Advantages and disadvantages of all FSAs

An FSA allows money to be deducted from an employee's paycheck pre-tax and then spent on qualified expenses.

For an example of potential tax savings associated with a flexible spending account, a person in the 28% Federal marginal tax bracket and an example 4% state tax (along with FICA taxes of typically 7.65%, for a total tax of almost 40%), could deduct $2,000 and put that money into an FSA for health care. This would result in almost $800 in tax savings.

If this example person had not utilized the FSA and instead itemized their deductions, they likely would not have been able to deduct this $2,000 expense because it would not have met the 7.5% of Adjusted Gross Income threshold needed to be able to deduct it on their federal tax return. Even if the expenses had met the 7.5% threshold, only the part in excess of 7.5% would count as an itemized deduction; and itemized deductions are only beneficial if they exceed the standard deduction, which is hard to meet unless you have home mortgage interest or large charitable contributions. Finally, expenses for over-the-counter drugs cannot be deducted or counted towards the 7.5% threshold, but they can be paid for by the FSA.

One major drawback is that the money must be spent within the "plan year" as defined by the cafeteria plan (commonly the calendar year), and any money that is left unspent at the end of the plan year is forfeited; this is commonly known as the "use it or lose it" rule. In 2005, the Internal Revenue Service authorized an optional 2½ month grace period that employers can use in their plans, allowing use of the funds for 2½ months after the end of the plan year.

Also, the annual contribution amount must remain the same throughout the year unless certain qualifying events occur, such as birth of a child or death of a spouse.

* Methods of withdrawal from FSAs

In recent years, the FSA debit card was developed to eliminate "double-dipping" by allowing employees to access the FSA directly, as well as to simplify the substantiation requirement which required labor-intensive claims processing; the debit card also enhances the effect of "pre-funding" medical FSAs. However, the substantiation requirement itself did not go away, and has even been expanded on by the IRS for the debit-card environment; therefore, withdrawal issues still remain for FSAs.