing a child, or any change in the number of dependents. If your dependent legally stops being your dependent because they turn 18 or move out, that will also count as an eligible event.
- Losing your job, leaving your job, coming back from an unpaid leave of absence, leaving work because of a strike, or returning to work after a strike.
- Gaining or losing access to Medicare or Medicaid. If your spouse becomes eligible for Medicare during the year, you can change your contribution.
Ask your HR department for their FSA qualifying life event policy and make sure you understand when you can and can’t change your contributions.
Use your funds within a year — or risk losing them. In most cases, you have to use up your FSA funds by Dec. 31 of each year. You may be able to file claims for eligible expenses up until the tax deadline, however, those expenses must have been incurred before Dec. 31 of the tax year.
There’s an exception to this rule: Your employer may give you the option to roll over some funds to the following year.
Clint Haynes, CFP® of NextGen Wealth says some employers allow workers to choose between two options to extend their benefits: roll over a maximum of $500 from their flexible spending account to the next year, or spend the remainder of their balance before March 15. Every employer has their own policy, so check yours carefully.
Individuals who are self-employed aren’t eligible for flexible spending accounts.
Tax penalties. If you use the money on non-eligible items, you could end up owing income tax on the distribution and a 20% penalty.
Flexible spending account eligible expenses
The list of FSA-approved expenses is substantial, but it doesn’t include everything. Insurance premiums, for example, are not on the approved list. In general, you can use flexible spending account funds on yourself, your spouse, or any dependents that are claimed on your taxes.
Here is a sample of approved flexible spending account expenses:
- Out-of-pocket doctor’s visits
- Lab work
- Wheelchair and walkers
- Contact solution
- Hearing aids and batteries
- Pregnancy and fertility tests
- Home medical equipment
- Denture cleansers
- First-aid kits
Ineligible items include:
- Long-term care premiums
- Expenses covered by insurance or reimbursed by the health care provider
- Non-prescription drugs, products, or equipment unless a medical professional has written a prescription for it. That can include eye drops, nasal sprays, laxatives, acne treatments, etc.
Flexible spending account limits
Contribution limits for the FSA are $2,650 for 2018, which is up from $2,600 in 2017.
Employers may also contribute to your flexible spending account, but are not required to. Check with your employer to ask if their contributions count toward your annual contribution limit or not. You may also be able to deduct employer contributions on your taxes, further decreasing your taxable income.
How does a flexible spending account work?
When you enroll in an FSA, you’ll likely receive a designated debit card to use when you pay for eligible medical expenses. You can swipe it at a pharmacy when you’re buying a prescription or for the copay at your doctor’s office. You can even use it when you get a medical bill in the mail. If your FSA doesn’t provide a debit card, you’ll have to submit claims manually to have them reimbursed.
Contributions to your FSA come out of your paycheck, similar to a 401(k) or health insurance premium.
Unfortunately, flexible spending accounts have one prickly rule that make them unpopular with many: you have to use it or you lose it (unless your employer allows you to roll over some funds). So, if the year is ending and you still have funds left your FSA, you should try to use them before they expire. You won’t get a refund for those lost funds.
How much to save in your FSA
Experts tend to recommend different strategies for using a flexible spending account depending on your specific medical and insurance situation. One good rule of thumb is to set aside at least enough to cover your annual health care deductible.
“If you have a history of reaching your deductible every year or you're planning to have a big medical expense this upcoming year, it’s wise to look at putting away as much as you can,” said Crystal Rau, a certified financial planner at Beyond Balanced Financial Planning. “After all, why not shelter that money from taxes that you know you're going to have to spend anyway?”
Since your employer may not offer an FSA rollover option, you should be careful when deciding how much to contribute.
To determine an appropriate amount, create a spreadsheet with a list of all your out-of-pocket health care-related expenses for the last year. Include what you spent on your spouse and your children. You can even do the same for the year before if you’d like a more accurate estimate of your annual health care costs.
Then, see if those expenses look typical for you. Did your son need to get his wisdom teeth taken out in 2016? Did you have kidney stones that required a visit to the emergency room? Or were you unusually healthy and rarely went to the doctor’s office?
Find a figure that represents the minimum of how much you’ll spend on health care and compare it with what you spent last year. There are downsides to choosing too little or too much. If you set aside too little in a flexible spending account, you won’t get the tax benefits that come with contributing to your account.
“The real risk is in overestimating and not being able to spend the funds by the deadline,” said Antowoine Winters, a certified financial planner at Next Steps Financial Planning. “It is a little bit of a double-edged sword that way.”
Remember, you can’t change your contributions mid-year unless you have a special circumstance, so it’s important to be as accurate as possible.
If you wind up with leftover funds at the end of the year, stock up on eligible medical supplies you might need around the house that are FSA-eligible, like sunblock and first-aid kits. Walgreens and FSA Store's websites have designated shopping areas where you can browse FSA-only products.
Flexible spending account vs health savings account (HSA)
Just like investors have a choice between a 401(k) — offered by an employer — and an IRA — an account they can open on their own — flexible spending accounts have their own counterpart: the health savings account. The HSA is similar to an FSA, but with some key differences.
Rollover policy. Funds in an flexible spending account are limited to use for that year, while health savings accounts have no expiration date. All the money you put in will remain yours until you withdraw it. You can even leave your HSA funds in an estate when you die.
Contribution requirements. To contribute to an HSA, you must have a high-deductible health insurance plan with a minimum deductible of $1,300 for individuals and $2,600 for families. Since more and more people are signing up for high-deductible plans, many find themselves suddenly eligible for health savings accounts.
Contribution limits. Contribution limits are higher for health savings accounts, at $3,450 for individuals and $6,900 for families. Those 50 and older can contribute an extra $1,000 in their HSA. This limit is much higher than the flexible spending account allowance of $2,650 for both individuals and families.
Unlike flexible spending accounts, HSA contribution limits can be changed at any point, even if you don’t have a qualifying life event. The overall flexibility of health savings accounts make them a far superior choice to flexible spending accounts. If you have the option of choosing between one or the other, it’s always better to go with the HSA.
Health savings accounts can also act as a retirement account. If you have more than $2,000 saved in your HSA, you can invest the funds the same as you would for an IRA. This allows some people to use an HSA like an extra retirement account if they’ve maxed out their IRA or 401(k).