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 generally forfeited if not used by the end of the year, although employers may extend the deadline for using unspent balances up to 2½ months after the end of the plan year (i.e., March 15 for most plans). This report describes FSAs, the basis for their tax treatment, and data on their use. It also includes a discussion of the changes made to FSAs by the Patient Protection and Affordable Care Act (ACA). 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, adoption assistance, or for medical and dental expenses. However, there must be separate accounts for these three 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 cannot replenish the account until the next year. Any amount that remains unspent at the end of the year (or after the 2 ½ month extension, if available) is forfeited to the employer. 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 0.25); in addition, the employee could save $69 in Social Security and Medicare taxes (i.e., $900 x .0765). 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. 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. 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. 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. 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. 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. Regardless of how they are funded, rules regarding FSAs are not spelled out in the Internal Revenue Code; rather, they were included in proposed regulations that the Internal Revenue Service (IRS) issued for cafeteria plans in 1984 and 1989. Final rules regarding circumstances in which employers may allow employees to change elections during a plan year were issued in March 2000 and January 2001. 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; and health care FSAs must exhibit the risk-shifting and risk-distribution characteristics of insurance. 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 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. In August 2007, the IRS issued new proposed rules for cafeteria plans that have not been finalized. The proposed rules generally preserve rules set out in regulations from 1984 and 1989 that were also never finalized. The new rules also reflect changes in tax law from the past 20 years. One key area of the proposed rules is detailed requirements for nondiscrimination testing. Nondiscrimination testing measures whether a plan disproportionately favors highly compensated employees. All cafeteria plans will have to comply with these rules even those that currently do not undertake such testing. The August 2007 proposed rule, however, has not yet been finalized. The IRS rules lay out what is permissible with respect to FSA plans, but employers may add their own requirements. For example, prior to ACA, the IRS did not limit the amount that an employee can be reimbursed through a health care FSA, but employers established their own ceiling. (One reason they might do so is to limit the financial risk that employees might resign having received reimbursements that exceed their contributions.) Employers may exclude certain elective expenses from their plans. Beginning in 2013, however, ACA will limit contributions to FSAs to $2,500, which will be adjusted for inflation in subsequent years. FSAs can provide tax savings for the first dollars of health care expenditures that people have each year, similar to the tax savings associated with comprehensive insurance plans having negligible deductibles and copayments.