Order Code RL32656
CRS Report for Congress
Received through the CRS Web
Health Care Flexible Spending Accounts
November 1, 2004
Chris L. Peterson and Bob Lyke
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress

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Health Care Flexible Spending Accounts
Summary
Health care Flexible Spending Accounts (FSAs) are benefit plans established
by employers to reimburse employees for health care expenses such as deductibles
and copayments. FSAs are usually funded by employees through salary reduction
agreements, although employers are permitted to contribute, as well. The
contributions to and withdrawals from FSAs are tax exempt.
FSA contributions are forfeited if not used by the end of the year. Legislation
has been introduced in recent years to permit part or all of remaining balances to be
rolled over to accounts next year or to qualified retirement accounts. Up until his
most recent budget proposal (FY2005), President Bush’s annual submissions had
sought the rollover of up to $500 remaining in an FSA at the end of the year.
In 2002, 39% of private-sector employees could establish a health care FSA,
though actual usage was lower. FSAs were not as common for workers in small
businesses. In establishments with fewer than 50 employees, 7% of workers had
access, compared to 57% of workers in establishments with at least 50 employees.
In July 2003, FSAs became available to federal employees for the first time.
These other points should be noted about health care FSAs:
! FSAs are limited to employees and former employees.
! The Internal Revenue Service (IRS) imposes no dollar limit on health care
FSA contributions, but employers generally do.
! FSAs can be used only for unreimbursed medical expenses that would be
deductible under the Internal Revenue Code, not including insurance and
several other exceptions.
! Employers may impose additional restrictions.
FSAs are different from Health Savings Accounts (HSAs), Health
Reimbursement Accounts (HRAs), and Archer Medical Savings Accounts (MSAs).
For a comparison of these four accounts, see CRS Report RS21573, Tax-Advantaged
Accounts for Health Care Expenses: Side-by-Side Comparison. This report will be
updated for new data or as legislative activity occurs.

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Contents
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Data on Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Principle Rules Regarding FSAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Eligibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Qualifying Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Nonqualified Withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Carryover of Unused Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Current Legislation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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Health Care Flexible Spending Accounts
Health care Flexible Spending Accounts (FSAs) are employer-established
benefit plans to reimburse employees for specified health care expenses as they are
incurred. They arose in the 1970s as a way to provide employees with a flexible
benefit at a time when the cost of health care was a growing concern. In contrast to
traditional insurance plans, FSAs generally allow employees to vary benefit amounts
in accordance with their anticipated health care needs. FSAs can be used for
unreimbursed medical expenses, and contributions to FSAs have tax advantages.
However, FSA contributions are forfeited if not used by the end of the year.
This report describes FSAs, the basis for their tax treatment, and data on their
use.1 The report concludes with a brief discussion of recent presidential and
legislative proposals affecting FSAs.
Background
FSAs are employer-established benefit plans that reimburse employees for
specified expenses as they are incurred. They usually are funded through salary
reduction arrangements under which employees receive less take-home pay in
exchange for contributions to their accounts. Employees each year choose how much
to put in their accounts, which they may use for dependent care or for medical and
dental expenses. However, there must be separate accounts for these two purposes,
and amounts unused at the end of the year must be forfeited to the employer. If FSAs
meet these and other rules, contributions are not subject to either income or
employment taxes. The focus of this report is on the FSAs devoted to health care.
To illustrate the tax savings, consider a health care FSA funded for an employee
through a salary reduction arrangement. Before the start of the year, the employee
elects to reduce his salary by $75 a month in exchange for contributions of that
amount to the FSA. Other employees might choose to contribute more or less than
$75. Throughout the year, as the employee incurs medical and dental expenses not
covered by insurance or other payments, he may use funds in the account to pay
them. His total draw, which must be available at the start of the year, is limited to
$900 (the sum of his monthly contributions for the year). If all $900 is used the first
nine months, for example, he generally cannot replenish the account until the next
year. Any amount that remains unspent after 12 months is forfeited to the employer.
1FSAs are different from the three other types of tax-advantaged health care accounts:
Health Savings Accounts, Health Reimbursement Accounts, and Archer Medical Savings
Accounts. For a comparison of all these accounts, see CRS Report RS21573,
Tax-Advantaged Accounts for Health Care Expenses: Side-by-Side Comparison, by Bob
Lyke and Chris L. Peterson.

