Who thought flexible spending accounts were a good idea?

The most befuddling tax break in the US health care system, explained.

Filling up a flexible spending account for health care can feel like a perverse game of The Price Is Right: Quick, guess how much money you’re going to spend on doctor’s visits, prescriptions, and unforeseen medical emergencies next year. Guess correctly, and you’ll save a little money. Overestimate, and you could lose it (or find yourself frantically buying sunscreen with your remaining funds on December 31).

Or maybe you don’t have a flexible spending account at all — and, well, that is really the first problem with FSAs.

Like the rest of the US health insurance system, FSAs are overly complicated. They favor people with higher incomes. And yet, much like employer-sponsored insurance itself, the tax-preferred savings accounts are too wedged into the US system of employee benefits to be seriously overhauled or eliminated — even if, in an ideal world, that is exactly what you’d want.

Here’s how FSAs works. You sign up for an account during open enrollment. For a health care FSA, you can decide to set aside about $3,000. For a dependent care FSA, you can put as much as $5,000 into the account. The money is tax-deferred, meaning it is made available to you without being taxed as income. But you have to spend it within the calendar year: Only about $600 in a health care FSA can be rolled over to the next year if your employer allows it; no rollovers are permitted for dependent care. (You might also be able to sign up for a health savings account, if your company offers one and you enroll in a high-deductible health plan. You can put away $4,150 for an individual plan or up to $8,300 for a family plan, and that money can be rolled over. We said it was complicated!)

FSAs reveal just how much of the American health care system is built upon the tax code. Most people get health insurance through their jobs because the federal government does not tax those benefits the way it does wages.

If the whole thing seems maddeningly, needlessly complicated, that’s because it is.

“FSAs are an expansion of a very inefficient way of subsidizing health insurance,” Gene Steuerle, an institute fellow at the Urban Institute and former senior official at the Treasury Department, told me. FSAs aren’t the biggest issue in the US health system: “They’re just a tiny piece of that broader matrix,” he said.

But they are symptomatic of the problems that plague the country’s convoluted way of providing benefits.

Nobody really wanted FSAs to exist, but now we’re stuck with them

So who’s to blame for this crazy system? The FSA came into being about 40 years ago —more or less by accident.

In 1978, when Congress overhauled the part of the tax code that deals with employer benefits, they were focused on tax policy, not health care. The new law permitted employers to offer “cafeteria plans,” which allow workers to choose among various benefits that they can pay for with pretax dollars. At the time, the focus was on fringe insurance benefits like life insurance or disability care, not on flexible spending accounts, two law professors, Daniel Fox and Daniel Schaffer, wrote in a 1987 academic journal article.

But someone saw an opportunity, and employers quickly began putting flexible spending accounts on their benefits menu. Early FSAs were refundable: If you didn’t spend all of the money, you got it back (with taxes taken out) at the end of the year. Employers, who wanted to compete for workers with good benefits while also passing along more health care costs, liked them too.

“Introducing flexible spending accounts made employees less resentful as employers reduced the value of the health insurance they provided,” Fox and Schaffer wrote. “The FSA was the candy coating on a bitter but necessary pill.” Some employers also argued that by forcing people to spend more of their own money on health care, FSAs would help contain medical costs.

Then, in 1983, the federal government realized (somewhat belatedly) that it had created a new way for employers and workers to avoid taxes. But by then, the accounts were already entrenched and popular with employers. So the IRS’s solution was to introduce some risk: they banned refundable flexible spending accounts — leaving Americans playing the use-it-or-lose-it guessing game we face today.

Years later, employers still see flexible spending accounts as a vital tool for attracting talent. They won’t surrender them easily.

“Health benefits are just table stakes. They need to ante up before they attract and retain a high-quality workforce,” Jake Spiegel, research associate at the Employee Benefit Research Institute, told me of how human resource departments view these benefits, based on focus groups he’s attended.

And for the people who can use them, they are a nice benefit. Previous attempts to limit FSAs and HSAs have failed or wound up being undone. FSAs are like a lot of the rest of the US health care system. They are not the most effective way of covering people’s necessary expenses. But they’re the one we’ve got.

