Health Flexible Spending Account (FSA)

• Section 125 cafeteria plan document (with FSA provisions): The foundational written document required by IRC Section 125(d). If you already have a POP plan document, you need a formal amendment adding the FSA. The plan must specify the plan year, eligible employees, annual election limit, eligible expenses, run-out period, carryover or grace period (if any), and claims procedures.
• Summary Plan Description (SPD): ERISA requires participants to receive an SPD. For most small FSA plans, the plan document doubles as the SPD. Provide a copy to each participant when they first become eligible.
• Salary reduction election forms: Signed pre-tax election for each participant, completed before the plan year or within the new-hire election window. Keep on file for at least 6 years.
• TPA or benefits card agreement: Most employers contract with a third-party administrator to handle FSA debit cards, claim payments, and substantiation. Have this agreement in place before the plan year starts.
• Employee census (for NDT): A roster of all employees showing name, hire date, job title, prior year W-2 compensation, ownership percentage, officer status, enrollment status, annual premium salary reduction amount, and annual FSA election amount. Both amounts feed the Key Employee Concentration Test; see the NDT Worksheet in Templates & Resources below.
• Eligible expense list (for communications): A plain-language list of what the FSA covers (or, for LPFSA, what is limited to dental/vision only). Your TPA typically provides this, or reference IRS Publication 502.

Part A: Setting Up the Plan

Part B: Annual Nondiscrimination Testing

The Section 125 rules require three annual tests. Use the FSA NDT Worksheet in the Templates & Resources section; it accounts for both premium salary reductions and FSA election amounts together as "total benefits."

• Summary Plan Description: ERISA requires you to provide each participant with an SPD within 90 days of first becoming covered. For new FSA plans, provide it before or at enrollment. For existing plans, provide to new participants as they become eligible.
• Election forms: Employees must make elections in writing (paper or electronic) before the plan year or within the new-hire election window. No election means no pre-tax deduction. Collect and retain signed elections every year.
• Reimbursement substantiation: Every FSA reimbursement must be substantiated; the employer (or TPA) must verify that the expense is an eligible medical expense. An FSA debit card does not eliminate this requirement; it just automates some of it. Unsubstantiated expenses must be repaid to the plan or offset against future claims.
• Reimbursement timing: Once a valid claim is submitted and substantiated, reimbursement must be made within a reasonable time. Most TPAs process within 5-10 business days.
• Uniform coverage rule notice: Employees should understand that their full annual election is available on day one, and that if they terminate employment mid-year with a balance, they may owe money back (or the employer absorbs the loss). Clear communication at enrollment prevents disputes.
• Electronic delivery: Plan materials and election forms may be delivered electronically if the employer meets DOL safe harbor requirements (employees have regular access to the delivery system and an opportunity to request paper versions).

• Signed plan document (and all amendments)The original signed cafeteria plan document establishing the FSA. Retain indefinitely. Each amendment must be signed and dated before the change takes effect.
• Annual election formsSigned salary reduction elections for each participant, for each plan year. Retain for at least 6 years (ERISA recordkeeping standard).
• Claim recordsFor each FSA reimbursement: the claim form or TPA record, the substantiation documentation (receipt, EOB, or other evidence), and the payment record. Your TPA typically retains these, but confirm with them. Retain for at least 6 years.
• Nondiscrimination test resultsA written record of each year's test calculations: employee census used, HCI/key employee classifications, test inputs (premium plus FSA amounts), and pass/fail results. The completed NDT Worksheet serves this purpose. Retain for at least 6 years.
• Mid-year change documentationFor each mid-year election change: the qualifying event, date, nature of the change, and updated election. Keep in the employee's file.
• SPD distribution recordsA log showing when the SPD was provided to each participant and any updated SPDs distributed after plan changes.
• Forfeiture recordsA record of unused balances forfeited at year-end and how those funds were applied (per the plan document's forfeiture provision).

Common traps

FAQs

If I already have a POP, do I need to replace it when I add an FSA?

No, you amend it. Your existing POP plan document is a Section 125 cafeteria plan document. To add an FSA, you add FSA provisions via a formal written amendment signed before the FSA becomes effective. The amended document continues to cover both the pre-tax premium arrangement and the new FSA. You do not need a second, separate plan document.

What is the uniform coverage rule, and what does it mean for the employer?

The uniform coverage rule requires that an employee's full annual FSA election be available to them on the first day of the plan year, not just the amount they've contributed so far. If an employee elects $2,400 and submits a $2,400 claim on January 2nd before any deductions have processed, you must reimburse the full $2,400. The employer absorbs the loss if the employee then terminates before contributing the full amount. This is the financial risk of offering an FSA without adequate safeguards, and it's one reason some small employers have the TPA fund reimbursements rather than paying out of their own accounts.

What expenses are eligible for a general purpose health FSA?

Eligible expenses are defined under IRC Section 213(d): generally, amounts paid for medical care not compensated by insurance, including doctor and hospital costs, prescription drugs, dental and orthodontia, vision care, and many over-the-counter items (including OTC drugs and menstrual care products since 2020). Cosmetic procedures, gym memberships, and general wellness expenses are not eligible. IRS Publication 502 has the complete list. Your TPA should also provide a current eligible expense list to employees at enrollment.

What expenses are eligible for a Limited Purpose FSA?

An LPFSA is limited to dental and vision expenses only, until the HDHP minimum deductible is met if the plan offers a post-deductible medical option. Medical expenses before the deductible are not eligible, and paying them from an LPFSA would disqualify the employee's HSA contributions. Eligible dental examples: exams, cleanings, fillings, crowns, orthodontia, oral surgery. Eligible vision examples: exams, prescription glasses, contact lenses, LASIK. Cosmetic dental and vision (teeth whitening, non-prescription sunglasses) are not eligible.