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CRS-2
If the FSA was funded by the employer, as sometimes is the case, the employee’s
draw must similarly be available at the start of the year. It is possible for FSAs to be
funded both by salary reductions and employer contributions.
If the employee were in the 25% tax bracket, the federal income tax savings
from the $900 salary reduction used to fund the account generally would be $225
(i.e., $900 x .25); in addition, the employee could save $69 in Social Security and
Medicare taxes (i.e., $900 x .0765).2 There could be state income tax savings as well.
If the employee were in the 15% tax bracket, the federal income tax savings would
be $135, three-fifths as large, while if he were in the top 35% bracket they would be
commensurately greater, $315).3
The employer would also save $69 in employment taxes from the $900 salary
reduction. Employers often use these savings to help pay the expenses of
administering an FSA.
Tax savings can exceed losses due to forfeiture of a remaining balance at the
end of the year; thus, not all of an account must be used for employees to come out
ahead financially. Since tax savings are greater in the higher tax brackets, higher
income employees may be less concerned about forfeitures (assuming they recognize
they could still be better off) than lower income employees.4
The tax savings associated with a health care FSA are not unlike those for
traditional comprehensive health insurance, which also allows employer payments
to be excluded from the income and employment taxes of the employees as well as
from the employment taxes of the employer.
2If the employee’s earnings exceeded the Social Security wage base ($87,900 in 2004), the
only savings would be $13 from Medicare taxes (i.e., $900 x .0145). Reductions in Social
Security taxes due to FSA salary reductions could affect the Social Security benefits that the
worker later receives, though not by much.
3In 2004, the 15% bracket for single filers applied to taxable income (that is, after
exemptions and deductions are subtracted) of $7,151 to $29,050; for married couples filing
jointly, the bracket extended from $14,301 to $58,100. The 25% brackets for these
taxpayers were from $29,051 to $70,350 and from $58,101 and $117,250, respectively.
4The breakeven point for an employee in the 25% bracket who contributes $900 would
generally be $606 (i.e., $900 minus income tax savings of $225 and employment tax savings
of $69). The employee comes out ahead if unreimbursed expenses exceed that amount,
assuming they would have been incurred in the absence of the FSA. If expenses would not
have been incurred except for the FSA, then the breakeven point generally would be higher
since the employee presumably values the obtained services at less than the market price.

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Basis for Tax Treatment
FSAs are one way that employment benefits can be varied to meet the needs of
individual employees without loss of favorable tax treatment. Flexible benefit
arrangements generally qualify for tax advantages as “cafeteria plans,” under which
employees choose between cash (typically take-home pay) and certain nontaxable
benefits (in this case, reimbursements for health care expenses) without paying taxes
if they select the benefits. The general rule is that when taxpayers have an option of
receiving cash or nontaxable benefits they are taxed even if they select the benefits;
they are deemed to be in constructive receipt of the cash since it is made available to
them. Section 125 of the Internal Revenue Code provides an express exception to
this rule when certain nontaxable benefits are chosen under a cafeteria plan.5
FSAs and cafeteria plans are closely related, but not all cafeteria plans have
FSAs and not all FSAs are part of cafeteria plans. FSAs are considered part of a
cafeteria plan when they are funded through voluntary salary reductions; this
exempts the employee’s choice between cash (the salary subject to reduction) and
normally nontaxable benefits (such as health care) from the constructive receipt rule
and permits the latter to be received free of tax.6 Thus, instead of receiving a full
salary (for example, $30,000), the employee can receive a reduced salary of $29,100
with a $900 FSA contribution and will need to treat only $29,100 as taxable income.
However, if FSAs are funded by nonelective employer contributions then their
tax treatment is not governed by the cafeteria plan provisions in Section 125; in this
situation, the employee does not have a choice between receiving cash and a
normally nontaxable benefit. Instead, the benefits are nontaxable since they are
directly excludable under some other provision of the Code. For example,
nonelective employer-funded FSAs for dependent care are tax-exempt under Section
129, while nonelective employer-funded FSAs for health care are tax-exempt under
Sections 105 and 106.
Particular rules governing the tax treatment of FSAs are not spelled out in the
Internal Revenue Code;7 rather, they were included in proposed regulations that the
Internal Revenue Service (IRS) issued for cafeteria plans in 1984 and 1989.8 Final
5In addition, cafeteria plans may include some taxable benefits; like cash, these are taxable
if the employee selects them.
6For a critical discussion of the Internal Revenue Service’s interpretation of constructive
receipt with respect to employee benefit plans and Section 125, see Leon E. Irish, Cafeteria
Plans in Transition, Tax Notes, Dec. 17, 1984, pp. 1135-1136.
7For many years, the Code had no explicit reference to FSAs. The Health Insurance
Portability and Accountability Act of 1996 (P.L. 104-191) added a definition in subsection
106(c)(2) when it disallowed coverage of long-term care services through such accounts.
849 Federal Register 19321, May 7, 1984, 49 Federal Register 50733, Dec. 31, 1984 and
54 Federal Register 9460, Mar. 7, 1989. The proposed regulations have not been finalized,
but they remain the position of the IRS. The rules cover both FSAs funded by salary
reductions and FSAs funded by nonelective employer contributions. Although employers
(continued...)

