What is the rationale behind an FSA being "Use it or Lose it"?

Question

One of the biggest gripes most people have with the Flexible Spending Account is the rule that you must "Use it or Lose it". This can lead to people frantically running around just before their money expires trying to rack up eligible expenses they probably don't need. And so I wonder, why was the FSA designed this way?

One plausible answer is that many FSA plans have the concept of eligible events which enable an employee to use their FSA money in advance of having paid enough money into their account. Sometimes those employees end up leaving before the funds are paid back (because they quit or get laid off/fired), and then the employer is out the money. One way an employer can help recoup those potential losses is by expiring extra FSA funds that are not used in time. But I don't like that answer, and here's why:

1. It shouldn't be the case that current employees might have to pay for ex-employees medical expenses.
2. The responsible and frugal person could be penalized, whereas a potential deviant person (someone who purposely spends their entire FSA and quits their job shortly after) is rewarded.

It seems to me that it would be significantly more fair if the following rules existed instead:

1. You cannot spend more than is in your account.
2. Extra FSA funds at the end of the time frame are given back to you and added to your income. (Since it was subtracted from your income when you paid that amount into the plan.)

Now, to prevent this question from being marked as "too broad" or "primarily opinion based", I should clarify what I'm asking:

Given that employees generally dislike that FSA plans are Use-it-or-Lose-it, and also that there appears to be an obvious alternative that would be preferable, what is the rationale for defining the FSA plan in such a way?

Side note: Prior to 2005 the funds in an FSA account expired at the end of the 12 month plan, and this was even worse than it is today, whereas now most employers elect to allow a 2.5 month grace period.

Answer 1

The FSA, in contrast to the HSA, is not an "account" that you put money in. FSA stands for "Flexible Spending Arrangement," not "Account." Technically, it is a defined-benefit plan. Here is the difference:

With an account such as an HSA, you put money into the account, and you get that same money out. You can't take money out unless you first put money in.

The FSA doesn't work that way. Instead, you pick an annual amount that your FSA will cover, and work out a monthly fee to pay for it. For example, you might decide on a $1800 FSA, which will cost you $150 per month. However, the $150 you pay each month does not go into an account for you; instead, it goes to your employer, who is managing the plan.

Let's say that in January, at the beginning of the plan year, you have a large medical expense of $1000. You've only had $150 taken out of your paycheck so far this year, but you are covered for $1800, so you get reimbursed the full $1000. This is referred to as "uniform coverage", meaning that you get the full $1800 of coverage on day 1 of the year.

Now let's say that you leave your job in March. You've only paid $450, and you've received $1000 in benefit. You do not owe your employer the rest of the money; your employer eats this cost. This is the trade-off that the FSA offers over other types of accounts: depending on an employee's circumstances, an employer might make money (use-it-or-lose-it) or might lose money (uniform coverage) on an individual employee.

The idea behind the use-it-or-lose-it provision of the FSA is to help the employer pay for the uniform coverage provision.

The details behind the FSA (and other types of health plans) are outlined in IRS Publication 969.

I'm sure that a secondary reason behind the use-it-or-lose-it provision is that it encourages an employee to keep his FSA plan small, so he can use it all up and not have to lose too much of it at the end of the year. And a smaller FSA contribution means more tax money for the government.

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To address your point that it shouldn't be this way:

I'm personally not a fan of the FSA because of the use-it-or-lose-it provision. But participation is voluntary, for both employers and employees. You proposed an alternative set of rules for the FSA, but you are basically describing an HSA, in which you cannot spend more than you have, and you get to keep whatever is left over. The recent rules changes that allow plans to feature a grace period or a small carryover balance were an attempt to make the FSA a little more attractive/useful, but if you want the ability to keep your money and not have to spend it at all, use an HSA instead.

Answer 2

The interesting thing about an FSA is that you have access to your total annual election immediately. After electing to put $200 per month toward your FSA, you can go have a $1,500 surgery on January 3rd and pay with your FSA funds. Then you can leave the company on February 1st, and not owe the company anything.

I understand that you don't like that this is the answer, but it is. The employer is on the hook for the full elected liability of an FSA plan as of the first day of the plan year. The employer is also paying admin costs that aren't passed to the employees. You contest that this arrangement could leave current employees picking up the bag for departed employees, but there is no employee liability. FSA plans run at a net cost the the employer (I'm sure there are outlier exceptions however).

I disagree with your premise that

"Employees generally dislike that FSA plans are Use-it-or-Lose-it, and also that there appears to be an obvious alternative that would be preferable [...]

The employees that dislike the rules of FSA accounts don't fully understand the nuances and surely assume that FSA is a synonym for HSA. Tons of employers offer their employees FSA plans and they are very well received. You can fill full prescriptions off of a debit card on the third day of the year before you've even contributed anything.

HSAs are great (I have one), but they require enrollment in a HDHP and you can only spend the funds currently available in your account. These are two huge limitations addressed by FSA plans. You can have a $0 deductible platinum plan with a $2,000 out of pocket max and an FSA debit card for virtually tax free healthcare. The caveat being if you don't use your full FSA election you give it up.

In fact, my biggest gripe with the FSA/HSA discussion is that anyone feels the need to claim that "HSA funds don't expire at the end of a plan year" as though it's something other than a personal savings account. An FSA is a spending account (or arrangement) which is an entirely different animal. It would be like claiming that IRA funds don't expire, as though they might somehow.

Answer 3

From personal experience it's difficult to predict when and how much is needed for an FSA especially if you planned for a major medical event only for the physicians to change the date or need. It's wasteful to simply try and spend the money by either buying unnecessary products or services just so that income is not given away.

I was unable to find any data that suggested that employees leaving prior to fully funding their account was a significant enough issue to warrant the current rule. Better rules could have been put in to place to limit the employer's liability without hamstringing the employee.

It also seems to be up to the employer how it wants to interpret rules. For instance, IRS Publication 502 states that one can include only the medical and dental expenses paid this year, regardless of when the services were provided. However, some FSA administrators will only reimburse when the service is rendered. For those that have to prepay in order to schedule service would mean having to float that money until the service actually occurs.