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You might have heard about the mysterious “dependent care account” or “flexible spending account” at work.
While you may understand how a health savings arrangement, or HSA, works, FSAs can be confusing. How do FSAs work? And what’s the difference between an FSA you use for healthcare costs and one you use for dependent care costs?
Let’s look at these accounts, how they work, and how they could help you pay for certain expenses — like childcare and some healthcare costs — tax-free.
The “A” in FSA actually stands for “arrangement,” not “account.” A flexible spending arrangement is a benefit that employers can choose to offer their employees.
Generally, FSAs can be used to reimburse costs for dependent care, adoption or medical care — but you can’t do all three with one FSA. A dependent care FSA is specifically intended to pay for dependent care expenses, while a healthcare FSA is for paying qualified medical costs.
FSAs are only available through an employer, and employers are not required to offer them. In fact, according to the Bureau of Labor Statistics, just 36% of workers in the private sector had access to a dependent care FSA in 2014. And in 2015, 59% of private-sector workers had healthcare FSAs.
Since you can’t shop around for an FSA the way you can with a bank account, it’s important to “choose your employer wisely,” advises Lesley Pearson, a CPA and blogger at Stronger Wallet.
“Make sure you understand the fringe benefits available to you from your employer,” Pearson advises.
How FSAs work
If your employer offers FSAs, you’ll need to speak with your benefits coordinator to set up deductions from each paycheck that will be funneled into your FSA account.
Here’s how the process typically works for both healthcare and dependent care FSAs.
- Your employer offers a flexible spending arrangement as part of a “cafeteria plan” — a benefits plan maintained by your employer that meets specific requirements of the Internal Revenue Code.
- You decide how much of your salary (within limits) you want to put into the arrangement and what type of FSA you want — healthcare or dependent care.
- Your salary is reduced by the amount you decided, and instead of paying those wages, your employer puts the funds into your FSA. Because of this arrangement, neither you nor your employer has to pay federal taxes on that money.
- You use the funds in your FSA to pay for qualified expenses.
Here’s an example of how FSA contributions could reduce your income — and, therefore, your tax obligations.
Imagine your annual salary is $50,000 per year. You elect to put $5,000 into your dependent care FSA. At the end of the year, when you get your W-2 from your employer, it will show taxable income of $45,000 and an FSA contribution of $5,000 — which you won’t pay taxes on.
If you’re married filing jointly and have three dependents, this would mean you could save $600 in federal income taxes!
To calculate how much you could save, you can use this calculator.
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Using your dependent care FSA money
It’s important to understand what you can use your FSA funds for. It’s a good idea to talk to your benefits administrator for information about qualified expenses you can pay with your FSA, and how that payment will occur.
For example, some accounts allow you to use a special debit card, while others require you to spend the money first out of your own pocket and then file for a reimbursement.
Generally, you can use a dependent care FSA to pay for qualified expenses for …
- A qualifying child younger than 13 who is your dependent
- A disabled spouse who isn’t able to care for themselves
- Any disabled person who can’t care for themselves and whom you claim as a dependent (provided they had gross income of less than $4,050, didn’t file a joint return, and neither of you can be claimed as a dependent on someone else’s return)
The types of expenses that can qualify for payment through a dependent care FSA include …
- The costs of care for a child or other qualifying dependent while you worked or actively looked for work
- Maid, housekeeper, cleaning person, babysitter or cook if part of their job included caring for a qualifying person (including your share of their employment taxes)
- Daycare center costs
- Day camp (but not sleep-away camp)
Limits on the amount you can contribute to a dependent care FSA are generally $5,000 per year ($2,500 for people who are married filing separately). However, you can’t contribute more than you (or your spouse, if you’re married) earned that year.
Using your healthcare FSA
When you sign up for an FSA, you’re required to pledge a certain amount of cash from each paycheck to go to the account. In 2018, you can save up to $2,650 per year in a healthcare FSA. That means if you’re paid biweekly, you can save up to $101.92 from each paycheck into this account.
