Flexible Spending Account (FSA): What It Means for Employers

What it means in practice

A health FSA is set up by an employer. According to IRS Publication 969, employees contribute through a salary reduction agreement, and the employer may also contribute if the plan provides for it. The publication states that you do not pay federal income tax or employment taxes on the salary you contribute. That is why an FSA changes how a paycheck is calculated: the contribution is taken out of gross income before taxes are figured, which affects net pay, and it has to be handled correctly in every payroll run. Because employment taxes are not owed on the contributed amount, it also bears on FICA wages.

The cafeteria plan behind the FSA. Most FSAs sit inside a cafeteria plan under Internal Revenue Code section 125. IRS Publication 15-B describes a cafeteria plan as one that lets participants choose among qualified benefits on a pre-tax basis, and it states that a cafeteria plan generally cannot include a benefit that defers pay. Notice 2013-71 adds that a section 125 plan must be a written plan maintained by an employer, and that every participant must be an employee. Publication 15-B says not to treat a 2% shareholder of an S corporation as an employee for this purpose. Publication 969 separately says self-employed persons are not eligible for FSAs.

The yearly salary reduction limit. The IRS sets a yearly cap on what an employee may elect to contribute. For cafeteria plan years beginning in 2026, the IRS announced the health FSA salary reduction limit as $3,400, a $100 increase, and Publication 15-B says a cafeteria plan may not allow an employee to request salary reduction contributions for a health FSA above that amount. The same publication warns that a plan that does not limit health FSA contributions to the cap is not a cafeteria plan, and all benefits under it become includible in income. Publication 969 gives $3,300 for 2025.

How contributions work. Publication 969 explains that the employee chooses an amount at the start of the plan year, and the employer withholds it from pay in installments under that election. An election can be changed or revoked only if specifically allowed by law and by the plan. Notice 2013-71 adds that elections generally must be made before the start of the plan year, with limited exceptions such as certain changes in status.

Money is available early (uniform coverage). Publication 969 says the maximum amount you can receive tax free is the total you elected to contribute for the year, and that the FSA can pay qualified expenses even if funds have not yet been credited. Notice 2013-71 calls this the uniform coverage rule: the maximum reimbursement, including salary reduction and any nonelective employer credits, must be available for claims incurred at all times during the coverage period, reduced as of any point for prior reimbursements in the same period.

Worked example, early availability. An employee elects the 2026 maximum of $3,400. Over 26 biweekly paychecks that is about $130.77 each. If the employee incurs a $1,200 eligible expense in the first month of the plan year, the plan must be able to reimburse it even though only one paycheck of withholding has occurred. After that reimbursement, $3,400 minus $1,200 leaves $2,200 available for the rest of the coverage period.

What the FSA can reimburse. Under Publication 969, distributions must be paid only to reimburse qualified medical expenses incurred during the coverage period. The plan specifies the expenses, which must generally qualify for the medical and dental expense deduction. The publication lists over-the-counter medicine, whether or not prescribed, and menstrual care products as covered. Covered people include the employee, spouse, claimed dependents, and a child under age 27 at the end of the tax year. Health insurance premiums, long-term care, and amounts covered under another health plan are not reimbursable. The FSA cannot make advance reimbursements of future or projected expenses.

Substantiation and debit cards. To be reimbursed, the employee must give the FSA a written statement from an independent third party showing the expense was incurred and its amount, plus a statement that no other health plan paid for it. Publication 969 adds that employer-provided debit, credit or stored value cards can be used to reimburse participants, and that certain substantiation methods may avoid asking for further information. On the employee side, Publication 502 says amounts fully reimbursed by an FSA cannot be included as medical expenses.

Use-it-or-lose-it, grace period and carryover. Publication 969 describes FSAs as generally "use-it-or-lose-it" plans: unused amounts generally cannot carry into the next year. Two optional relief rules exist, and a plan may adopt one but not both. Under the grace period rule, a plan may allow up to two months and 15 days after the plan year ends for expenses to be paid from the prior year balance (Notice 2013-71). For a calendar-year plan that is through March 15. Under the carryover rule, a plan may allow a limited amount of unused money to be used for expenses in the next plan year. The employer is not permitted to refund any part of the balance to the employee, and a plan cannot cash out or convert unused health FSA amounts to another benefit.

The carryover maximum. Notice 2013-71 set the carryover at $500. Notice 2020-33 indexed it to 20 percent of the section 125(i) salary reduction limit, in multiples of $10 because the limit rises in $50 steps. For 2026, 20 percent of $3,400 is $680, matching the IRS inflation release; for 2025, the figure is $660 per Publication 969 (20 percent of $3,300). The plan may set a lower maximum or no carryover at all, and the same limit must apply to all participants. The carryover does not reduce the amount an employee may elect to contribute for the new year.

