- Learn about Flexible Spending Accounts.
- Discover common features of an FSA.
- Learn about FSA allowable medical expenses.
- What happens to unused amounts (use it or lose it)?
- Find information regarding Health Savings Accounts (HSAs).
- Learn about enrollment in Medicare and HSAs.
- Find information about HSA contributions and contribution limits.
- Learn how to use an HSA as a supplemental retirement vehicle.
- Find an FSA-HSA comparison table.
The tax code provides two tax-advantageous plans for taxpayers to pay medical expenses. One is a Flexible Spending Account (FSA) and the other is a Health Savings Account (HSA). Taxpayers often misunderstand and frequently mix up their provisions and then fail to take advantage of the tax benefits available from these accounts.
This article explains the workings, qualifications, and tax benefits of each with a side-by-side comparison chart of the two programs. Both have a common theme: account holders make contributions to both with pre-tax dollars (they reduce taxable income) and pay no tax on distributions to pay qualified medical expenses. After that, the two plans vary quite a bit.
Flexible Spending Accounts (FSAs)
There are three types of FSAs: dependent care assistance, adoption assistance, and medical care reimbursements. This article will only deal with the latter, often referred to as a Health FSA. A Health Flexible Spending Account is part of a qualified cafeteria plan offered by an employer. It allows employees to contribute pre-tax dollars annually for use in paying medical expenses of the employee, their spouse, and dependents during the year. The maximum contribution is annually inflation adjusted, and for 2023 equals $3,050 (up from $2,850 in 2022). In the case of a married couple where each spouse has an FSA account with an employer, both can contribute the maximum.
Since an FSA is an employer plan, an employee cannot take it with them if they leave their employment. Thus, FSAs are not transferrable and cannot be rolled into an individual’s health savings plan.
Common Features of an FSA
People can use funds for health insurance deductibles, copays, medication, and other healthcare-related out-of-pocket costs. For ease of use, most FSA accounts come with a debit card. Employees can spend the money in the account before they fully fund the account if an employee leaves or is terminated. A reimbursement may be requested by the former employee for expenses incurred before the date employment ceased for a period determined by the plan, and if reimbursements have been made in excess of employee contributions, they are not recoverable by the employer.
FSA allowable medical expenses include those for:
- The diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body,
- Prescription Drugs,
- Medication available without a prescription (an over-the-counter medicine or drug that is prescribed),
- Transportation primarily for and essential to medical care,
- Supplementary medical insurance for the aged,
- Feminine menstrual products, and
- Personal Protective Equipment (COVID)
No Double Dipping
Taxpayers cannot claim medical expenses reimbursed from the FSA as a Schedule A medical itemized deduction.
Unused Amounts (Use It or Lose It)
Employees generally forfeit unused amounts at the plan’s year-end. However, a plan can have either:
- A grace period of up to 2½ months after the end of the plan year in which to use up the unused amount or
- Allow up to 20% of the annual contribution limit ($610 for 2023) of unused amounts from the end of the plan year used to pay or reimburse qualified medical expenses in the following year.
Account holders forfeit unused amounts other than the carryover amounts (they cannot be returned to the employee). The carryover amount does not reduce the maximum contribution amount allowed for the carryover year.
FSA participants need to pay close attention to their FSA account balances to ensure they do not forfeit any funds at year’s end.
Health Saving Accounts (HSAs)
Individuals must meet the following requirements to contribute to an HSA:
- Not claimed as a dependent on anyone else’s tax return.
- Not enrolled in Medicare.
- Covered under a high-deductible health plan (HDHP) and not covered under any other health plan which is not an HDHP, unless the other coverage is permitted insurance or coverage for accidents, disability, dental care, vision care, or long-term care.
Enrolled in Medicare
The IRS has interpreted being “enrolled in Medicare” to mean both eligibility for and enrollment in Medicare. An individual who is otherwise eligible, but who is not enrolled in Medicare Part A, may contribute to an HSA until the month enrolled in Medicare.
Covered Under a High-Deductible Health Plan
HDHPs come in two varieties: Self-Only plans and Family plans. Use the flow chart below to determine if a plan qualifies as a high-deductible health plan.
HSA Contributions and Contribution Limits
Individuals may establish an HSA either independently or with their employer. If made with an employer, and the individual subsequently leaves the employment, the individual can roll the funds into their own HSA or take a taxable distribution subject to a 20% penalty.
In addition to the individual, others can make contributions to the HSA, including employers as well as other persons (e.g., family members) subject to the annual inflation-adjusted contribution limits. Those limits for 2023 are:
- $3,850 for self-only coverage
- $7,750 for family coverage
- $1,000 additional amount for those aged 55 and older.
An account holder gets the deduction for contributions to his HSA even if someone else (e.g., a family member) makes the contributions. Employer contributions to an HSA are excluded from the employee's income – so employees cannot deduct these contributions on their tax returns. Distributions for qualifying medical expenses are tax-free.
HSA Allowable Medical Expenses
Generally, the eligible medical expenses are the same as those allowed for FSAs. The qualified medical expenses must be incurred only after the HSA has been established. Account holders cannot claim medical expenses paid or reimbursed by HSA distributions as medical expenses for itemized deduction purposes.
HSA as a Supplemental Retirement Vehicle
Establishing and contributing to an HSA can be more than just a way for individuals to save taxes and gain control over their medical care expenditures. You can also use an HSA as a retirement vehicle, especially for taxpayers who max out their other retirement plan options or who can’t contribute to an IRA because of income limitations.
There is no requirement that medical expenses must be paid or reimbursed from the HSA. So, a taxpayer can maximize tax-free growth in the account by using funds from other sources to pay routine medical costs. Later, account holders can use distributions tax-free to pay post-retirement medical expenses. Or, if used for non-medical purposes, a retiree aged 65 or older will pay income tax on the distribution, but not a penalty. Those younger than 65 who use their HSA funds for other than qualified medical purposes pay a penalty of 20% of the amount distributed in addition to income tax on the distribution. Unlike IRAs, account holders do not have to take minimum distributions from an HSA at any specific age.
FSA-HSA Comparison Table
The following table compares the key differences between Health Flexible Spending Accounts and Health Savings Accounts:
As you can see, either an FSA or HSA can help you pay your out-of-pocket medical expenses. On top of that, you can make contributions on a pre-tax basis directly reducing your taxable income. If in an employer plan, in addition to reducing your taxable income, contributions reduce payroll taxes. Plus an HSA can be a supplemental retirement vehicle.