Cafeteria Plans: Health Flexible Spending Account (HFSA)

A Health Flexible Spending Account (HFSA) within a cafeteria plan offers significant tax advantages and flexibility for employees to cover eligible medical expenses. 

Cafeteria plans (often called flexible benefit programs or flex plans) are employer-sponsored benefit programs offering tax advantages under § 125 of the Internal Revenue Code. A cafeteria plan offers the employee a choice between a taxable benefit (e.g., cash, taxable salary) and at least one nontaxable benefit (e.g., qualified benefit(s) such as flexible spending accounts). This allows the employee to pay for the plan’s qualified benefits from gross pay before federal income taxes, Social Security, and Medicare taxes, and, in most instances, state income taxes are deducted. Employees save by reducing these income and employment taxes. Amounts paid through a cafeteria plan are not subject to employment taxes such as Social Security and Medicare taxes, representing a savings to employers.

See Cafeteria Plans: An Introduction for general information. A cafeteria plan can offer a variety of benefits. One of the most common and popular benefits is a health flexible spending account (HFSA), as discussed on this page.

An HFSA is a cafeteria plan option that allows eligible employees to elect to have an amount deducted from their gross pay each payroll period during the plan year before it is taxed and directed to the HFSA. Generally, these deductions are evenly distributed throughout the plan year. The money in the HFSA can then be used to pay for or reimburse eligible expenses incurred by the employee, the employee’s spouse, or the employee’s dependents.

Eligible Expenses

An HFSA can reimburse most expenses for healthcare as defined by the IRS: the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body, and transportation primarily for and essential to medical care.

IRS Publication 502, Medical and Dental Expenses, includes a list of many deductible healthcare expenses. Employers may design their cafeteria plan to limit the definition of eligible expenses, but most HFSAs are designed to reimburse all expenses allowed by the IRS. Examples include expenses for the following:

  • Eyeglasses and contact lenses
  • Medical, dental, and vision plan deductibles, copays, and coinsurance
  • Prescriptions
  • Over-the-counter drugs and medications
  • Menstrual care products
  • Orthodontia
  • Chiropractic services
  • Dental treatments
  • X-ray and laboratory services
  • Care provided by doctors or specialists who are not within the employee’s insurance network

In any case, the following are not HFSA-eligible expenses:

  • Health insurance premiums
  • Long-term care coverage or expenses
  • Amounts that are reimbursed by another health plan
  • Cosmetic surgery
  • Hair transplants
  • Household help
  • Maternity clothes
  • Vitamins and supplements for general health
  • Personal use items (other than menstrual care products)

Limited-Purpose Flexible Spending Account

limited purpose flexible spending account (LPFSA) is an HFSA that only reimburses limited types of expenses, such as dental and vision care expenses, but not medical expenses. Alternatively, a general purpose HFSA can include reimbursement of medical expenses but that are types of disqualifying non-high deductible health plan (HDHP) coverage for purposes of determining a taxpayer’s eligibility to make contributions to a health savings account (HSA). In order not to interfere with the employee’s (or the employee’s spouse’s) eligibility to make HSA contributions, the employer may want to offer an LPFSA.

Enrollment

Employees may enroll in the employer’s HFSA during an annual enrollment period for participation in the following plan year. For companies that operate on a calendar year, this period generally occurs during the regular benefits open enrollment in the fall, so the employee’s choices take effect on January 1.

Once the employee elects to participate and authorizes a dollar amount to be contributed each pay period, the employer will take regular deductions out of the employee’s pay, on a pre-tax basis, and set aside those amounts to be used for the employee’s HFSA.

The employee’s election amount, or choice not to enroll, applies throughout the 12-month plan year. Elections cannot be changed during the year unless the employee experiences a permitted election change event, such as a change in marital status, birth or adoption of a child, or certain employment changes. For details, see Sample Cafeteria Plan Permitted Election Changes.

Contributions

The IRS imposes a limit on the maximum amount of elective HFSA contributions per employee for each 12-month plan year. For the plan year beginning in 2023, the maximum HFSA contribution limit is $3,050. For the plan year beginning in 2024, the maximum HFSA contribution limit is $3,200.

If both spouses work and are eligible for HFSAs as employees, each can elect to contribute up to the plan year limit for their separate HFSA. The employer may design its HFSA plan with a lower limit, although most plans use the federal limit.

An employer may contribute to an HFSA using flex credits based on IRS regulations. Generally, an employer may match up to $500 regardless of whether the employee contributes. Amounts above $500 may only be made on a dollar-for-dollar match of an employee’s contribution. An employer contribution is in addition to the amount an employee may elect, should be provided on a nondiscriminatory basis, and only be available to employees eligible for the employer’s health insurance plan.