One of the odd (but very nice) quirks of this account is that you will still have access to the full amount you elected to contribute for the year, even if you haven’t contributed enough to your healthcare FSA to cover the cost yet.
For example, let’s say you need to have a surgery done, but it’s only February and you’ve only got $400 saved so far. If you’ve elected to make a full contribution of $2,650 for that year, you can go ahead and receive up to $2,650 now to cover your qualifying surgical costs, while you continue to make your contributions throughout that year.
In this way, “FSAs can be really helpful in cash flow planning” and avoiding medical debt, Pearson says.
You can use your healthcare FSA to pay for a wide range of medical expenses. Generally, anything that would be deductible as a medical expense under the Tax Code can be paid for with an FSA. Here’s just a small list of things that could qualify.
- Doctor visits and procedures (including with dentists and eye doctors)
- Contact lenses and solution
- Fertility treatment
- Mental healthcare
- Weight-loss programs (if a doctor prescribes it)
- Over-the-counter medications only with a doctor’s prescription
It’s important to note that healthcare FSAs are not the same as health savings accounts. They are different in many ways, including that anyone with a high-deductible health insurance plan can open an HSA, while FSAs are only available through employers. You can read more about both types of accounts in IRS Publication 969.
Key differences between flexible spending arrangements and health savings accounts
What are some key differences between healthcare flexible spending arrangements and health savings accounts?
- FSAs are only available through employer benefits plans, but any qualified person with a high-deductible health insurance plan can set up an HSA for themselves. Employers often offer HSAs to workers with high-deductible plans.
- Anyone whose employer offers an FSA can open one, regardless of the type of health plan they have.
- FSAs reduce your total income before you have to pay taxes on it. However, the amount you contribute to an HSAs gets deducted from your taxes.
- If you change jobs, you can take your HSA with you. It’s not tied to your employer. Since an FSA is offered only through an employer, you can’t take it with you when you switch jobs.
- Contribution limits differ.
- HSAs are not “use-it-or-lose-it.” If you have money left in the account at the end of the year, you can carry it over to the next year. Generally, if you don’t use all your FSA money, you’ll lose it because it won’t carry over to the new year. Note that some employers may allow you to rollover up to $500 of your FSA from year to year.
A game plan for using your FSA
The most important thing to know about FSAs is that they are “use-it-or-lose-it” accounts. If you don’t use up all the money in your account by the end of the year (with some exceptions), you forfeit the remaining money in the account.
However, some employers may allow you to carry over up to $500, or give you a two-and-a-half-month grace period to use remaining money at the end of the year.
At this point, you might be wondering if these accounts are even worth it, considering all the rules and the horrifying possibility that you could lose all your money at the end of the year. Don’t give up just yet!
FSAs can be beneficial if you understand how FSAs work and develop a game plan for using them.
First, you’ll need to make sure you understand how your FSA works. You can request your plan documents from your workplace benefits coordinator, or the company that administers your account. Take the time to read through the fine print.
Estimating how much to save
Next, consider how much you should save in your account.
“Most of us have some predictable, ongoing out-of-pocket expenses, and those recurring items can be used to determine how much you contribute to your FSA,” says Pearson.
For example, if you know your daycare center charges $150 a week, and that you’ll need care for 30 weeks in a year, you’ll want to put $4,500 (150 x 30) into your dependent care FSA. If you’re paid twice a month and you want to distribute your FSA withholdings throughout the whole year, you’ll need to elect to have $187.50 set aside from each paycheck ($4,500 / 24 paychecks = $187.50).
This approach can help ensure you spend all the money you save.
One thing’s for certain, says Pearson. “You don’t want to end up with unused funds at the end of the year.”
If you have a healthcare FSA and you still have some unused funds at the end of the year, you might be able to spend your funds through an online FSA store. Check with your benefits manager to see if you can do this.
Flexible spending arrangements can be a great way to reduce your taxable income — which means lower taxes — while saving money to pay for necessary expenses like childcare and healthcare costs. Just be sure you understand all the rules and requirements of your arrangement and have a game plan in place to ensure you use every dollar in your FSA before the deadline.