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CRS-4
rules regarding circumstances in which employers may allow employees to change
elections during a plan year were issued in March 2000 and January 2001.9 To be
exempt from the constructive receipt rule, participants must not have cash or taxable
benefits become “currently available”; they must elect specific benefits before the
start of the plan year and be unable to change these elections except under specified
circumstances. With respect to health care FSAs:
! the maximum amount of reimbursement (reduced by any benefits paid for
covered expenses) must be available throughout the coverage period;
! coverage periods generally must be 12 months (to prevent employees from
contributing just when they anticipate having expenses);
! reimbursements must be only for medical expenses allowable as deductions
under Section 213 of the Code;
! claims must be substantiated by an independent third party;
! expenses must be incurred during the period of coverage;
! after year-end forfeitures, any “experience gains” (the excess of total plan
contributions and earnings over total reimbursements and other costs) may at
the employer’s discretion be returned to participants or used to reduce future
contributions, provided individual refunds are not based on participants’
claims;10 and
! health care FSAs must exhibit the risk-shifting and risk-distribution
characteristics of insurance.11
The effect of the IRS rules is to allow only forfeitable FSAs under which
employees lose whatever they do not spend each year. The rules disallow three other
types of FSAs that had started to spread before 1984: benefit banks, which refunded
unused balances as taxable compensation at the end of each year; ZEBRAs, or zero-
based reimbursement accounts, under which reimbursements were subtracted from
8(...continued)
generally do not permit annual reimbursements from FSAs to exceed the amount slated for
contribution during the year, the proposed regulations do not require this. The proposed
regulations allow a maximum annual reimbursement of up to 500% of the total annual
contribution, or “premium” (including both employer-paid and employee-paid portions of
the contribution to the FSA). An FSA operating in this way would be more similar to
typical health insurance in that the maximum benefit is not limited to the year's contribution
total. However, such an FSA would still differ from typical health insurance in that the
maximum benefit is relatively low.
965 Federal Register 15548, Mar. 23, 2000 and 66 Federal Register 1837, Jan. 10, 2001.
The rules apply to cafeteria plans generally, not just FSAs. The rules allow mid-year
election changes for changes in status (marital status, number of dependents, employment
status, place of residence) and significant changes in cost or coverage; however, mid-year
election changes for health care FSAs are not allowed for cost or coverage changes since the
plans must exhibit the risk-shifting and risk-distributions characteristics of insurance. These
rules only permit employers to allow mid-year changes, they do not require them.
10Thus an employer might refund the same dollar amount to every participant, even though
some used all their benefits while others forfeited unused amounts.
1154 Federal Register 9460, Q and A 7. Some of the seven requirements listed in the text
had been issued in 1984.

