A flexible spending account allows you to save pre-tax dollars for healthcare expenses. Both you and you employer can contribute funds to an FSA up to a maximum amount, and the contributions are not taxable. You can only spend FSA funds on qualified expenses, which do not include insurance premiums.
The IRS limits annual contributions to flexible spending accounts. As of 2013, the limit was $2,500. You can use the money to pay for out-of-pocket expenses not covered by your health insurance, including deductible amounts and co-pays for office visits, tests, hospitalizations and prescriptions. FSA money can also be used for over-the-counter medications -- but you must have a doctor's prescription for them. Insulin is the only exception to this rule.
No Wiggle Room on Premiums
If you have a qualified medical expense that you wish to pay from the FSA account, you submit a claim to your FSA account custodian, which then reimburses you directly. Some plans also offer debit cards you can use at the point of service. You may not use the FSA funds to pay for health insurance premiums or any other type of insurance. This also goes for long-term care insurance and COBRA continuation coverage, which you can elect to buy with taxable income if you lose your job.
Use It or Lose It
If you use FSA funds to pay for medical expenses, you can't use the same expense as an itemized deduction on your tax return. The IRS requires that you forfeit any money that's left in the FSA at the end of the year. You can only apply the available money to expenses actually incurred during the calendar year, not before or after. The IRS does allow for a two-and-a-half-month grace period after the end of the year in which you can pay for qualified expenses with previous year's FSA contributions. If you are self-employed, you won't have an FSA available, but the IRS will allow you to deduct your health insurance premiums.
Plan B: HSAs
The IRS is a bit more flexible on health savings accounts, which you set up on your own with a trustee, such as a bank or insurance company. You can use HSA funds to pay for long-term care insurance, COBRA continuation coverage if you lose your job or health insurance premiums you pay while receiving unemployment compensation. HSA money can also pay for Medicare premiums if you are at least 65 years old. You also are allowed to accrue HSA funds, so if you don't use them, they roll over to the next year.
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