8902 / What is a health flexible spending arrangement (FSA)?

Editor’s Note: The Affordable Care Act (“ACA”) imposes an annual limitation on contributions to a health FSA. For taxable years beginning after 2012, FSA contributions will not be treated as a qualified benefit unless the cafeteria plan provides that an employee may not elect for any taxable year to have salary reduction contributions in excess of $2,500 made to the arrangement. The limit will be indexed for inflation ($3,300 in 2025 and $3,200 in 2024).¹

A health flexible spending arrangement (FSA) is a program that is established under IRC Section 125 to provide for the reimbursement of certain expenses that have already been incurred. This benefit may be provided as a stand-alone plan or as part of a traditional cafeteria plan.

Health coverage under an FSA is not required to be provided under commercial insurance plans, but the coverage that is provided must demonstrate the risk shifting and risk distribution characteristics of insurance. Reimbursements under a health FSA must be paid specifically to reimburse medical expenses that have been incurred previously.

A health FSA cannot provide coverage only for periods during which the participants expect to incur medical expenses if the period is shorter than a plan year. Further, the maximum reimbursement amount must always be available throughout the period of coverage (properly reduced for prior reimbursements for the same period of coverage).

This must be true without regard to the extent to which the participant has paid the required premiums for the coverage period, and without a premium payment schedule based on the rate or amount of covered claims incurred in the coverage period.² Though there was no statutory limit on contributions to a health FSA prior to 2013, most employers imposed a limit to protect themselves against large claims that had not yet been funded by salary reductions.

The period of coverage must be 12 months, or in the case of a short first plan year, the entire first year (or the short plan year where the plan year is changed). Elections to increase or decrease coverage may not be made during a coverage year, but prospective changes may be allowed consistent with certain changes in family status.

The plan may permit the period of coverage to be terminated if the employee fails to pay premiums, provided that the terms of the plan prohibit the employee from making a new election during the remaining period of coverage. The plan may permit revocation of existing elections by an employee who terminated service.³

As is the case with a cafeteria plan, a health FSA may provide a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement. The grace period must apply to all participants in the plan. Plans may adopt a grace period for the current plan year by amending the plan document before the end of the current plan year.⁴

For tax years beginning in 2014 and beyond, a health FSA may be amended so that $500 ($660 for 2025, $640 in 2024, $610 in 2023, $570 in 2022 and $550 in 2020 and 2021) of unused amounts remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carry forward provision may not also offer the grace period.⁵

The plan may not reimburse premiums paid for other health plan coverage, but it may reimburse medical expenses of the kind described under IRC Section 213(d).⁶ Beginning in 2011, reimbursements for medicine are limited to doctor-prescribed drugs and insulin. Before 2020, over-the-counter medicines were not qualified expenses unless the participant obtained a doctor’s prescription.⁷ However, beginning in 2020 the CARES Act now allows these over-the-counter medical expenses to be reimbursed by an FSA without a prescription.⁸

The reimbursed medical expenses must be expenses incurred to obtain medical care during the period of coverage. The employee must provide substantiation that the expense claimed has been incurred and is not reimbursable under other health coverage.⁹ The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred, provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.¹⁰ On a one-time basis, a plan may allow a qualified HSA distribution (see Q 8834).

An employee must include the value of employer-provided coverage for qualified long-term care services provided through an FSA in gross income. ¹¹

Substantiation Requirements

The IRS has released guidance¹² on the types of substantiation that are acceptable for health FSAs offered via IRC Section 125 cafeteria plans. The IRS is clear that the plan must adopt procedures to ensure that all claims are substantiated.

The IRS guidance approved a system where a plan will only reimburse Section 213(d) medical expenses that are substantiated by information from a third party that is independent of the employee and the employee’s spouse and dependents (where the information from the third party describes the service or product, the date of service or sale, and the amount of the expense). The approved system also reimburses expenses based on information from independent third parties (such as an explanation of benefits from an insurance company) and requires that information from the independent third party include (i) the date of the medical care and (ii) the employee’s share of the cost of the medical care (i.e., coinsurance payments and amounts below the deductible). Employee must also certify that any expense paid by the plan has not been reimbursed by insurance or otherwise and that the employee will not seek reimbursement from any other plan covering health benefits.

Under the guidance, self-certification of claims that are not otherwise substantiated does not ensure that all claims are substantiated, meaning that cafeteria plans are prohibited from adopting a self-certification regime. Similarly, plans that (1) adopt a “sampling” technique, (2) only require substantiation of claims below a certain dollar threshold or (3) do not require substantiation of claims paid via a debit card to certain preferred dentists, doctors, hospitals, or other health care providers fail to ensure that all claims are substantiated.

For cafeteria plans that adopt prohibited substantiation rules, all amounts paid under their health FSAs will be included in gross income.