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Your Take: The FSA Loophole

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Drugstore PharmaciesWhat’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)

{ 48 comments, please add your thoughts now! }

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48 Responses to “Your Take: The FSA Loophole”

  1. Peter says:

    Yes, I have taken advantage of this loophole. I left a job in February, having already used up my entire $2500 on dental work for my wife and I. At that point I had only paid in $200. With my new job, I was able to sign up for an additional $2500 (although I fully funded it this time). So the loophole is not only that I got to keep that extra money, but I was able to double my coverage for that year.

  2. Henry Phish says:

    This is not a loophole it is part of the design. The reason that it functions in this manner is that the IRS views medical FSA plans as insurance. I don’t know about you but I would hate to have my house destroyed in a natural disaster and wait until my insurance premium equaled the damage.

  3. CK says:

    I’m ok with it. The employer certainly knows when they decide to offer FSA accounts this is a possibility.

    Interestingly enough accounts for dependent care are pay as you go, ie you can only be reimbursed for what you have contributed to date.

  4. says:

    I wouldn’t feel too bad for the employer; they’re the ones that get the unused plan contributions.

    Personal note – I’ve used the ‘loophole’ to benefit myself ~ $600 when quitting a job.

  5. Yeah, given that employers get to keep unused contributions, I can’t say that I feel too bad for them.

  6. Amy says:

    My husband used this loophole. We knew he was leaving a job in February so the previous November, we signed him up for the out of pocket costs for two crowns. He got this work done in the first week of January, it was paid for and he left the first week of February. We didn’t feel guilty at all!

  7. Monkey Monk says:

    My wife inadvertently used the loophole at her previous job to save about $350 on unfunded medical expenses when she quit her job.

    We had a baby in early February and blew through our entire $2,000 fund by mid-April. No current plans to leave the job this year though.

    The other oddity we had happen this year was our FSA plan (Healthworks) sending us reimbursement checks for money that was eventually covered by our insurance provider. This was part of the reason we blew through the $2000 so fast. We made about 6 phone calls to make sure it was okay to cash the checks since it didn’t feel like our money but everyone told us it was fine. We likely would have still used the entire $2000 throughout the year but it’s not to know that we won’t have left over money.

    Now we wish we had upped the fund to $3000 or $4000 for the year and gotten even more tax-free savings.

  8. Curtis says:

    Please note this is true only of health FSAs. Dependent care FSAs are different, in that they require that you have money in the account (i.e., taken from your paycheck) before you get reimbursed. So, you couldn’t, say, pay for a year’s worth of daycare in advance and then quit your job.

  9. I just started working for an employer and signed up for the FSA. I plan to contribute just enough money to pay for my estimated co-pays for me and my wife with a little wiggle room just in case, If i think I won’t use use that wiggle room in time, i’ll just get my teeth cleaned or something.-Good times

  10. Kevin says:

    As a Senior Human Resources Manager, it’s people like the one’s above who think “oh, who cares about the big corporation, I’m going to get mine” who cost honest people in the end.

    I work for a non-profit retirement community and we use the unused money to help defray health care costs for the next year. As a result we haven’t had to raise the employee portion of insurance premiums for the past 4 years (individuals in our HMO plan are covered free of charge).

    I’m not saying this because we deserve thanks for doing this, but for companies whose employees take advantage of the program (Amy’s husband, Peter, Abegray) and cause the employer to withdraw this option, it’s the honest employees who get hurt.

    Fivecentnickel, it’s a shame that you appear not to have the ethics (or intelligence to think things through) that I find in the articles on Blueprint for Financial Prosperity.

    I don’t think the loophole can be closed however. The majority of people are honest and use the FSA as a valuable tool to help defray medical costs not covered by insurance.

    Just my two cents as an opposing position from the management side of things.

  11. Peter says:

    Uh, excuse me. I didn’t take advantage of anything, other than a loophole not of my doing. I left my job in February for totally unrelated reasons, and the $2500 windfall was a total surprise. I even called the IRS to check on the rules to make sure that I wouldn’t have to pay taxes on it.
    If you think the law as it exists is a problem, then lobby your congressman. There is nothing wrong with taking advantage of legal loopholes. I did nothing illegal or dishonest.
    And you talk about honest people who use the money to defray medical costs not covered by insurance. What do you think I, and all the other people you mentioned, did? The only way to get the money is to submit receipts for legitimate medical expenses. That’s exactly what I did.

  12. Peter says:

    You also don’t seem to mind that the ‘unused’ money that you refer to came from hard-working people who apparently didn’t have the medical expenses that they thought they would. Why don’t you return the money to the people it belongs to? Oh right, because the law allows you to keep it. Who’s being dishonest now?

  13. Rebecca says:

    Wow, I have to comment that I was not aware of this loophole. My employer offers FSA and I always assumed that you were required to reimburse the employer/insurance co if you left before the year was up.

  14. Mike D says:

    I took advantage of this at my previous job. I had an extra $200 that I used for prescription polarized sunglasses before I left the job in June.

  15. Kevin, how is it ethical for an employer (non-profit or otherwise) to keep someone’s money and then use it to defray healthcare premiums the next year? They’re taking funds from an individual and effectively spreading them around to everyone else. Fair? I think not.

