Video Explains New FSA Flexibility Rules

Who says you have to "use-it-or-lose it?" In a new YouTube video created by the IRS, the nation's tax collection agency instructs taxpayers about carrying over unused funds in a flexible spending account (FSA) year-to-year. The new video is helpful on the basics, although there is more you need to know.

Here's the gist of it: If an employer offers FSAs, employees can choose to allocate pre-tax dollars to a separate account for qualified health care or dependent care expenses, within certain limits. For instance, an employee may take distributions to pay deductibles or copays on physician visits. The annual limit for an account set up for health care expenses is $2,500, while contributions to dependent care accounts are limited to $5,000. (Prior to 2013, there was no limit for health care FSAs.) Thus, if you're in the 25 percent tax bracket, you can save $625 in federal income tax by contributing $2,500 to a health care FSA (25 percent of $2,500), plus up to $191.25 in payroll taxes (7.65 percent of $25,000).

More details are available in IRS Notice 2013-71.

When a participant taps into his or her account, the distributions as tax-free, to the extent the funds are used to pay for qualified expenses. Any other part of the payout is taxable.

Typically, FSA allocations are made before the start of each calendar year, based on an estimate of expenses. The contributions are then withheld from paychecks. However, for years taxpayers were stymied by the use-it-or-lose-it rule. Under this rule, any amounts left over in the FSA at the end of the year were forfeited. This often discouraged taxpayers from using FSAs or resulted in "lowballing" to be on the safe side.

At last the IRS relented and allowed employers to institute a 2½ month grace period. In other words, employees could take until March 15 of the following year to empty out their account from the prior year without losing any funds. Yet this still left the onus on employees to allocate the appropriate amount.

Now the IRS says a participant in a healthcare FSA can carry over up to $500 funds from one year to the next. That should make it easier for employees to estimate their contributions at the beginning of the year. The annual $2,500 limit on contributions remains the same.

But there's a catch to the IRS's kindness. (Isn't there almost always?) An employer can elect to allow the 2½ month period or the carryover provision, but not both. It's one or the other, so you can't have your cake and eat it too. Finally, note that the grace period applies to both types of FSA, but the carryover option is only available to health care FSAs.

Related articles:

IRS Relaxes Rules for Health Care FSAs
Flexible Spending Accounts: More Time to Spend