Flexible Spending Accounts

Flexible spending accounts (a.k.a. Section 125 plans) provide an IRS-approved way to lower taxes for both employers and employees. There are several types of FSAs but the medical expense FSA and the dependent care FSA are the most common. These plans allow employees to redirect compensation to pay for qualified unreimbursed medical expenses dependent care expenses, adoption expenses, and certain insurance premiums before personal taxes are computed on their paychecks. Employees end up paying less tax because their taxable income is lower.

The business pays less in Social Security matching funds because employees do not pay Social Security tax on amounts placed in their plan accounts. While sole proprietors, partners, members of an LLC or LLP (in most cases), and individuals owning more than 2% of an S corporation may not participate in flexible spending accounts, they may still sponsor a plan and benefit from lower payroll taxes.


Set up a flexible spending account to allow employees to pay for medical expenses that insurance does not reimburse, such as eye surgery, prescription drugs, orthodontia, copays, and deductibles.


Medical Expense Reimbursement

Under current law, only medical expenses that exceed 7.5% of AGI are deductible on your 2021 tax return. Since many medical expenses are not covered by insurance plans, paying for them through a flexible spending account with tax-free dollars provides an opportunity for savings.

With a flexible spending account, certain medical expenses become, essentially, tax deductible. Covered expenses include insurance deductibles and copays, doctor’s office visits, dental and orthodontia expenses, vision care, eye surgery, prescription drugs, and medical transportation costs.

Dependent Care

Many flexible spending accounts allow employees to pay for a certain amount of child and adult dependent care expenses each year with pre-tax dollars. The American Rescue Plan Act (ARPA) of 2021 temporarily raises the pre-tax contribution limits for dependent care flexible savings accounts to $10,500 for single filers ($5,250 for married couples filing separately) for tax year 2021. Generally, a child or dependent must be younger than 13 or disabled to qualify.

It is important to keep in mind that dependent care expenses paid through a flexible spending account will reduce the amount of the taxpayer’s Child and Dependent Care Tax Credit dollar-for-dollar.

Health Insurance

By allowing employees to deduct health insurance premiums from their pay on a pre-tax basis, the employer can save on taxes. In fact, for every dollar employees spend on health insurance, the employer saves 7.65%, or the FICA match. Premium Only Plans are easy to set up and administer, and unlike other types of flexible spending accounts, they do not require filing claims or an IRS tax filing.

Adoption Assistance

Employees adopting a child can be reimbursed through a flexible spending account for up to $14,400 in 2021. Employees can only take the reimbursement once per child. If the adoption process spans several years, employees may want to consider which year they want to take this reimbursement.

Your employees may benefit by using the adoption assistance as a tax credit. The $14,400 limit is the same as if the reimbursement were filed through a flexible spending account; if eligible expenses exceed $14,400, both the flexible spending account and the tax credit may be utilized. If employees are in the 24% tax bracket or higher, paying for adoption expenses through the flexible spending account may save them more than the credit. This tax credit gradually phases out based on income levels. Click here for more info.