The Internal Revenue Service permits employers to offer their employees flexible spending accounts (FSAs) as part of their employee benefit packages. If an employee chooses to participate in a medical FSA, he contributes pre-tax dollars to cover the cost of expenses he expects to incur during the year for which he'll receive no other means of reimbursement. If a worker fails to exhaust the pre-tax funds in an FSA, he forfeits the remaining balance by a deadline identified by either his employer or the IRS.
To fund an FSA, an employee chooses to defer a certain amount of his salary over the course of the benefit plan year. His employer then reduces the employee’s compensation in equal increments for each pay period to equal the total amount the employee wanted to contribute to his FSA for the year.
Once an employee commits to setting aside a certain amount, he cannot change his election until the next plan year unless he experiences a life-changing event. Such occurrences include job loss, the birth or adoption of a child, marriage and divorce.
The IRS allows employers to contribute to FSAs on behalf of their participating employees. While the IRS does not limit the amount an employee or employer may contribute, it requires an FSA plan to establish an annual maximum contribution amount.
An employee receives a distribution from his FSA when he incurs a medical expense for which he does not receive reimbursement from any other source such as a health insurance provider. An employer releases funds from an employee’s FSA when the employee documents an incident of medical expenditure, not when an employee presents a cost projection for future treatment.
The IRS mandates that an FSA plan allow an employee to access the total amount he intends to dedicate to his FSA at any point of the plan year regardless of how much he has contributed to date. For example, if an employee pledges to defer $600 to his FSA over the course of a year with $50 being contributed from each of his monthly paychecks and incurs a medical bill of $500 during the first month of the plan year, the IRS requires his employer to make $500 of FSA funds available to cover his expense at that time even though the employee has deferred only $50 up to that point.
The IRS requires an employee to exhaust the funds in his medical FSA by two months and 15 days after the end of the plan’s year or risk forfeiting his account’s balance. The guidelines included in an employer plan take precedence, however, and may require an employee to use the money in his FSA by the end of the plan’s year to avoid forfeiting any remaining funds.
Generally, an employee may use his FSA to cover expenses included in IRS Publication 502 paid on behalf of himself, his spouse and family members claimed as dependents on his federal tax return. The IRS does not allow FSA funds to pay for health insurance premiums or expenses arising from someone’s long-term care.
Reversing a 2003 ruling, the IRS does not allow employees to use FSA funds to cover the cost of over-the-counter medication, except insulin, as of 2011.