Flexible spending accounts (FSAs), sometimes called reimbursement accounts, are accounts set up by employers. These accounts allow employees to make annual, pre-tax contributions that can be used to pay for certain health care and dependent care expenses that are not paid for by insurance companies. FSAs are offered under the umbrella of cafeteria benefit plans and are sometimes called cafeteria plans. FSAs must comply with all applicable rules and regulations governing benefits under cafeteria plans.


Employers must establish flexible spending accounts so that they comply with all applicable federal legislation. Once an FSA is established, employees have the opportunity to sign up for the plan during the annual "open enrollment" period. During the sign-up period that precedes the plan year, employees must estimate the relevant costs they are likely to incur during the year and indicate the amount of money they want set aside in the FSA for the year. Usually, the money is set aside using regular payroll deductions from the employee's paychecks. The deductions from employees' wages are pre-tax, thus reducing the employee's tax liability. Employees must carefully consider the amount they elect to contribute to the FSA, because amounts unused at the end of the plan year cannot be carried over to the next year and are forfeited by the employee if a balance remains at the end of the year. There is no legal limit to the annual amount that can be set aside, but employers can set their own limit if they wish.

As employees incur eligible expenses throughout the plan year, they must obtain and retain all receipts and documentation. Employees then provide required documentation that they have incurred eligible expenses (usually by providing receipts for the expenditures) and are reimbursed from the accumulated money in their account. Employees can turn in requests for reimbursement throughout the plan year or save all their documentation and turn in their request at the end of the plan year. Utilizing a flexible spending account requires employees to carefully plan and estimate their expenses. Flexible spending accounts can result in tax savings for both employers and participating employees, and can also result in greater understanding on the part of employees as to the cost of their health care and their responsibility for planning and budgeting to meet the cost. Recent innovations in FSAs include the introduction of debit cards by some employers. These debit cards allow employees to obtain immediate reimbursement for eligible expenses rather than compiling receipts and documentation, submitting the paperwork, and waiting for the employer to cut them a check.


Flexible spending accounts can be used to pay for eligible costs related to health care and dependent care for children or elderly parents. FSAs cover insurance premiums, deductibles, co-payments, prescription drugs, and many health-related expenses not covered by an employee's health insurance. For example, employees can pay for procedures and items such as laser eye surgery, orthodontia, hearing aids, and contact lenses with their FSAs. Flexible spending accounts can also be used to pay for certain expenses related to child and elder care. In 2003, the government expanded the drug coverage under FSAs to include certain types of over-the-counter drugs, such as pain relievers, cold medicines, nicotine patches, and allergy medications.


The United States Congress passed Internal Revenue Code Section 125 in the late 1970s. Section 125 allows employers to offer cafeteria plans to their employees. Such a plan allows employees to choose, from among a menu of optional benefits, those that best fit their individual needs; thus, employees can customize their benefit packages. To be in compliance with Section 125, all the participants in the plan must be employees and the plan must allow employees to choose among cash and qualified benefits. When an employee elects to receive an optional benefit under a cafeteria plan, there are tax advantages to both the employer and employee. Since the employee's taxable income is reduced, the employer pays less Federal Insurance Contributions Act (FICA) tax. The employee subsequently pays less FICA and state/federal income tax. Employees' choices of optional benefits are limited only by the total benefit dollars available and the variety of benefits offered by the employer. Benefits that can be included in a Section 125 cafeteria plan include, among others:

Although flexible spending accounts have been available since the enactment of Section 125 in the late 1970s, for many years employers didn't offer them and only a small percentage of eligible employees utilized them. There were various reasons for their lack of popularity. Employers were initially put off by what they perceived as the complexity and administrative costs associated with cafeteria plans in general, and flexible spending accounts in particular. Employees were reluctant to participate because of the forfeiture rule, which requires a participating employee to "use or lose" the funds set aside in the FSA each year. The advent and spread of managed care plans, such as health maintenance organizations (HMOs) and preferred provider organizations (PPOs) in the 1980s and 1990s, also hampered the growth of flexible spending accounts. Managed care plans often included a low (or no) deductible, low co-payments, and coverage for preventive care. Employees' "out-of-pocket" health care expenses were often reduced; thus there was less incentive for employees to set aside money to cover non-reimbursed medical or dependent care expenses.

Rising health care costs and dissatisfaction with managed care plans in the 1990s and early 2000s however, caused many organizations to look for ways to cut health care costs. Many found it necessary to raise the premiums employees pay for health insurance, the deductible employees pay before health expenditures are covered, and the co-payments that employees pay once deductibles are met. Thus, employees' out-of-pocket expenses rose. The flexible spending account offers a way for employees to cover some of these extra expenses with pre-tax dollars, which lowers their out-of-pocket expenses. For example, if an employee had $2,500 a year of non-reimbursed medical expenses, and an FSA plan, they could set aside this amount from pre-tax earnings. Depending on the employee's overall tax rate, this could save the employee 25 to 35 percent in state and federal taxes, in addition to FICA savings. Employers offering FSAs also benefit, because employee contributions to an FSA reduce the amount of FICA taxes employers pay on their behalf. Because of this, a large percentage of employers now offer FSAs and similar types of accounts such as medical savings accounts and health savings accounts, with a large percentage of eligible employees taking part in this benefit.

A 2004 survey by the Society for Human Resource Management found that over 70 percent of member organizations offer flexible spending accounts as part of a cafeteria benefits plan. Small employers however, are much less likely to offer such plans. For example, one Bureau of Labor Statistics report estimated that only 4 percent of employers with fewer than 100 employees offer flexible spending accounts.


Flexible spending accounts are similar to, but very different from, health savings accounts (HSAs). Flexible spending accounts have been available since the 1970s, although they have not always been widely utilized. Health savings accounts were created in 2003. Flexible spending accounts can be offered in conjunction with just about any type of medical insurance coverage because they are designed to cover expenses not otherwise covered. Health savings accounts, on the other hand, can only be offered as part of a "high deductible" insurance plan. The high-deductible plan must have a minimum $1,000 deductible for single employees and a $2,000 deductible for families. In addition, flexible spending plans basically allow employees to contribute up to an employer-specified maximum to their FSA each year. HSAs, limit employee contributions to the amount of the deductible in their health insurance plan. The contribution levels were initially capped at $2,600 for single employees and $5,150 for families. The deductible and contribution limits will increase over time, as they are tied to measures of inflation.

Perhaps the largest difference between flexible spending accounts and health savings accounts is in the way unused funds in the accounts are handled. Funds left unused in the FSA after the plan year ends are forfeited by the employee, which accounts for the largest drawback to their use. Health savings account contributions, in contrast, can be rolled over from year to year; thus, amounts left unused in one plan year can be applied to expenses incurred in a successive year. This is a major advantage of HSAs as opposed to FSAs.

Employers will likely continue to offer flexible spending accounts as a means to allow employees to better manage their health-care expenditures. However, the advent of health savings accounts in 2003, and another recent innovation—the health reimbursement account (HRA)—have both increased and complicated the choices available to employers and employees. Employers have the difficult choice of which plan to offer to employees, and employees have a difficult choice as to which of these plans best fit their needs. The federal government has provided guidance and illustration to employers to help them see the advantages and disadvantages of each plan. Employers have the responsibility of fully communicating to employees the range of options available to them and the strengths and weaknesses of each. The Human Resources department in the organization should take the lead in educating employees as to the opportunities available to them so that employees can make informed choices as they attempt to maintain quality health coverage at an affordable cost.

SEE ALSO: Employee Benefits ; Health Savings Accounts

Tim Barnett


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