Flexible Spending Accounts (FSAs): Offer A Popular Tax-Free Benefit

Flexible Spending Accounts (FSAs) are powerful, tax-advantaged tools that help employers deliver more value through their benefits programs while reducing payroll taxes. They allow employees to set aside pre-tax dollars for eligible medical and dependent care expenses, which lowers their taxable income and boosts financial wellness.

For employers, FSAs support recruitment, retention, and compliance goals, especially when paired with other benefits like Health Savings Accounts (HSAs) or High-Deductible Health Plans (HDHPs). But offering FSAs comes with regulatory responsibilities—including the need for a written plan document under Section 125 of the Internal Revenue Code.

This guide explains what FSAs are, how they benefit both employers and employees, and how to implement and manage them correctly.

What Is a Flexible Spending Account (FSA)?

An FSA is an employer-sponsored savings account that allows employees to pay for eligible out-of-pocket expenses using pre-tax income. Employees enroll in an FSA during open enrollment or after a qualifying life event and contribute a portion of each paycheck on a pre-tax basis.

Key Employer Advantages:

• Reduces payroll taxes: Employers avoid paying FICA (Social Security and Medicare) taxes on employee contributions.
• Enhances your benefits offering: FSAs are relatively low-cost but highly valued by employees.
• Supports workforce flexibility: Especially useful for caregivers, parents, and employees managing chronic conditions.

Employers may also contribute to employee FSAs, though contributions are optional and must remain within annual IRS limits.

Types of FSAs Employers Can Offer

Employers may offer multiple types of FSAs depending on their benefits strategy and employee population.

1. Healthcare FSA (Medical FSA)

Employees use this account to pay for out-of-pocket healthcare expenses not covered by insurance.

Eligible expenses include:

• Copayments and deductibles
• Prescription medications
• Dental and orthodontic care
• Vision care, contacts, glasses, and LASIK
• Over-the-counter medications and first aid supplies
• Mental health services and therapy

Who can offer it? Any employer with a Section 125 Cafeteria Plan.

Employer Advantage: Helps employees stretch their healthcare dollars while lowering employer FICA liability.

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2. Dependent Care FSA (DCFSA)

Used to reimburse expenses for care of dependents—typically children under age 13 or adult dependents who are incapable of self-care—so the employee can work.

Eligible expenses include:

• Daycare, nursery school, preschool
• After-school programs and summer day camps
• In-home babysitters or nannies (work-related only)
• Adult day care for elderly or disabled dependents

Contribution limits (2026):

• $7,500 per household
• $3,750 per parent if married filing separately

Employer Advantage: Helps working parents stay productive and reduces absenteeism due to childcare challenges.

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3. Limited-Purpose FSA (LPFSA)

Designed for employees enrolled in an HSA-compatible HDHP, this type of FSA covers only dental and vision expenses. It allows employees to use both an HSA and FSA without jeopardizing HSA eligibility.

Eligible expenses include:

• Dental exams, fillings, and orthodontia
• Vision exams, glasses, contacts, and LASIK

Employer Advantage: Allows HSA participants to access additional tax savings for routine dental and vision needs.

The IRS sets annual contribution limits for FSAs, which employers must enforce.

FSA Type	Contribution Limit
Healthcare FSA	$3,300
Dependent Care FSA	$7,500 per household ($3,750 if married filing separately)

Employer Contributions: If an employer chooses to contribute to an FSA, the total cannot exceed the IRS limits.

FSAs are subject to a “use it or lose it” policy, meaning unused funds are forfeited at the end of the plan year unless the employer offers one of the following options:

• Carryover Option – Employees can roll over up to $640 of unused funds into the next plan year.
• Grace Period Option – Employees have 2.5 extra months after the plan year to use their remaining funds.

Employer Tip: Offering either the carryover or grace period increases employee participation by reducing risk of losing funds.

Employers offering an FSA under a Section 125 Cafeteria Plan are required by the IRS to have a written plan document. This document outlines the plan’s rules, eligibility, contribution limits, and administrative procedures.

Why You Need One:

• IRS compliance: Mandated under Internal Revenue Code Section 125
• Avoid disqualification: Without a formal plan, employee contributions could be treated as taxable income
• Legal protection: Clarifies roles, rules, and responsibilities for employees and third-party administrators

Common Components:

• Employer’s legal name, address, and EIN
• Effective dates and plan year structure
• Eligibility criteria and waiting periods
• Enrollment and contribution procedures
• List of qualified expenses and reimbursement rules
• Rules for mid-year election changes (e.g., marriage, birth)
• Carryover or grace period policies
• Nondiscrimination testing procedures and protocols

Employer Tip: Even if your FSA is managed by a third-party provider, the employer is responsible for maintaining a compliant plan document. Consult with an ERISA attorney or your third-party FSA vendor to create a compliant plan document.

Employers should work with an FSA provider to manage contributions, claims, and compliance. Popular providers include:

• HealthEquity
• WEX (formerly Discovery Benefits)
• Paychex
• ADP

Choosing a provider with automated payroll integration reduces administrative burden.

Employers must ensure pre-tax deductions are applied correctly for enrolled employees. Payroll integration simplifies administration and ensures IRS compliance.

Many employees are unfamiliar with FSAs and may not take full advantage of them. Employers should provide:

• Educational materials during open enrollment
• FSA enrollment workshops or webinars
• Reminders about deadlines & eligible expenses

Providing real-world examples of savings helps employees see the value of FSAs.

To maintain IRS compliance, Section 125 plans must pass nondiscrimination testing to ensure FSAs are not disproportionately benefiting highly compensated employees (HCEs).

A Flexible Spending Account (FSA) program is a cost-effective way to enhance your benefits package while reducing employer payroll taxes.

Key Takeaways for Employers:

• FSAs lower payroll taxes while providing valuable benefits to employees.
• Offering a grace period or carryover increases participation.
• Pairing an HSA with a Limited-Purpose FSA optimizes tax savings.
• Dependent Care FSAs are a highly valued benefit for working parents.
• Working with a third-party administrator simplifies compliance and claims management.

By implementing an FSA program, businesses can offer valuable tax-saving benefits while keeping costs manageable.