Key Takeaways
- Flexible Spending Accounts (FSAs) allow employees to set aside pre-tax dollars for qualified medical, dependent care, or limited-purpose expenses.
- Health FSAs have a "use it or lose it" rule — unused funds are forfeited at year-end, subject to a limited carryover or grace period option.
- Dependent Care FSAs (DCFSAs) cover childcare and elder care expenses — a highly valued benefit for working parents that costs the employer nothing beyond payroll tax savings.
- Limited-Purpose FSAs cover only dental and vision expenses and are compatible with HSA eligibility — allowing HDHP/HSA participants to also use an FSA.
- Employers keep forfeited FSA funds — but most use them to offset plan administration costs rather than as a profit center.
Types of FSAs
There are three main types of Flexible Spending Accounts, each with different eligible expenses, contribution limits, and compatibility rules:
| FSA Type | Eligible Expenses | 2025 Limit | HSA Compatible? |
|---|---|---|---|
| Health FSA | Medical, dental, vision, Rx | $3,300 | No (disqualifies HSA) |
| Limited-Purpose FSA | Dental and vision only | $3,300 | Yes |
| Dependent Care FSA (DCFSA) | Childcare, elder care, day camp | $5,000 ($2,500 if MFS) | Yes |
The Health FSA and the HSA cannot coexist for the same employee — a general-purpose Health FSA disqualifies HSA eligibility. Employers offering both an HDHP/HSA and a traditional plan must be careful about FSA design: employees enrolled in the HDHP should be offered only a Limited-Purpose FSA, while employees on the traditional plan can use a general Health FSA.
Health FSA: How It Works
A Health FSA is a pre-tax account funded by employee salary deferrals (and optionally employer contributions) that can be used for qualified medical expenses. The key features are:
- Uniform coverage rule: The full annual election amount is available on day one of the plan year — even if the employee has not yet contributed that amount through payroll deductions. This is a significant advantage over HSAs, where funds must be contributed before they can be used.
- Use it or lose it: Unused funds at year-end are forfeited. Employers may offer a grace period (up to 2.5 months after year-end) or a carryover (up to $660 in 2025) — but not both.
- Employer contributions: Employers may contribute to employee Health FSAs. Employer contributions do not count against the employee's contribution limit.
- Qualified expenses: IRS Publication 502 defines qualified medical expenses — including deductibles, copays, prescription drugs, dental care, vision care, and many over-the-counter items.
- Substantiation: FSA claims must be substantiated — employees must provide documentation that the expense was a qualified medical expense.
Dependent Care FSA: The Underutilized Benefit
The Dependent Care FSA is one of the most valuable and underutilized benefits in the employer toolkit. It allows employees to pay for childcare, elder care, and day camp expenses with pre-tax dollars — saving 25 to 35% on costs that most working parents are already incurring.
- Eligible expenses: Licensed daycare centers, in-home childcare, before- and after-school programs, summer day camps, and elder care for a dependent who is physically or mentally incapable of self-care.
- Contribution limit: $5,000 per household ($2,500 if married filing separately). This limit has not been indexed for inflation since 1986 — it covers a fraction of actual childcare costs in most markets.
- Tax savings: An employee in the 22% federal bracket saves $1,100 in federal income tax plus $382 in FICA taxes on a $5,000 DCFSA contribution — a total of $1,482 in annual tax savings.
- Employer FICA savings: The employer saves 7.65% in FICA taxes on DCFSA contributions — approximately $382 per employee contributing the maximum. For a 100-employee company with 30 DCFSA participants, this is over $11,000 in annual employer FICA savings.
- No uniform coverage rule: Unlike Health FSAs, DCFSA funds must be in the account before they can be used. Employees cannot front-load DCFSA claims.
Many employers offer DCFSAs but fail to communicate their value effectively. A simple annual communication showing the tax savings calculation — "a $5,000 DCFSA contribution saves you $1,482 in taxes" — dramatically increases enrollment. DCFSA enrollment rates at well-communicated programs are 40 to 60% higher than at programs with minimal communication.
Limited-Purpose FSA: The HSA Companion
A Limited-Purpose FSA covers only dental and vision expenses — making it compatible with HSA eligibility. It allows HDHP/HSA participants to use pre-tax FSA dollars for dental and vision costs while preserving their HSA for medical expenses and long-term savings.
- Eligible expenses: Dental care (cleanings, fillings, orthodontia), vision care (exams, glasses, contacts, LASIK), and vision correction surgery.
- Contribution limit: Same as the Health FSA — $3,300 in 2025.
- HSA compatibility: A Limited-Purpose FSA does not disqualify HSA eligibility because it does not cover medical expenses.
- Strategy: Employees who maximize their HSA contributions can use the Limited-Purpose FSA to cover predictable dental and vision costs — keeping their HSA funds invested for long-term growth.
FSA Administration and Compliance
FSAs must be offered through a Section 125 cafeteria plan. Key administrative and compliance requirements include:
- Section 125 plan document: The employer must maintain a written cafeteria plan document that describes the FSA benefits, contribution limits, and election procedures.
- Non-discrimination testing: Health FSAs and DCFSAs must pass annual non-discrimination tests to ensure the plan does not disproportionately benefit highly compensated employees.
- Election irrevocability: FSA elections are generally irrevocable during the plan year — employees cannot change their election except upon a qualifying life event (marriage, divorce, birth, change in employment status).
- Forfeiture handling: Forfeited FSA funds belong to the employer. Most employers use forfeitures to offset plan administration costs. Forfeitures cannot be returned to employees as cash.
- COBRA: Health FSAs are subject to COBRA continuation requirements. Employees who lose coverage mid-year may elect COBRA for the FSA if they have a positive balance.
Your Action Steps
- 1Confirm your FSA plan document is current and includes all three FSA types you offer — Health FSA, Limited-Purpose FSA, and DCFSA.
- 2Review your FSA carryover or grace period election — confirm you have chosen one option (not both) and that it is documented in the plan.
- 3Calculate DCFSA enrollment rates — if below 30%, develop a targeted communication campaign showing the tax savings calculation.
- 4Verify that employees enrolled in your HDHP are offered only a Limited-Purpose FSA — not a general Health FSA that would disqualify their HSA eligibility.
- 5Confirm your FSA administrator is conducting annual non-discrimination testing and providing results before year-end.
- 6Review forfeiture handling — confirm forfeitures are being used to offset plan costs and are not being distributed to employees as cash.
Knowledge Check
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