The Affordable Care Act (ACA) requires HSFAs to be an excepted benefit by meeting two conditions:

  • The availability condition requires another nonexcepted group health plan available (e.g., a medical plan).
  • The maximum benefit condition states the maximum amount available is less than two times the employee election plus $500 or a matching contribution between employer and employee. The following examples represent this condition:
    • Employee contributes $100, employer contributes $600 (matches employee contribution plus $500), employee’s HFSA is $700.
    • Employee contributes zero, employer contributes $500 (maximum allowable by an employer when an employee does not contribute), employee’s HFSA is $500.
    • Employee contributes $2,000, employer contributes $2,000 (employer matches employee’s contribution), employee’s HFSA is $4,000.

Claims and Claim Substantiation

To receive reimbursement from an HFSA for an eligible expense, an employee must submit a claim to the HFSA administrator with supporting documentation. The employer’s plan may set time limits for claiming reimbursements, such as 90 days from the date the expense is incurred.

The HFSA administrator typically provides a form for use when submitting claims. Along with the claim form, employees need to submit proof that they made a payment and that the expense was of the type that is covered by the HFSA. Documentation requirements vary depending on the HFSA administrator, although all plans require a receipt that shows the following:

  • Date of service
  • Cost of service
  • Provider name
  • Type of service

The IRS requires all claims to be substantiated for HFSA reimbursement. A memorandum from the IRS Office of the Chief Counsel provides an explanation of the substantiation requirements as follows:

  • Full substantiation is required for every reimbursement (including debit card usage);
  • Reimbursements that are not fully substantiated must be included in an employee’s gross income;
  • Cafeteria plans must require substantiating documents from an independent third party (e.g., explanation of benefits document, invoice from a provider) and
  • Cafeteria plans must require participants to provide certifications or documents providing that reimbursements have not been covered by other plans, or that they will not seek reimbursement for the same expense from other plans.

Guidance contained in the Chief Counsel memorandum is advice based on their interpretation of the law.

HFSA Debit Cards

The HFSA debit card, which allows participants to pay for healthcare expenses directly from their account rather than having to submit a claim and wait for reimbursement, eliminates the need for employees to pay out-of-pocket at pharmacies, doctors’ offices, dentists’ offices, vision centers, and hospitals, as well as for the services of other valid healthcare providers. Federal regulations apply to the use of debit cards for HFSAs, and providers and employees may be required to substantiate (produce supporting documentation) for each expense.

Uniform Coverage Rule

The employee’s entire annual election amount is available to the employee from the first day of the plan year, even if the employee has not put the full amount in yet. For example, John has elected to contribute $2,600 for the plan year, so $50 is being deducted from each weekly paycheck. John paid $1,000 for a root canal on January 15, which is less than his annual election amount, so his entire claim will be paid even though he has only contributed $100 to the plan so far that year.

The employer bears the risk of the employee leaving the company before the employee has contributed the full elected amount into the HFSA. On the other hand, employees forfeit contributions made to their HFSAs if they do not use the funds to reimburse eligible expenses.

Use It or Lose It Rule

A critical element of an HFSA is the “use it or lose it” rule. Traditionally, money set aside in an HFSA could only be used for expenses incurred within the specific plan year. If the entire amount an employee elected to set aside in an HFSA was not spent to reimburse eligible expenses incurred during that plan year, the employee forfeited any unspent funds. Federal rules have been changed to allow exceptions, at the employer’s option, from the standard use it or lose it rule.

Grace Period

The employer’s HFSA may be designed to provide a grace period of up to 2½ months after the plan’s year-end date during which unused contributions can be used to reimburse eligible expenses incurred during the grace period.

If the plan includes a grace period, the grace period must apply to all participants in the plan. Expenses incurred during the grace period must be paid or reimbursed from benefits remaining unused at the end of the immediately preceding plan year. An employer may not permit unused benefits or contributions to be cashed out or used to pay or reimburse expenses that are not eligible expenses. Any benefits unused after a 2½ month grace period cannot be carried forward to any subsequent period and are forfeited under the use it or lose it rule. See Carryover Period section, next.

Carryover Period

Another exception from the typical use it or lose it rule is allowed at the employer’s option. The employer’s plan may provide for a carryover period of up to 12 months following the end of the plan year. During the carryover period, the employee may incur and reimburse eligible expenses up to their unused year-end balance. The IRS sets a limit on the maximum amount allowable under an HFSA carryover provision. For plan years beginning in 2023, the limit is $610. For plan years beginning in 2024, the limit is $640. In addition, the following apply:

  • The employer’s HFSA plan may offer either a grace period or a carryover provision, or neither, but cannot offer both with respect to the same plan year.
  • The availability of an HFSA grace period or carryover provision may affect the employee’s (or the employee’s spouse’s) eligibility to make HSA contributions.

