Flexible spending accounts: What are they & how do they work?

An FSA is a tool some employers offer that allows employees to set aside pretax dollars to pay for certain out-of-pocket expenses. There are two types of FSAs: one for health care costs and one for dependent and child care expenses.

Since the money used to fund an FSA is pretax—meaning it's taken from your paycheck before deducting taxes—you can save on federal and state income and payroll taxes. And as long as you use the money to pay for eligible expenses, returns and withdrawals from the account are tax-free.

If your employer offers an FSA as part of its benefits package, you need to be aware of a few rules and requirements.

You can participate in an FSA by enrolling with your benefits department during open enrollment season and determining how much you want to contribute to the account each year. Your employer sets the maximum amount you can contribute. However, it can't be more than the IRS limit.

2024 contribution limits:

• $3,200 to a health care FSA
• $5,000 to a dependent care FSA (DCFSA)

An FSA isn't a savings account. Any unused money in your account goes back to your employer if you leave your job. FSAs also have "use it or lose it" rules. You may forfeit the remaining amount to your employer if you don't use all the funds you've contributed to your account by year-end.

This is the primary difference between FSAs and health savings accounts (HSAs). Unlike an FSA, an HSA belongs to you. You can take an HSA with you if you leave your employer, and there's no timeline for spending the money. If you don't need it to cover your current health care costs, you can hold onto it indefinitely and benefit from tax-free growth.

However, your employer might offer options to help you avoid losing FSA money, such as:

• FSA carryovers. If your plan allows it, you can carry over up to $640 from your FSA for taxable years beginning in 2024 (a $30 increase from 2023) and still contribute the maximum amount to your account the following year. IRS rules don't allow carryovers of DCFSA funds.

• FSA grace period. Some plans—both health care FSAs and DCFSAs—provide a grace period, giving you an extra two and a half months to spend your FSA funds after the end of the plan year.

Your employer may offer either a carryover or a grace period but not both.

For withdrawals from an FSA to be tax-free, you must spend the money on qualified expenses.

For health care FSAs, qualified expenses generally include out-of-pocket medical expenses for you, your spouse and any dependents you claim on your tax return. You can find the complete list of eligible medical expenses in IRS Publication 502, but some common ones include:

• Contact lenses and supplies and eyeglasses
• Dental treatments
• Doctor visit copays
• Eye exams
• Fertility treatments
• Hearing aids
• Hospital and emergency room fees
• Lab fees
• Long-term care expenses
• Medical supplies and equipment, including bandages, crutches and blood-sugar monitors
• Medicine—both prescription and over-the-counter
• Mental health counseling
• Transportation to and from medical care

• Adult day care center fees
• Au pair or nanny wages
• Before- or after-school program fees
• Child care costs (as long as you're paying for the care to work or look for work)
• Day camps
• Preschool tuition

If this is your first time contributing to an FSA, you may wonder how much to contribute. Estimating dependent expenses is usually simple—many working adults with young children or dependent family members spend more than the $5,000 contribution limit on those expenses, so you may want to contribute the maximum allowed.

Here are three steps to help you decide how much to contribute.

If you and your family are blessed with good health, your routine out-of-pocket medical expenses might include copays for annual doctor's visits and dental cleanings, a year's worth of prescriptions and new glasses or contacts.

If you have medical conditions requiring extra doctor's visits or supplies, you may want to bump up your contribution to cover those expenses, too.

If you're a new parent or planning to start a family soon, your health care and child care expenses may increase. Factor potential costs, such as hospital fees, pediatrician appointments and day care, into your FSA contributions.

If your child is aging out of day care or reaching adulthood and won't be a dependent anymore, you may want to decrease your contribution to account for that change.

If medical expenses were routine and predictable, deciding how much to contribute to your FSA could be simple. However, broken bones, sudden chest pains and other accidents or illnesses can happen anytime. If you've taken into account predictable expenses and haven't yet maxed out your contribution limit, you might want to contribute a little extra to cover the unexpected.

If you don't use it up by year-end and your plan allows it, you can carry the funds to next year or use them during the grace period. Otherwise, you can use the remaining dollars to stock up on over-the-counter medications and supplies.

No matter how much you set aside, contributing to an FSA can be a prudent way to pay for health and dependent care expenses for you and your family. Connect with a local financial advisor to learn more about FSAs and how they might fit into your family's financial plans.