Worked example, carryover. Suppose a calendar-year plan permits the full $680. At the end of the plan year, after reimbursements during the run-out period, an employee has $900 unused. The carryover is the lesser of the unused amount or the plan maximum, so $680 carries over and $220 is forfeited. If the employee elects $3,400 for the new year, up to $4,080 ($3,400 plus $680) can be available for claims incurred that year, consistent with the example in Notice 2013-71, which added a carried-over $450 to a $2,500 election for $2,950 available.

Run-out period. Notice 2013-71 defines a run-out period as the period right after the plan year ends during which a participant can submit claims for expenses incurred in that plan year. Unused amounts are measured after claims are reimbursed at the end of the run-out period. A run-out can also follow a grace period. The notices reviewed do not set a length for the run-out period.

Written plan amendments. Notice 2013-71 requires that a cafeteria plan be amended to set out a carryover. The amendment must be adopted on or before the last day of the plan year from which amounts may be carried over, and it may be effective retroactively to the first day of that plan year if the plan operates accordingly and informs participants. A plan that currently has a grace period and adds a carryover must also be amended to eliminate the grace period by the end of the plan year from which amounts are carried over.

Leaving the job. Notices 2013-71 and 2020-33 state that any unused amount in a participant's health FSA at termination of employment is forfeited, unless, if applicable, the employee elects COBRA continuation coverage for the health FSA.

Limited-purpose and post-deductible FSAs, and HSAs. An employee who is covered by a high-deductible health plan and also has a general-purpose health FSA generally cannot contribute to a health savings account (HSA). Publication 969 describes two exceptions. A limited-purpose health FSA can pay or reimburse the items allowed alongside other coverage, such as dental and vision care, plus preventive care. A post-deductible health FSA does not pay or reimburse any medical expenses incurred before the minimum annual deductible is met.

Dependent care FSA. A dependent care FSA is a different benefit from a health FSA. Publication 15-B says an employee can generally exclude up to $7,500 a year ($3,750 if married filing separately) of benefits from a written dependent care assistance program that covers only the employer's employees. The exclusion cannot exceed the smaller of the employee's or the spouse's earned income. That figure is for 2026; Publication 503 for 2025 shows $5,000 ($2,500 if married filing separately). Example: if an employee earns $60,000 and the spouse earns $6,000, the exclusion is capped at $6,000, not $7,500. The employer reports the total value of dependent care assistance in box 10 of Form W-2. Publication 15-B shows $7,000 from an FSA plus $700 of on-site care as $7,700 in box 10, with the $200 above the limit in boxes 1, 3 and 5.

Highly compensated and key employees. Publication 969 cautions that limits may apply to highly compensated participants and key employees. Publication 15-B explains that if a cafeteria plan favors them, those employees must include the value of taxable benefits they could have selected in wages. For 2026 it defines a highly compensated employee as a 5% owner or someone paid more than $160,000 in the preceding year, and a key employee as an officer paid more than $235,000, a 5% owner, or a 1% owner paid more than $150,000 [VERIFY ANNUALLY]. A plan favors key employees if more than 25 percent of its nontaxable benefits go to them.

Where states differ. This entry describes the federal baseline only. States may treat FSA contributions differently for state income tax. As one example, the New Jersey Division of Taxation published Technical Bulletin TB-39(R) (issued March 3, 2003) stating that New Jersey Gross Income Tax law does not adopt the federal section 125 treatment, and its own example says an employee's salary reduction for an FSA remains subject to New Jersey tax and withholding. The bulletin states that it is accurate as of its issue date, so confirm current treatment with your state revenue department.

FAQ: Is an FSA required? No. HealthCare.gov says an employer decides whether to offer an FSA and is not required to contribute. If it offers a grace period or carryover, it does not have to offer either one.

FAQ: Can unused money be paid back to the employee? No. Publication 969 says the employer is not permitted to refund any part of the balance, and Notice 2020-33 prohibits cashing out unused health FSA amounts or converting them to another benefit.

FAQ: Can a plan offer both a grace period and a carryover? No. Publication 969 and Notice 2013-71 both say a plan with a carryover cannot also provide a grace period for the health FSA.

FAQ: Can an owner or partner participate? Not as a self-employed person under Publication 969, and Publication 15-B says a 2% S corporation shareholder is not treated as an employee for cafeteria plan purposes. Ownership structures vary, so confirm the facts with the IRS or a qualified professional.

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