The Pros and Cons of a Flexible Spending Account
An FSA, or flexible spending account, is a type of tax-advantaged financial account that can help you save up money to pay for certain qualifying expenses related to healthcare or the care of your dependents. By choosing to have regular portions of your paychecks deposited directly into an FSA, which you may be able to have set up through your employer, you'll enjoy lower taxable income, among a number of other financial benefits. To determine if this type of arrangement is right for you, learn more about what an FSA is, along with the various pros and cons of setting up this type of account.
What Is an FSA?
An FSA is a type of account that you can fund each year using regularly deposited portions of your paycheck, and you can use the money you put into this account to pay for qualifying out-of-pocket medical expenses. At the beginning of the year, you decide on the total amount of money you want as your account balance — in 2021, the maximum limit is $2,750. Once you’ve selected your amount, throughout the year portions of your paychecks are diverted towards funding the account up to your predetermined amount.
It's important to understand that there are several different types of FSAs, but the two most popular are healthcare FSAs and dependent-care FSAs. Both types are funded by depositing regular portions of your paychecks, but you’ll use them to pay for different types of expenses.
You can use the money in a healthcare FSA to pay for medical, vision or dental expenses such as copayments, qualifying prescriptions, medical equipment and other healthcare-related costs. A dependent-care FSA, on the other hand, can pay for the care of children under age 13, elderly family members and disabled spouses who meet certain qualifications.
What Are the Pros of an FSA?
What makes an FSA different from any other savings account in which you'd set aside money for the same expenses? FSAs have several perks that are worth considering. Some of these include:
- Tax benefits: Any payroll deductions that are used to fund your FSA are taken out before taxes are assessed on your income; this means they’re a pre-tax benefit. As a result, your overall annual taxable income will decrease by the amount you choose as your FSA maximum.
- Healthcare savings: Depending on the health insurance policy you have, you may discover that you can use your FSA to pay for things that your insurance doesn't cover. This might include over-the-counter prescriptions, preventative tests, mental health services and more. Review the IRS website for a detailed list of expenses that an FSA has the potential to cover.
- Immediate availability: One major benefit of an FSA is that the amount of money you pledge to fund it with during a given year becomes available immediately. In other words, you can use the full amount if you need to, even if the deductions haven't been taken from your paychecks yet. This could save you from having to take out a loan or from incurring high interest rates in the event of a medical emergency.
- Ease of use: Many FSA accounts now come with an accompanying debit card, which allows you to pay for items easily at registers. That said, make sure this is the case with an FSA before signing up. Some employers use FSAs that operate on a reimbursement system. This means that you'll pay your own money upfront, submit the receipts and have the FSA plan reimburse you. You'll usually be reimbursed within a few weeks, but it's important to make sure you can cover the cost until then.
What Are the Cons of an FSA?
It's important to understand that an FSA also has limitations. Some of the main elements to take into consideration when deciding if and how much you want to contribute to an FSA include:
- Funding limitations: The IRS imposes limits on how much money you can contribute to an FSA every year. In 2021, as mentioned, you can only contribute up to $2,750 per account for a healthcare FSA or $2,500 or $5,000 for a dependent care FSA, depending on your filing status. The smaller limit applies to married filing separately couples. If you have a working spouse, they can also contribute $2,750 into their own medical FSA account.
- The "use it or lose it" principle: In general, you must use any money you've put in your FSA by the end of each plan year or forfeit it. There are some exceptions in which employers may allow you a 2.5-month grace period that extends into the following year. Alternatively, they may allow you to roll over up to $550 of unused funds to the following plan year. Make sure you understand these terms before signing up so you don't end up losing the money you don't spend.
- Employer dependency: Before signing up for an FSA, make sure that you plan to stay on with your employer the full year. As your plan is highly dependent on your employer, you can lose your benefits if you end up no longer working for that company. Additionally, make sure you know when the sign-up window is, as you may be out of luck until the next plan year if you miss it.
- Tax trade-offs: While you can decrease your overall taxable income by funding an FSA, you should also realize that you can't use any expenses that your FSA covers as tax write-offs.
Picking a Withholding Amount
One tricky part about managing an FSA can be deciding how much money you'd like to contribute to it during a given plan year. While you don't want to risk losing money by contributing too much, you may not want to risk contributing too little either, depending on your health status.
It can be difficult to change the amount you want to contribute to an FSA after the plan year has begun. There are some exceptions to this rule, however, including major life events like:
- A change in marital status
- A change in your number of current dependents
- A change in employment status
- Circumstances that affect whether or not someone can be considered your dependent
If you think you may qualify under one of these conditions, talk with your employer’s human resources department to see if they can help you make mid-year changes to your account. Otherwise, it's worth it to sit down and chart out how much money you routinely spend on medical, dental, vision and dependent care costs per year. It’s also vital to understand all the different types of expenses that an FSA covers so you can pick an amount that's right for your needs. It may also be worth it to increase the amount somewhat in case of emergencies, especially if your employer offers a yearly rollover option.