    While the “use it or lose it” clause is an IRS stipulation, there is nothing stopping a company from giving the money back to their employees in the form of a bonus during the next year. Since the money was taken out of their checks tax free, the fact that it would go back as a taxable bonus is a non-issue. How many companies are you aware of that do this? None that I know of. There might be some rare instances, but it’s far from commonplace.

    Before you go around questioning someone’s ethics and/or intelligence, perhaps *you* should think things through a bit more carefully. While using the funds to defray insurance expenses is more admirable than pocketing it as profit, it’s still not the right thing to do.

  16. Kevin says:

    I’m sorry, Nickel, perhaps it’s not so much lack of intelligence, as lack of research. Although that seems equally as egregious for someone claiming to run a finance website.

    “By law employers cannot return money to individuals who fail to exhaust their accounts, lest FSAs start to look like tax shelters. But companies can give the money back pro rata to everyone in the plan. Almost none do, choosing instead to offset plan administrative costs — an outrage that Congress finally noticed last year. ”
    Time Magazine – Sunday, Oct. 13, 2002

    I apologize for not quoting the IRS law directly but I’m not digging through their website to find it.

    Please note that companies are not just “pocketing the profit” as you say. They are using them to offset plan administrative costs to help them to continue to offer such plans.

    And Peter, to answer your question, it is still the people who are fully aware that their company is funding their FSA up front and steal from that company, who are being dishonest.

    Try to justify it however you want. Chances are if you have to question whether or not you should feel guilty…you probably should.

  17. Peter says:

    “And Peter, to answer your question, it is still the people who are fully aware that their company is funding their FSA up front and steal from that company, who are being dishonest.”

    I’m still not following you. Please clarify which actions you think I took which were dishonest? Do you think that someone with a legitimate medical expense in January should not file a claim if the amount of the claim is higher than what he has contributed so far?

    I am not questioning whether or not I should feel guilty. You are the only one doing that.

  18. Kevin says:

    @Peter: Re-read my response that you quoted in your post. I’m didn’t say you should feel guilty. I’m saying that if you know you plan to leave an employer, max out your FSA, utilize it all and then leave the employer without reimbursing them, they you are dishonest. Freudian slip, maybe? 😉

    After reviewing your initial post, I can’t assume that this is what you did, so I apologize and withdraw you from inclusion with Amy’s husband, who is clearly dishonest.

    I think I’ve made my opinion sufficiently clear on this topic. The last thing that I will say is that there are exceptions in every case. Some people can’t avoid taking advantage of this situation. But if you are knowingly taking advantage of a system that is provided primarily to help people, that, in my opinion, is dishonest.

  19. Umm, Kevin… Using the funds to offset administrative costs is equivalent to pocketing the profit. Both have the exact same effect on the bottom line. Employers offer these programs as a benefit, but then the majority of them (according to your own source) take money from a subset of employees and use it to offset their costs. If this was such a magnanimous gesture, why would Congress be outraged?

    Bottom line: I’m not saying that it’s right for people to benefit from this loophole. Rather, it’s a poorly constructed system. The benefit derived by employees pocketing an excess in claims before departing is no worse than an employer pocketing the overage from employees. They are both perfectly legal byproducts of an imperfect system.

    As an aside, I’ve always felt that the system should be set up such that your limit for next year is the legal max minus whatever you have left at the end of the year (which you are allowed to carry over). That way nobody gets to abuse the tax benefits by piling up huge sums in an FSA account, and at the same time nobody gets stung by things that are out of their control (such as a couple that sets aside money for a child birth and all of the attendant pediatric care and then has a miscarriage).

    There are at least two downsides that I can see to this idea. First, it might be difficult from an administrative standpoint, especially since open enrollment typically occurs before the end of the year, so you don’t know exactly how much money will be carried over. Second, it would expose employers to a potentially major liability — the loophole that Jim mentioned with no overage to cover the difference. This could, however, be remedied by allowing employers to go after former employees for the difference.

    Given your position in Human Resources, perhaps you could comment on this idea (preferably without the personal attacks) or suggest an alternative fix.

  20. CK says:

    I’m a bit confused. How is it unethical for me to follow the rules that both parties agreed to and understand? The employer keeps my contribution if I don’t use it and I keep excess if I leave the employer. Seems like a good tradeoff.

  21. Amy says:

    My response to whoever thinks we are dishonest is: if a person is aware of and utilizes a well known and legal (key word here!) loophole, that’s not dishonest. That’s being a smart consumer.

  22. jim says:

    Judge Learned Hand once said : “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

  23. Nathan says:

    The “loophole” worked against me. When I was laid off last month without notice, my employer got to keep $1200 of my own money I had not yet used. I had contributed the maximum amount ($3000) to pay for an upcoming surgery and lost pretty much all I had put in (I am in the middle of the lengthy appeal process now).

  24. Peter says:

    Nathan, if this happened less than 60 days ago, you are entitled to continue the benefits through Cobra. You would continue paying the monthly FSA contribution you’ve been making, plus a 2% surcharge. You can then continue to draw funds, including the additional contributions you’ve made since you were laid off. Just keep doing this until the end of the year and you should be able to use the entire $3000

  25. Nathan says:

    Peter, thanks for the response. If you’re still tracking this post, maybe you could clarify this for me. Are you saying I can continue just the FSA benefits or would I have to get the full insurance coverage too? In that case, it wouldn’t really be worth it to me.

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