What’s the FSA loophole you ask? First, an FSA is a Flexible Spending Account and it’s an account where you can deposit funds pre-tax, they’re deducted from your paycheck. You can only use those funds to pay for qualified medical expenses. A qualified medical expenses can be anything from co-pays to prescription and over the counter medications. The only downside to the FSA is that you must spend all the funds within the plan year or they expire. Allocate too much and you find yourself wasting it on over the counter drugs you hadn’t planned on buying; allocate too little and you lose out on some of the tax benefits.

There is a loophole in the system though. Once you determine your FSA balance for the year, you can begin immediately spending it and be reimbursed. The amount you allocate is deducted from your paycheck each month so you could conceivably spend your entire year’s allocation before you even pay for it. If you were to leave your job, you wouldn’t have to pay the negative balance, between the amount spent and how much you’ve contributed, on your FSA. That’s the FSA loophole.

I’ve heard stories of people paying for entire operations (think: $$$$$) through underfunded FSAs prior to quitting their job. The idea behind the program is that the shortfalls are balanced out by the expired overages, though I wonder if they’re designed to handle extreme cases.

What do you think of this loophole? Have you ever taken advantage of this loophole? Do you think it should be closed off? If so, how? Have you heard of people paying for thousands of dollars in elective operations this way?

(Photo: dan4th)

When I first started working several years ago, I was amazed at the idea of a Flexible Spending Account (FSA). I could make tax-deductible contributions and they could be withdrawn tax free for qualified medical expenses and over the counter products. Since then, I’ve become aware of two other types of accounts: Health Savings Accounts (HSA) and Health Reimbursement Accounts (HRA). Each have their benefits and drawbacks and not every employer offers those program so it mostly depends on your luck. In the two employers I’ve had, I’ve only ever had access to the FSA. So, let’s talk about the differences between each of the programs.

Flexible Spending Accounts

Both the employer and employee can make tax-deductible contributions through paycheck deductions and there is no limit to how much one can contribute to the FSA. You are either issued a debit card linked to that account or you submit receipts of service or products for reimbursement after the fact. The primary downside to an FSA is that the funds are forfeited each year so it’s a “spend it, or lose it” account. If you leave your job mid-year, you lose the funds too (but you pay monthly so the loss is only what you actually paid in).

One loophole with an FSA is that you can spend the full year’s value before you’ve made the contributions. So if you put $1200 into your FSA, or $100 per month, you can spend all $1200 in the first month. What this means is that you can leave in month two and not repay the FSA value. This is usually mitigated by the fact that the funds are forfeited if they are not spent.

Health Savings Accounts

These are actually investment accounts and both the employer and employee can make tax-deductible contributions subject to federal limits. The earnings of the account are tax free and the withdrawals are tax free if used to pay for qualified medical expenses. The funds are linked to the employee and not the employer-employee relationship so it follows the employee even if they leave a company. Another added benefit is that the funds accumulate over the years, as opposed to an FSA where they are forfeited.

Health Reimbursement Accounts

I’ve seen the least of these and they are usually set up by your employer as part of your benefits package. Employees cannot make contributions and an employer’s contributions are not considered income for you and are also not subject to limitations. I know the least about these types of programs as they are not as popular as FSAs and HSAs.

If you’d like to learn more about these plans (and a few others), the IRS has a detailed Publication 969 governing them. I think I’ve captured the important details but they do a much more detailed and dryer job.