FSAs are another low-key government giveaway to higher-wage workers

Let’s make one thing clear: If you have an FSA available to you, and you’re pretty sure you’ll use it for either health care or dependent care, it’s a good deal. Using tax-free income for those expenses is more cost-effective for the individual than using taxed income. (Another type of flexible account, health savings accounts or HSAs, are a little more complicated, as they also require enrolling in a health insurance plan with higher out-of-pocket costs.)

People do tend to use FSAs if they’ve got them, Spiegel told me. Based on his team’s research, about 90 percent of account holders take money out of their accounts every year, and the total amount of distributions line up with contributions pretty closely. In other words, people take out what they put in. Younger workers usually put less money in than older workers, which makes sense: They probably expect to have fewer medical expenses in a given year.

But for the government, it’s not as evident this is a good use of resources. The people who benefit the most from these accounts are less likely to really need the assistance, while the people who could use the help are less likely to have the option of enrolling in an FSA in the first place.

Among workers in the bottom 25 percent of earnings, just 1 in 5 are offered a health care FSA by their job, according to the Urban-Brookings Tax Policy Center. Meanwhile, nearly 70 percent of people in the top 25 percent as measured by their annual wages have access to an FSA. It helps to work at a larger company too: Three-quarters of workers in the firms with 500 employees or more can sign up for an FSA, but just 1 in 4 workers at companies with less than 100 can. The same pattern shows up for dependent care FSAs: Overall, only 1 in 3 US workers can establish an account, and those who can tend to earn higher wages.

Still, even with their limited reach, there is a lot of money tied to FSAs. Data for these accounts is extremely limited, but for dependent care FSAs, Americans saw a combined $1.2 billion tax benefit in 2020. Millions upon millions of dollars are up for grabs, and so an entire cottage industry has grown up around FSAs.

While dependent care tends to be pretty straightforward — if you need a year’s worth of daycare, you are probably paying the full $5,000 allotment to your child care provider — health care FSAs and HSAs can be used for a variety of expenses, from covering the copay for a doctor’s visit or medication to buying a new pair of prescription glasses.

TheFSAStore.com has founded its entire business on the premise of stocking only items that are eligible for FSA purchases. Amazon has an FSA store of its own too. You can buy vitamins and supplements, cold medicine, baby lotion, first aid kits, tampons, the works.

But that brings us back to the central question: Is this a smart use of the government’s tax outlays? These benefits are already concentrated among higher-income people. Because of the rules for health care FSAs, you generally have to use all of the money you’ve put into the account by the end of the year. (HSAs allow for money to roll over and even to be taken out for retirement, another way they benefit the already-privileged.)

“You had to figure out at the end of the year what the hell you would end up spending money on by the end of the year,” Eric Toder, institute fellow in the Urban-Brookings Tax Policy Center, told me of his own bewildering experience with FSAs. “You had to use it up.”

That creates the possibility people are spending FSA money on things they don’t really need, to make sure they don’t lose the money in their account. And because the money is tax-advantaged, that makes people less sensitive to the costs they are incurring. It’s the exact same problem as the tax exclusion for employer-sponsored insurance: This is “free” money (at least compared to regular income) and consumers are therefore less judicious in how they spend it. That creates more wasteful — yet tax-free! — spending.

The tax policy experts I spoke to would often scratch their proverbial heads when discussing FSAs. This is just not an area of specific expertise for most policy wonks. Even Spiegel, who has studied their utilization as closely as anyone, said that the accounts are “not a flash point” for policymakers.

Yet nobody I spoke to seemed to think that this is the smartest way for the government to subsidize these costs for Americans. Much like employer-sponsored insurance, if you were starting from scratch, you probably wouldn’t come up with FSAs to subsidize out-of-pocket health expenses or child care. They came about more or less by accident and persist largely through inertia.

“If I were reforming the tax system, I’d get rid of FSAs,” Paul Van de Water, senior fellow at the Center on Budget and Policy Priorities, told me.

But nobody really expects them to go away either. The Affordable Care Act attempted to limit the allowable items for FSA purchases, but after less than a decade, that provision was quietly rolled back as part of the Covid-19 response bills.

FSAs may not attract the same political attention as other parts of the health care system, but they do have a constituency. They are preserved by the golden rule of the US health care system, as Toder articulated it: “It’s very hard to take away benefits that people have.”

Still have questions? Dylan Scott will be chatting with Vox contributors on Thursday, October 19. To sign up, make a monthly or annual contribution to Vox before Wednesday afternoon.