Flexible Spending Accounts (FSAs) remain one of the most popular employee benefit programs offered by businesses across the country. These plans allow employees to set aside pretax dollars for qualified health or dependent care expenses while also providing payroll tax savings for employers.
For companies that operate a calendar-year FSA plan with a 2½-month grace period, employees generally have until March 15 of the following year to incur eligible expenses using funds from the previous plan year. After that deadline passes, unused balances may be forfeited under the well-known “use-it-or-lose-it” rule.
Because these rules can impact both employer compliance and employee satisfaction, it is important for businesses to understand how FSAs function and what options exist for managing forfeited balances. The tax professionals at Botwinick & Company regularly advise businesses on employee benefit plan compliance, payroll tax strategies, and tax-efficient benefit structures.
Understanding Flexible Spending Accounts
FSAs are employer-sponsored benefit plans that allow employees to contribute a portion of their salary on a pretax basis to cover eligible expenses. Contributions are deducted from wages before federal income tax, Social Security tax, and Medicare tax are calculated. In many states, state income taxes are also reduced.
These tax advantages make FSAs an appealing option for both employers and employees. Employers benefit from lower payroll taxes, while employees gain the ability to pay for qualified expenses with tax-free funds.
Most FSA programs fall into two primary categories.
Health Care Flexible Spending Accounts
A health care FSA allows employees to pay for qualifying out-of-pocket medical expenses that may not be fully covered by insurance. These typically include medical, dental, and vision expenses for the employee, their spouse, and eligible dependents.
For the 2026 tax year, the maximum employee contribution limit for a health care FSA increases to $3,400, up from $3,300 in 2025. The IRS adjusts this contribution limit annually to account for inflation.
Common eligible expenses may include:
- Medical copayments and deductibles
- Prescription medications
- Dental treatments such as fillings or orthodontics
- Vision care including eye exams, glasses, and contact lenses
- Certain approved over-the-counter health products
Dependent Care Flexible Spending Accounts
A dependent care FSA helps employees pay for care services needed while they work or actively seek employment. This typically includes child care or adult dependent care services for qualifying family members.
Recent tax legislation increased the annual dependent care FSA contribution limit to $7,500 per household beginning in 2026. For married taxpayers filing separately, the limit is $3,750. Previously, the contribution cap was $5,000 per household ($2,500 for separate filers) in 2025.
Unlike health care FSAs, the dependent care FSA contribution limit is not indexed for inflation. This means it will remain unchanged unless Congress passes new legislation increasing the allowable amount.
Eligible dependent care expenses may include:
- Daycare or preschool services
- Before- and after-school programs
- Summer day camps
- In-home caregiving for qualifying dependents
- Adult day care services
The “Use-It-Or-Lose-It” Requirement
FSAs operate under a long-standing IRS rule commonly referred to as the “use-it-or-lose-it” provision. This rule states that funds remaining in an employee’s account at the end of the plan year are typically forfeited if they are not used for eligible expenses.
The purpose of this rule is to ensure that FSAs function as reimbursement plans rather than long-term savings vehicles. However, IRS regulations allow employers to adopt certain plan features that provide employees additional time or flexibility when using their funds.
Grace Period Option
Many employers include a grace period provision in their FSA plan design. A grace period allows employees additional time after the end of the plan year to incur eligible expenses using the remaining balance from the previous year.
The maximum grace period permitted by the IRS is 2½ months. For plans operating on a calendar year basis, this means employees typically have until March 15 of the following year to use any remaining funds.
Both health care and dependent care FSAs may offer this grace period option.
Health Care FSA Carryover Option
As an alternative to a grace period, employers may allow employees to carry over a limited amount of unused funds from a health care FSA into the next plan year.
For the transition from 2026 to 2027, employees may carry over up to $680 of unused health care FSA funds. This amount increased from the $660 carryover allowed between 2025 and 2026.
It is important to note that employers must choose between the carryover option and the grace period. A health care FSA plan cannot offer both provisions at the same time.
Dependent care FSAs are not eligible for carryover provisions and may only offer the grace period extension.
What Happens to Forfeited FSA Funds?
After the grace period ends or after applying any allowed carryover amount, remaining unused funds may become forfeited. Under IRS cafeteria plan regulations, these forfeited balances revert to the employer.
However, businesses must handle these forfeitures carefully and follow specific compliance rules when deciding how the funds are used.
Many employers apply forfeited balances toward plan administration costs. These may include third-party administrator fees, compliance expenses, or other costs associated with maintaining the FSA program.
IRS regulations also allow businesses to apply forfeited balances in other ways, provided they follow reasonable and nondiscriminatory allocation rules.
Permitted uses may include:
- Reducing future employee contributions required to reach a designated FSA balance
- Enhancing employee FSA balances in the following plan year
- Returning funds to participants as taxable wages subject to payroll taxes
For example, an employer might structure the plan so employees contribute $950 to obtain a $1,000 FSA balance, with the additional $50 funded by forfeited amounts from the prior year.
However, forfeited funds cannot be distributed based on individual claims experience or used to disproportionately benefit certain employees. Any allocation must follow the nondiscrimination rules outlined in IRS cafeteria plan regulations.
A Good Time for Employers to Review Their FSA Plan
The period leading up to the March grace-period deadline provides a natural opportunity for businesses to review how their FSA program handles unused funds. Employers should evaluate whether their current plan structure supports both compliance requirements and employee benefit goals.
Key considerations may include:
- Whether the plan should offer a grace period or a carryover provision
- How forfeited funds are currently allocated
- Administrative costs associated with the program
- Employee participation rates and benefit usage
Making adjustments to an FSA plan may help improve employee satisfaction while ensuring the plan remains compliant with IRS regulations.
Professional Guidance for Benefit Plan Compliance
Flexible Spending Accounts provide valuable tax advantages, but they also involve technical compliance rules that employers must carefully follow. From plan design decisions to managing forfeitures and payroll tax implications, businesses often benefit from professional guidance.
Botwinick & Company works closely with businesses to evaluate employee benefit strategies, manage payroll tax considerations, and ensure compliance with evolving tax regulations. Our team can help review your FSA plan provisions, advise on forfeiture handling, and prepare your organization for the next enrollment cycle.
If your business would like assistance reviewing its employee benefit programs or tax planning strategies, contact Botwinick & Company today to learn how our experienced accounting and advisory team can help.
