IRS Guidelines for a Flexible Spending Account

A flexible spending account, sometimes referred to as a flexible spending arrangement or FSA, is a tax-favored program that allows the account holder to pay for certain expenses with pre-tax dollars. The types of expenditures that can be paid with funds from an FSA was significantly impacted by the passage of the the Affordable Care Act that went into effect on January 1, 2011.

Description

• Flexible spending accounts were originally considered medical individual retirement accounts and were codified in Section 125 of the Internal Revenue Code. These arrangements allow employers to establish tax-advantaged accounts which may be contributed to by employees, then drawn upon to pay for medical expenses that are not covered by health insurance.

Establishment

• Flexible spending arrangements can only be established by employer. They are not available to self-employed taxpayers. They can be established as part of a cafeteria-style benefits program in which employees may elect or decline to participate. Employees are not required to be covered by the company's health insurance plan to have a flexible spending account.

Contributions

• Flexible spending accounts are usually funded entirely by the employee through payroll withholding. The employer may contribute but is not required to do so unless such contributions are mandated by the plan. The employee makes the determination at the beginning of the plan year regarding how much money he wishes to contribute to the account. That amount is divided by the number of pay periods in the plan year, and the appropriate amount is withheld from the employee's paycheck on a pre-tax basis.

Benefits

• Flexible spending accounts can help cover the cost of medical expenses that are not covered by health insurance, including deductibles. Contributions to these accounts are made with pre-tax, or salary reduction, dollars that can lower the employee's tax obligation. Withdrawals that are made from the account to pay for qualified expenses are free from federal income taxes. Employees can withdraw funds from their accounts, up to their elected amount, at any time during the plan year, even if they have not yet made those contributions.

Considerations

• The Affordable Care Act, which went into effect on Jan. 1, 2011, changed the qualification status of certain items. Medications that are purchased without a prescription no longer qualify for reimbursement from flexible spending accounts on a tax-free basis. Funds that remain in a flexible spending account at the end of the plan year are usually forfeit. Medical expenses that were reimbursed by a flexible spending account may not be included as a deduction on IRS Form 1040, Schedule A.