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CRS-5
salaries each month (thus reducing taxable compensation at the time it was paid); and
ultimate ZEBRAs, under which salaries already paid were recharacterized at the end
of the year into reimbursements and taxable compensation. Neither ZEBRAs nor
ultimate ZEBRAs had accounts that were funded, and they were criticized as abusive
arrangements.
The IRS rules lay out what is permissible with respect to FSA plans, but
employers may add their own requirements. For example, the IRS does not limit the
amount that an employee can be reimbursed through a health care FSA, but
employers may establish their own ceiling.12 Similarly, employers may exclude
certain elective expenses from their plans, or they might require employees who
terminate employment to continue to participate until the end of the plan year.
One justification for the tax advantages of FSAs is that they might be equivalent
to the tax savings associated with comprehensive insurance plans having negligible
deductibles and copayments; from this perspective, they seem equitable. On the
other hand, similar tax savings are not available to individuals who can only claim
an itemized deduction for unreimbursed expenses that exceed 7½% of their adjusted
gross income.
Data on Use
Few surveys ask about FSAs, and those that do obtain only limited information.
Although surveys yield similar findings about the availability of FSAs, little is known
about the number and characteristics of workers who participate.
The 2002 Medical Expenditure Panel Survey (MEPS) found that 11% of
private-sector establishments offered an FSA to their workers. FSAs are more
common in larger firms; FSAs were offered in 47% of large-firm establishments (50
or more workers) but in only 3% of small-firm establishments.13 Similarly, a greater
percentage of employees had access to an FSA if they worked in a large-firm
establishment instead of a small one. In establishments with fewer than 50
employees, 7% of workers had access, compared to 57% of workers in
establishments with at least 50 employees. Overall, 39% of private-sector employees
could establish an FSA, according to MEPS.
Only 36% of eligible employees participate in a health care FSA, according to
one 2003 survey. Reasons for low FSA participation include employee perceptions
of complexity, concerns about end-of-year forfeitures, and limited employer
encouragement. For lower income employees, the tax savings may not be sufficient
incentive to participate. Among those who participated, the average employee
12A $5,000 limit applies to dependent care FSAs. The latter are governed by Section 129,
which includes that limit.
13CRS calculations were made from a MEPS-Insurance Component table provided by
statisticians at the Agency for Healthcare Research and Quality. The percentages pertain
to establishments that provided information regarding the fringe benefits they offer.

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CRS-6
contribution was $1,136. On average, in 2002, 2% of total contributions were
forfeited back to the employer at the end of the year.14
The modest participation levels suggest that early concerns about the extent to
which FSAs would reduce tax revenue may have been exaggerated. In 1985, a
congressionally mandated study concluded that forfeitable FSAs would increase
health expenditures by approximately 4% and 6%, depending on an employee’s
health plan, and that revenue loss would be $7 billion (in 1983 dollars).15 However,
the study assumed that all employees with employment-based health insurance would
eventually have FSAs. Moreover, the revenue estimate did not reflect any reduction
in health care use from additional cost-sharing requirements that employers
sometimes impose when implementing FSAs. These reductions would partially
offset increases in health care use due to funding FSAs with pre-tax dollars.16
Federal government employees can enroll in an FSA.17 The FSA program was
introduced with an initial effective date of July 1, 2003. Nearly 32,000 federal
employees participated in the health care FSA in 2003. Approximately one in eight
forfeited some amount at the end of 2003. The average forfeiture per participant was
$220. Following the open season for 2004 enrollment, the number of health care
FSA enrollees increased to 133,000.
Principle Rules Regarding FSAs
Eligibility
Eligibility for FSAs is limited to employees whose employers offer plans;
people who are self-employed or unemployed generally cannot participate. However,
14Mercer Human Resource Consulting’s 2003 National Survey of Employer-Sponsored
Health Plans.
15U.S. Department of Health and Human Services, Office of the Assistant Secretary for
Planning and Evaluation. A Study of Cafeteria and Flexible Spending Accounts, July 1985,
pp. 18 and 20. The study was mandated by Section 531(b)(6) of the Deficit Reduction Act
of 1984 (P.L. 98-369). The three prototype health plans on which the study was based had
deductibles of $0/$0, $150/$300 and $150/$300 for individuals and families, respectively;
15% coinsurance; and cost-sharing maximums of $150/$300, $500/$1,000, and no limit.
16For a critical review of the congressionally mandated study, see Daniel C. Schaffer and
Daniel M. Fox, Tax Law as Health Policy: A History of Cafeteria Plans 1978-1985, The
American Journal of Tax Policy, v. 8, spring 1989, p. 47.
17According to the Office of Personnel Management (OPM), nearly all executive-branch
agencies participate in the FSA program. Several independent agencies, such as the Federal
Reserve System and the Farm Credit Administration, do not participate. The House of
Representatives is the only legislative-branch agency not to participate, but the House will
join the program for the plan year beginning Jan. 1, 2005. The federal judiciary does not
participate.