Unused Funds

When unused HFSA funds remain after the applicable grace or carryover periods, an employer may use the funds in the following ways:

  • Apply to HFSA administrative costs that were incurred during the plan year where unused funds are available but cannot be administrative costs related to the initial expense of establishing the plan.
  • Credit unused funds to employees’ HFSAs for the plan year immediately following the year with forfeited funds. Credits must be used on a uniform basis unrelated to any claims experience and not violate § 125 rules:
    • Reduce employees’ HFSA fees by dividing the total forfeited funds across all employees (e.g., $500 in total forfeitures divided by 50 employees, an employee elects $700 with a credit of $10 from the forfeitures of the preceding year, which results in the employee’s actual withholding of $690 and an HFSA balance of the full $700).
    • Add to employees’ coverage (e.g., using the above example, an employee electing $700 would have an account balance of $710 while only withholding for the $700).

HFSA plan documents should include language describing the usage of forfeited funds.

Qualified Reservist Distributions 

The Heroes Earnings Assistance and Relief Act (HEART Act) of 2008 provides special rules for unused benefits in an HFSA by allowing § 125 plans to permit employees who are called to active military duty for 180 days or more or an indefinite period of time, the option to take a taxable qualified reservist distribution (QRD). The QRD options are: 

  • Full HFSA election amount less any reimbursements taken;
  • The amount the employee contributed to the HFSA, less any reimbursements taken; or
  • Any other amount up to the election value less any reimbursements taken.

Plan documents must include QRDs as a permitted distribution. If the plan documents are silent on an employee’s QRD options, the second option above is the default. 

Family and Medical Leave Act

The Family and Medical Leave Act (FMLA) entitles the employees of certain employers to have 12 weeks of unpaid leave for certain family or medical reasons. In the event of an unpaid leave under the FMLA, the participant must be provided with the election of whether to continue or suspend HFSA coverage during the leave.

If an employee elects to discontinue HFSA coverage during an FMLA leave, or if the employee’s HFSA coverage was discontinued because of nonpayment of premiums, the employer must offer the employee the right to reinstate the coverage upon return to work at the end of the FMLA leave. Such reinstated coverage would be on the same basis as the employee’s coverage prior to the FMLA leave unless a change in family status has occurred.

If the employee elects to continue health plan coverage during the FMLA leave, the employee may be required to pay the same contributions the employee was paying prior to the FMLA leave. The employer may give the employee one or more of the following options for continuing to pay the employee’s portion of the premium:

  • Pay-as-you-go. The employee pays their contributions periodically.
  • Prepayment. The employee pays their contributions for the FMLA leave period in advance.
  • Catch-up payment. The employee pays their contributions at the end of the FMLA leave.

The alternatives relating to the methods of payment are subject to the following rules:

  • The employer cannot offer the prepayment option as the only form of payment.
  • The employer cannot offer the catch-up payment option as the only form of payment unless that is the only form of payment offered to other persons on other unpaid leaves of absence.
  • The employer cannot offer the employee on an FMLA leave of absence a choice between the prepayment option and the catch-up payment option without the pay-as-you-go option unless they are the only two options offered to employees on other unpaid leaves of absence.

Because of the rules, in most cases, employers will have to offer the pay-as-you-go option and may or may not offer one of the other two options.

COBRA Continuation Coverage

Group health plans, including HFSAs, are required to offer COBRA continuation coverage to participants when their coverage would otherwise be lost due to certain qualifying events, such as termination of employment. (Employers with fewer than 20 workers generally are exempt from the federal COBRA rules.) For HFSA participants, electing and paying for COBRA allows the participant to continue accessing the account for new claims.

Although HFSAs are subject to COBRA, special rules apply:

  • COBRA terminates at the end of the plan year in which the qualifying event occurs (instead of the usual 18-month maximum continuation period), and
  • No COBRA offer is required if the employee’s HFSA is “overspent” at the time of the qualifying event.

Overspent means that the remaining HFSA benefit (i.e., annual election amount minus claims already reimbursed) is less than or equal to the COBRA premiums that would be required for the rest of the plan year.

For instance, assume the employee had elected $1,200 for a calendar-year HFSA, made $1,000 in eligible claim reimbursements, and then terminated employment on June 30. The HFSA was overspent since the remaining annual limit of $200 is less than the amount of COBRA premiums ($600) that would be due for July through December. In that case, the employer is not required to offer COBRA. (Note that the 2% administrative charge for COBRA is disregarded in our example.)

Due to claim lag, it can be difficult to determine whether a particular employee’s HFSA is overspent upon termination. For this reason, many employers prefer not to apply the overspent rule and instead offer COBRA to all HFSA participants.

Each employee's healthcare needs are unique, and an HFSA can provide tailored tax savings and reimbursement options. To learn more about implementing HFSAs in your organization, fill out the form below.

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