FSAs: Use It Or Lose It (Except Not All Of It)

I’ve written before about Health Savings Accounts (HSAs), and how they are great to pay for medical expenses pre-tax but even better if you use them as a stealth retirement account. I’ve also written about Section 125 Plans, which includes your insurance premiums and Flexible Spending Accounts (FSAs). But in recent discussions in a class I’m teaching I realized there are still many misconceptions about HSA’s older cousin Flexible Spending Accounts (FSAs) so I thought they deserved a post of their own.

There are actually four types of Flexible Spending Accounts (FSAs): Health Care FSA, Dependent Care FSA, Limited Purpose FSA, and Commuter FSA.

• Health Care FSA (2023 Contribution Limit: $3,050): This is the one people are the most familiar with. If you don’t have an HSA-qualified High Deductible Health Insurance Plan, it is likely that your employer offers a Health Care Flexible Spending Plan. This allows you to use pre-tax money to pay for any out-of-pocket expenses that you may incur for health care, dental care, or vision care.
  
• Dependent Care FSA (2023 Contribution Limit: $2,500 if married filing separately, otherwise $5,000 for household): If you have children (under age 13) in daycare, including before and after school care, you can use pre-tax money to pay for those daycare expenses. (Note this can also be used under some circumstances for adult dependent care.)
  
• Limited Purpose FSA (2023 Contribution Limit: $3,050): For those folks who have an HSA, their employer may also offer a Limited Purpose FSA, which allows you to contribute additional money that can be used for dental and vision expenses only (health care expenses can only be reimbursed from the HSA).
  
• Commuter FSA (2023 Contribution Limit: $300 per month for transit and $300 per month for parking): If your employer offers this, you can use pre-tax money to pay for public transportation, parking or both (so up to $600 per month total if you spend enough on each).

While people generally understand the benefits of using pre-tax dollars to pay for these things, many people have been hesitant to use them because of the “use-it-or-lose-it” provision. Unlike HSAs, which allow you to carry over any unused funds to future years, FSAs generally require you to spend it during your plan year. Anything in the account that you haven’t spent by the end of your plan year is forfeited. Because people often aren’t sure how much they are going to spend each year on out-of-pocket-costs, especially around healthcare, they worry about putting “too much” into their FSAs and ending up losing that money. As a result, many folks simply choose not to contribute to an FSA. For many – probably most – people, I think this is a mistake. Let’s take a look at how FSAs work and two reasons you might not need to be quite as concerned about the use-it-or-lose-it provision.

First, the IRS enables your employer to allow you to carryover some money in your Health Care FSA, Limited Purpose FSA, and Commuter FSA from plan year to plan year (but not your Dependent Care FSA for some reason, but most folks have a pretty decent idea of what their daycare expenses are going to be for the next 12 months). In 2023, the maximum they can allow you to carry over in the Health Care FSA and Limited Purpose FSA is $610, which is 20% of the total limit. That’s pretty good, but it’s important to realize that this is up to each individual employer. Some allow this and some don’t, so it’s very important to know whether your employer does or not. For Commuter FSAs, you can carryover the entire remaining balance if your employer allows it.

Why is this so important? Well, if you’re employer allows you to carryover $610 from year to year, there’s really no reason not to contribute at least $610 to your Health Care of Limited Purpose FSA. Even if you have $0 out-of-pocket expenses this year, the entire amount will carryover to the following year and you will eventually use it. I suppose you could argue that you could lose your job and then be out the money but, in general, I think it’s a pretty safe bet that you will use quite a bit of that and then be able to carryover what’s leftover. Similarly, for commuter benefits you can carryover whatever balance you have left (and, generally, you have a much better idea of what your transit and/or parking expenses are going to be so there shouldn’t be that much left over).

Second, and this actually builds on the above, FSAs come out pre-tax (that’s the whole reason for their existence), so it’s important to take that into account when assessing the risk of “losing” anything you don’t spend. Taxes obviously vary from person to person, but I’ll talk about a typical Coloradoan who is in the 22% federal tax bracket and the (just-lowered) 4.40% flat state tax bracket. But FSA contributions also come out pre-FICA, which means that it comes out before the 1.45% Medicare Tax and the 6.2% Social Security Tax. If you are a public school teacher who is a member of Colorado PERA, you don’t pay into Social Security, but FSA contributions still come out pre-Medicare tax and, if your PERA membership date is prior to June 30, 2019, it also comes out pre-PERA (which is currently 11%).

So, for a typical Coloradoan who pays into Social Security, contributions to any of these FSAs is going to save them 34.05% total on their taxes. If they are a PERA member with a membership date before June 30, 2019, then that goes up to 38.85%. PERA members who joined after June 30, 2019 do not have FSA contributions come out pre-PERA, so they would be saving “only” 27.85%.

Why is this important? Well, let’s use a $100 contribution to an FSA as an easy dollar-amount example. Some people are worried about “losing” that $100 if they don’t spend at least $100 on qualified expenses, but they fail to take into account the tax savings. Even if they spent $0 they still wouldn’t be out $100, they’d only be out $65.95 (Social Security), $61.15 (PERA member prior to 6/30/19), or $72.15 (PERA member after 6/30/19). That means they don’t have to spend at least $100 to come out ahead, they simply need to spend $72.15 at the most, because anything above that that they “lose” is money they’ve already saved on taxes. So even if they only can reimburse themselves for say $80, they don’t lost $20 they actually come out ahead. (And that’s not including any additional tax breaks they may get because these contribution lowered their AGI.)

If you combine that with your employer’s carryover provision (if they offer it), then it gives you much more leeway in terms of perhaps incorrectly estimating your future expenses that would be covered by any of these FSAs. You should still try to make a good estimate of what you will spend in each of these categories, but realize that if you overestimate a little bit you are still likely to come out ahead even if your employer doesn’t offer the carryover provision. And, if they do, then you have a lot of overhead to work with and then you can adjust your contributions the following plan year to account for the beginning balance you already have in the account.

So, if you’ve been hesitant to contribute to any of these FSAs due to the use-it-or-lose it provision, take another look. When you factor in the tax savings and the possibility of carrying some of it over to future years (depending on your employer), you might just realize that you can at least put a minimal amount in one or more of thsee FSAs and see how it goes. Then in future years as you get more comfortable, you could perhaps increase that amount if your expenses justify it.