Can the employer contribute to the FSA?

Yes. Employer contributions to a health FSA are not subject to FICA taxes and are excluded from employee income. Employer contributions must be specified in the plan document. If you contribute, the amount reduces what counts as "employee benefits" for the Key Employee Concentration Test calculation, which can help smaller employers pass. Employer contributions do not count against the employee's $3,400 annual contribution limit.

What happens at year-end to unused FSA balances?

Under the use-it-or-lose-it rule, unused FSA balances after the run-out period (and carryover or grace period, if offered) are forfeited. The forfeited funds may be retained by the employer, used to defray plan administrative costs, or allocated back to participants in the following year as employer contributions; but the last option must be specified in the plan document and cannot be proportional to participant forfeitures (which would defeat the purpose of the forfeiture rule). Most employers use forfeited funds to offset TPA fees.

• 26 CFR 1.125-5: Health FSA Rules (eCFR). The detailed Treasury regulation governing health FSAs under Section 125, including the uniform coverage rule, eligible benefits, use-it-or-lose-it rule, and carryover mechanics.
• 26 CFR 1.125-1: Cafeteria Plan General Rules (eCFR). The foundational cafeteria plan regulation covering plan document requirements, elections, and the tax treatment of qualified benefits.
• IRS Publication 502: Medical and Dental Expenses. The definitive IRS list of eligible and ineligible medical expenses for FSA reimbursement purposes.
• IRS Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans. Covers FSA rules, HSA compatibility, and LPFSA requirements in plain language.
• IRS Notice 2013-71: FSA Carryover Rule. The IRS notice permitting plans to offer a carryover of up to the indexed limit (currently $680 for 2026) in lieu of a grace period.
• 26 CFR 1.125-7: Nondiscrimination Rules (eCFR). The regulatory text for the Eligibility Test, Benefits & Rights Test, and Key Employee Concentration Test.
• IRS Notice 2020-33: OTC Drugs and Menstrual Care Products. Confirms eligibility of OTC drugs (without prescription) and menstrual care products as FSA-eligible expenses effective January 1, 2020.

• Limited Purpose FSA (LPFSA), HSA compatibility: If your employees contribute to an HSA (alongside an HDHP), a general purpose health FSA disqualifies their HSA eligibility. The LPFSA solves this by restricting reimbursements to dental and vision only (and optionally post-deductible medical after the HDHP minimum deductible is met). For 2026, the HDHP minimum deductible is $1,700 (self-only) or $3,400 (family). To offer both an LPFSA and an HSA, make sure your plan document explicitly limits the FSA to dental and vision; a general FSA labeled "limited purpose" without the proper plan language does not protect HSA eligibility.
• LPFSA carryover and HSA eligibility: If you offer a carryover on an LPFSA, the carried-over balance must remain limited-purpose into the next plan year. If it automatically converts to general-purpose at the start of the new year (even for just one day), the employee cannot contribute to an HSA for that entire year. Review your plan document and TPA configuration carefully.
• Post-deductible FSA option: A post-deductible FSA allows reimbursement of medical expenses after the employee has met the HDHP's minimum deductible. This is a design choice that must be specified in the plan document. It allows some medical coverage while still preserving HSA eligibility. However, it adds administrative complexity; the TPA must track whether the deductible has been met before processing medical claims.
• COBRA and the uniform coverage rule: When a participant loses FSA coverage due to a qualifying event, COBRA applies to health FSAs, but only when the FSA is "underspent" (the participant has received less in reimbursements than they've contributed so far). If the FSA is overspent, there is no COBRA obligation. The COBRA premium for an FSA is the maximum remaining annual election plus a 2% administrative fee. Coordinate FSA COBRA administration with your COBRA administrator.
• Termination mid-year, employer risk: Under the uniform coverage rule, if an employee terminates mid-year with an overspent FSA (they've received more than they've contributed), the employer generally cannot recover the overpaid amount from the employee's final paycheck in most states. The employer absorbs the loss. Employers sometimes set a lower employer-funded maximum to limit this exposure.
• Simple Cafeteria Plan (Section 125(j)): Employers with 100 or fewer employees may elect Simple Cafeteria Plan status, which automatically satisfies all three Section 125 nondiscrimination tests. This applies to the FSA just as it does to a POP. See the POP page for eligibility requirements. Note that Simple Cafeteria Plan status satisfies the Section 125 tests but does not eliminate FSA-specific rules (uniform coverage, substantiation, use-it-or-lose-it).
• S-corporation 2%+ shareholders: More-than-2% S-corporation shareholders cannot participate in the FSA. They are treated as partners rather than employees for Section 125 purposes. Their contributions would not receive pre-tax treatment.
• State income tax: Most states conform to federal Section 125 treatment, making FSA contributions exempt from state income tax as well as federal. New Jersey and Pennsylvania are notable exceptions; FSA contributions in those states may still be subject to state income tax. Confirm with your payroll provider.
• Dependent Care FSA (DCAP): A dependent care FSA is a separate benefit governed by IRC Section 129, with different contribution limits ($7,500, or $3,750 if married filing separately, increased from $5,000/$2,500 effective 2026 under the One Big Beautiful Bill), different eligible expenses (childcare, elder care), and different nondiscrimination tests. It is covered on the DCAP page. If you offer both a health FSA and a DCAP, they may share the same Section 125 plan document but must be separately tracked and tested.

★Two tools to help you manage FSA compliance yourself: an NDT worksheet built specifically for FSA plans, and the Section 125 plan document template that covers both premium reduction and FSA in one document.