A health flexible spending account (FSA) is an employer-sponsored benefit that allows eligible employees to pay for qualifying medical expenses on a tax-advantaged basis. Employees elect an annual amount that may be used to reimburse qualifying medical care expenses incurred during the plan’s coverage period. Health FSAs are offered under an employer’s cafeteria plan and are subject to specific design, eligibility, and compliance requirements under federal law.
Health FSAs may be offered by private or public-sector employers of any size that sponsor a cafeteria (§125) plan. Health FSAs can be made available to any common law employees, although eligibility is often limited to full-time employees and must be offered only to those who are also eligible for the employer’s group medical plan to maintain excepted benefit status. Self-employed individuals (e.g., sole proprietors, partners of a partnership, >2% S-Corp shareholders, and independent contractors) cannot participate in a health FSA.
Health FSAs are subject to salary reduction limits that apply on a plan year (not necessarily calendar year) basis. However, plans can incorporate a lower contribution limit than allowed under the IRC as a matter of plan design. Employee contributions subject to the limit include:
Amounts deducted pre-tax from an employee’s compensation through a cafeteria plan; and
Employer flex credits that the employee can use toward cash or other taxable benefits
The employee contribution limit applies per employee, rather than on a household basis, so if both spouses are employed and eligible for health FSA coverage, each spouse could contribute up to the applicable limit. In addition, the limit applies on a per employer basis, so an employee who works for two unrelated employers (i.e., not part of a controlled group or affiliated service group), whether simultaneously or at different times during the same plan year, may elect up to the limit under each employer’s health FSA. Employees who join mid-plan year may elect up to the contribution limit for the remainder of the plan year. However, when an employer runs a short plan year (<12 months), the annual limit must be prorated accordingly.
Employer health FSA contributions are generally limited to a match of the employee contribution
or $500, whichever is greater, to preserve excepted benefit status.
Health FSAs may be designed to reimburse most §213(d) qualifying medical expenses, but may not be used to reimburse insurance premiums, cosmetic surgery, general health items, or expenses reimbursed under other insurance. Health FSAs providing broad reimbursement for medical expenses are referred to as general-purpose health FSAs. Health FSAs more narrowly designed to reimburse only dental or vision expenses are called limited-purpose health FSAs.
Health FSAs may only reimburse expenses incurred during the plan year (or grace period, if applicable). Expenses incurred after employee’s participation in the FSA terminates are not reimbursable unless the employee elects COBRA continuation coverage. Eligible expenses may be submitted any time during the plan year or during the run-out period following the end of the plan year. The run-out period is generally 30-90 days following the end of the plan year.
Employers are required to implement claim substantiation procedures, including obtaining independent third-party verification of expenses and a participant certification that the expense has not been, and will not be, reimbursed from any other source.
§125 rules require that the health FSA operate with insurance-like risk in that there is a risk for the employer and risk for the employee participants.
Under the uniform coverage rule, the employer must reimburse up to the full amount of a participant's annual coverage election, even if such reimbursements exceed the participant's year-to-date contributions. For example, if an employee elects $1,200 for the year and incurs a $500 medical expense in February, they must be reimbursed $500, even if they’ve only contributed $200 so far. The uniform coverage rule does not allow the employer to require repayment of excess reimbursements or limit reimbursements to the amount collected.
Under the use-or-lose rule, any unused funds remaining in the health FSA at the end of the plan year or when participation terminates will be forfeited by the participant (subject to any carryover or grace period provisions). Exceptions to the use-or-lose rule
Health FSAs can be designed with a grace period or a carryover, but not both.
Grace Period - A period of up to 2 ½ months after the end of the plan year during which unused funds can be used toward expenses incurred during the grace period. Any amount remaining after the grace period will be forfeited.
Carryover – Unused funds up to a set amount (indexed annually by the IRS) can be carried over into the next plan year and will not impact the next plan year’s contribution limit.
Any forfeited amounts the employer receives from underspent accounts may be used to offset losses resulting from overspent accounts. If funds remain after all reimbursements and offsets have been made, these experience gains must be used in accordance with applicable IRS and ERISA regulations. Experience gains may be used: (i) to defray plan administration expenses; (ii) to reduce salary reduction amounts for the following plan year; (iii) to increase the annual coverage amount; or (iv) as a cash refund to employees. If experience gains exceed plan administration expenses and are passed along to participants, the amounts must be distributed uniformly and not based on plan usage.
Health FSAs are generally subject to ERISA’s plan document and summary plan description
(SPD) requirements as well as Form 5500 requirements if there are 100 or more participants.
Health FSAs must be included in the employer’s cafeteria plan (or §125) document and must follow §125 requirements regarding employee contribution limits, election change rules, uniform coverage rules, use-or-lose rules, reimbursement rules, and nondiscrimination requirements.
A health FSA is subject to federal COBRA continuation rules, except that there is a special rule which only requires COBRA to be offered through the end of the current plan year if the health FSA is underspent (no offer of COBRA is required if the health FSA is overspent). A health FSA is “underspent” if benefit still available for reimbursement (including any carryover from the previous plan year) is greater than the COBRA premium due for the remainder of the year.
COBRA Example – Underspent Account
Employee elects $2,400 (effective Jan 2026), employee submits claims totaling $600 during Jan - Jul 2026, and then employee terminates employment 7/31/26. Employee still has $1,800 available and COBRA premiums for the remainder of the year would be $1,000 ($200 x 5 months), so COBRA must be offered ($1,800 > $1,000). The COBRA premium is the monthly elected amount + 2% (e.g., the COBRA premium for a $2,400 annual election would be $204/month). If COBRA is elected, the individual would have access to the remaining health FSA balance through the end of the current plan year or for as long as COBRA is maintained, if shorter.
A health FSA must meet “excepted benefit” status to avoid violating health care reform requirements (e.g., no cost-sharing for preventive coverage and no annual or lifetime dollar limits on essential health benefits). To meet excepted benefit status, the health FSA must satisfy two conditions:
Maximum Benefit Condition. The maximum benefit payable under the health FSA to any participant cannot exceed the greater of: (i) 2x the participant’s salary reduction election; or (ii) the amount of the participant’s salary reduction election plus $500. In other words, the employer can contribute up to $500 or a match of the employee’s contribution, whichever is greater.
Availability Condition. Other non-excepted group health plan coverage (e.g., major medical coverage) must be made available for the year to those eligible to participate in the health FSA. Individuals must be eligible for both a group medical plan and a health FSA, but they do not have to be enrolled in both.
Health FSAs are self-funded medical reimbursement plans subject to §105(h) nondiscrimination rules.
Employees who are enrolled in general-purpose health FSA coverage are ineligible to contribute to or receive HSA contributions for the entire health FSA plan year even if their balance is reduced to $0. In addition, a grace period or carryover can further extend HSA-ineligibility into the following plan year for those with a balance at the end of the plan year. However, a limited-purpose or post-deductible health FSA can be offered alongside an HDHP without interfering with HSA eligibility.
Unison Risk Advisors Compliance Team | benefitscompliance@unisonriskadvisors.com
Disclaimer: Materials are solely for informational purposes as an educational resource. Please contact counsel to obtain advice with respect to any specific issue