Tax Considerations for Medical Spending Accounts and FSA Rules

Quick overview

Medical Spending Accounts and Flexible Spending Accounts (FSAs) are tools that reduce taxable income by allowing pre-tax contributions to pay qualified medical costs. The specifics—who can contribute, what expenses qualify, whether funds roll over, and how these accounts interact with Health Savings Accounts (HSAs)—depend on plan type and IRS rules. This article walks through the tax consequences, common pitfalls, and practical strategies so you can use these accounts efficiently.

How these accounts are structured and taxed

• Pre-tax contributions: Contributions to employer-sponsored health FSAs are deducted from pay before federal income and Social Security/Medicare taxes; that reduces your taxable wages for the year. Reimbursements for qualified expenses are not taxable. (See IRS Publication 502 for eligible medical expenses.)
• Employer ownership and portability: Health FSAs are owned and administered by the employer. Generally, if you leave a job you forfeit unused FSA funds unless your employer offers COBRA continuation for the FSA or allows you to submit claims for expenses incurred while employed.
• Plan-level rules: Employers may adopt either a grace period (up to 2½ months after plan year) or a small carryover (annual dollar maximum set by the IRS) but not both. Whether you have a grace period or a carryover is determined by your employer’s plan document.

Sources: IRS Publication 502; IRS Publication 969 (for HSAs and other tax-favored health plans).

Types of accounts and how they differ

• Health Flexible Spending Account (health FSA): Employer-sponsored. Funds are available to reimburse qualified medical expenses. Employers set plan year, election rules, and whether a grace period or carryover is allowed. Contributions reduce taxable income.

• Dependent Care FSA (DCFSA): Separate from a health FSA. Used to pay qualified dependent-care expenses (childcare, care for dependent adults) with pre-tax dollars. It has different eligibility rules and limits. See our Dependent Care Flexible Spending Account (FSA) guide for details and coordination tips: Dependent Care Flexible Spending Account (FSA).

• Medical Savings Accounts / Archer MSAs: Older, limited accounts available to certain self-employed people and small employers prior to the HSA era. Most taxpayers now use HSAs instead when they have a qualified high-deductible health plan. For a decision guide comparing HSAs and FSAs, see: HSA vs. FSA.

Eligible and ineligible expenses: practical guidance

Eligible examples (commonly accepted):

• Doctor and dental visits, hospital services
• Prescription medications and many over-the-counter medicines with a written prescription or as allowed by law
• Eligible vision care (exams, glasses, contacts)
• Deductibles, copays, and coinsurance

Typically ineligible:

• Purely cosmetic procedures (unless medically necessary and documented)
• General health items without a prescription (some OTC items may now qualify depending on current IRS guidance)
• Insurance premiums (with limited exceptions)

Always keep receipts and explanation-of-benefits (EOB) statements; the IRS and plan administrators require substantiation for reimbursements. See IRS Publication 502 for full lists and definitions: https://www.irs.gov/publications/p502

Use-it-or-lose-it, grace periods, and carryovers

A common source of confusion is whether unused FSA money disappears. Employers may choose either:

• A grace period—an extended time (often up to 2½ months) after the plan year to incur expenses and file claims, or
• A limited carryover—an employer may allow a small portion of unused funds to roll into the next plan year (IRS sets the maximum annual carryover amount).

Employers cannot offer both options simultaneously. Check your plan document or benefits coordinator early in open enrollment to confirm what your employer offers.

Interaction with HSAs and high-deductible plans

Coordination matters. If you’re enrolled in a high-deductible health plan (HDHP) and want to use an HSA, certain FSAs (other than a limited-purpose FSA for dental and vision) will make you ineligible to contribute to an HSA. Before electing an FSA, confirm whether your employer offers a limited-purpose FSA (L-FSA) that preserves HSA eligibility by restricting reimbursements to dental and vision only.

For more on how to choose between FSAs and HSAs in different situations, see our practical comparison here: When an HSA Beats an FSA: Case Studies and Decision Rules.

Refer to IRS Publication 969 for rules on HSAs and coordination with other tax-favored accounts: https://www.irs.gov/publications/p969

Reporting and documentation

• Neither your taxable W-2 wages nor your employer’s pre-tax contributions for a health FSA are taxed as income; however, employers will still report health FSA contributions on your Form W-2 in the box(es) required by IRS instructions.
• Keep copies of receipts, EOBs, and explanations for at least three years. Plan administrators and the IRS may request substantiation to support reimbursements.
• If audited, be ready to show that each reimbursement was for a qualified medical expense and that the expense was incurred during the plan year or permitted grace period.

Common mistakes and how to avoid them

• Overestimating contributions: Many people elect more than they use and lose funds. Plan contributions carefully—review predictable expenses like prescriptions, chronic-condition care, planned procedures, and routine visits.
• Missing enrollment deadlines: FSAs typically require election during open enrollment unless you have a qualifying life event.
• Assuming portability: FSAs are employer-owned. If you change jobs, unused funds are typically forfeited unless COBRA continuation is available.
• Mixing up dependent-care rules: Dependent Care FSAs have different eligible expenses and tax treatment than health FSAs. Don’t assume funds are interchangeable.

Practical strategies I use with clients

• Map known annual healthcare expenses before open enrollment. Include dental, vision, anticipated prescriptions, and planned elective care.
• Favor conservative estimates when you have uncertain medical spending. If your employer offers a small carryover, you can be slightly more aggressive.
• If you’re HSA-eligible, prioritize the HSA for long-term savings, especially if your employer offers contributions or the HSA has investment options. Use a limited-purpose FSA for current dental and vision needs.
• Keep a running digital folder of receipts and EOBs to make substantiation and claims painless.

Example (illustrative):

• Instead of guessing monthly, pull year-to-date EOBs and bank card history to estimate predictable out-of-pocket spending. That reduces the chance of unused FSA funds at year-end.

Employer-side considerations

Employers designing benefits should clearly communicate whether a plan uses a grace period or carryover, the enrollment deadlines, and how COBRA interacts with FSAs. Clear plan documents prevent costly misunderstandings and reduce benefit-related questions during open enrollment.

When you should get professional help

Consult a tax professional or benefits advisor when you:

• Change employers, especially if you have a large FSA balance;
• Consider contributions while also enrolled in an HSA-eligible HDHP;
• Face a complicated medical event with large out-of-pocket costs spanning plan years.

This article provides general information and is not individualized tax or legal advice. For tax-specific confirmation and up-to-date numeric limits (these limits are announced annually by the IRS), consult your tax advisor or the IRS website.

Authoritative resources and further reading

• IRS Publication 502, Medical and Dental Expenses: https://www.irs.gov/publications/p502
• IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans: https://www.irs.gov/publications/p969
• FinHelp guides: Flexible Spending Account (FSA), Dependent Care Flexible Spending Account (FSA), When an HSA Beats an FSA

Professional disclaimer

This content is for educational purposes only and does not replace personalized tax, legal, or benefits advice. Rules and numeric limits change annually; confirm current-year contribution and carryover limits with the IRS or a tax professional before making elections.