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former employees can be eligible provided the plan is not established predominantly
for their benefit.18 Employers may set additional conditions for eligibility.
FSAs allow coverage of a spouse and dependents. FSAs do not have to be
linked with any particular type of insurance, though it is said some employers
establish FSAs in order to win employee acceptance of greater cost-sharing.
Contributions
FSA contributions may be made by employers (through nonelective payments),
employees (through salary reduction plans), or both. FSA contributions occur during
the plan year, which is usually a calendar year. Since most FSAs are funded through
salary reductions, contributions typically occur pro-rata throughout the year.
The IRS imposes no specific dollar limit on health care FSA contributions,
though plans typically have a dollar or percentage maximum for elective
contributions made through salary reductions. Employers set limits to reduce losses
from employees who quit or die when their withdrawals (which might total the year’s
allowable draw) exceed their contributions from salary reductions.
Qualifying Expenses
Under IRS guidelines, health care FSAs can be used for any unreimbursed (and
unreimbursable) medical expense that is deductible under Section 213 of the Internal
Revenue Code, with several important exceptions.19 One exception disallows their
use for long-term care and for other health insurance coverage, including premiums
for any employer plan. Employers may add their own limitations.
The restriction against paying health insurance premiums can be circumvented
if the employer offers a separate premium conversion plan. This arrangement allows
employees to pay their premiums through what are deemed to be pre-tax salary
reductions. For example, if employees pay $600 a year for health insurance (with
their employer paying the balance), their payment can be considered to be made
directly by their employer (and so exempt from income and employment taxes)
instead of included in their wages (and so taxable). Premium conversion plans are
common among businesses that offer health insurance, particularly among large
companies. The federal government implemented a premium conversion plan in
October 2000.
Nonqualified Withdrawals
FSA funds may be used only for qualifying expenses, as defined above; they
cannot be withdrawn for other purposes. To ensure compliance, reimbursement
1849 Federal Register 19321, Q and A 4.
19Allowable expenses are discussed in an IRS publication number 502, Medical and Dental
Expenses, which is available at [http://www.irs.gov/pub/irs-pdf/p502.pdf].

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claims must be accompanied by a written statement from an independent third party
(e.g., a receipt from a health care provider).
Carryover of Unused Funds
FSA balances unused at the end of the year are forfeited to the employer; they
cannot be carried over. However, since employees can control how much is
contributed to FSAs through salary reduction plans, in effect they can “carry over”
amounts they do not anticipate using by not putting them in the account in the first
place.
Current Legislation
Until his most recent budget proposal (FY2005), President Bush’s annual
submissions sought to allow up to $500 in unused balances in health care FSAs to be
carried over to the following year without being taxed, to be distributed to
participants (in which case they would be taxed), or to be rolled over into certain
qualified deferred compensation plans (Section 401(k), 403(b), and 457(b) plans).
An amended version of H.R. 4279, which passed the House on May 12, would
allow up to $500 in unused balances in health care FSAs to be rolled over to the
following year or into a Health Savings Account.20 This is the only legislative
proposal to have been voted on in 2004 that directly affects health care FSAs.
Conclusion
FSAs can provide tax savings for the first dollars of health care expenditures
that people have each year. In contrast, taxpayers normally are allowed to deduct
medical expenses only to the extent they exceed 7½% of adjusted gross income, and
then only if the taxpayer itemizes deductions. The more favorable treatment for
FSAs might be justified since participants generally assume additional financial risk
for their health care. Some might question, however, whether the savings are
proportional to the risk and whether they are equitable among people of similar
incomes. This issue might be considered as Congress continues to review the tax
treatment of health insurance and health care expenses.
20For more information about Health Savings Accounts, see CRS Report RL32467, Health
Savings Accounts, by Bob Lyke, Chris Peterson, and Neela Ranade.

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