Flexible spending accounts date to the Revenue Act of 1978, which added Section 125 to the Internal Revenue Code and created the legal framework for pre-tax employee benefit plans. The history of flexible spending accounts since then is largely a story of IRS rulings tightening the rules, healthcare legislation reshaping them, and pandemic-era laws loosening them, with contribution limits and eligible expenses shifting along the way.
The 1978 Origin
Congress passed the Revenue Act of 1978 on November 6 of that year. Its Section 125 provision created what are known as cafeteria plans, the statutory container that health FSAs still sit inside today.1Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans
The change mattered because of a tax doctrine called constructive receipt. Before 1978, if an employer gave a worker the choice between cash and a benefit, the tax code generally treated the benefit as taxable income, since the worker could have taken the cash. Section 125 carved out an exception: employees could choose between wages and certain tax-free benefits, including money earmarked for medical expenses, without that choice alone triggering a tax bill.2Senate Committee on Finance. Conference Report – Revenue Act of 1978
The law also included nondiscrimination rules. If a plan disproportionately favored officers, large shareholders, or other highly compensated employees, the tax-free treatment did not apply to those groups.1Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans
Dependent Care Accounts Added in 1981
Three years later, Congress extended the cafeteria plan concept to childcare and elder care. The Economic Recovery Tax Act of 1981 added Section 129 to the tax code, creating dependent care assistance programs. Employees could now set aside pre-tax dollars to pay for care of children under 13 or other qualifying dependents.3Office of the Law Revision Counsel. 26 U.S. Code 129 – Dependent Care Assistance Programs
The dependent care FSA came with its own annual limit, set by statute at $5,000 per household ($2,500 for married individuals filing separately). Unlike the later health FSA cap, this figure was not indexed for inflation and stayed at $5,000 for decades.
The 1984 IRS Crackdown
Widespread employer adoption took several years, and during the early 1980s some employers pushed the boundaries of the new rules. The most notable case was the Zebra plan, short for Zero Balance Reimbursement Account. It let employees reduce their salary after incurring a medical expense, effectively converting all out-of-pocket health costs into pre-tax payments. On February 10, 1984, the IRS declared that these arrangements lacked economic substance and did not qualify as valid cafeteria plans.
A few months later, the IRS addressed another open question: what happens to money left in an FSA at year-end. Some administrators had been letting workers roll unused funds forward or take them back as taxable cash. In May 1984, the IRS issued proposed regulations formalizing the use-it-or-lose-it rule. Any money remaining in the account at the end of the plan year had to be forfeited.4Federal Register. Employee Benefits – Cafeteria Plans
The logic was that if participants could bank FSA dollars indefinitely, the accounts would function as tax-free savings vehicles rather than tools for covering annual expenses. Forfeiture forced closer estimation of yearly costs.
Loosening Forfeitures: 2005 and 2013
The strict version of the rule held for more than two decades. Then the IRS opened two doors.
IRS Notice 2005-42 let employers amend their plans to add a grace period of up to two and a half months after the plan year ended. For a calendar-year plan, participants had until March 15 of the following year to spend down their balance. Anything unused after that was still forfeited.5IRS.gov. Section 125 – Cafeteria Plans – Modification of Application of Rule Prohibiting Deferred Compensation Under a Cafeteria Plan (Notice 2005-42)
Eight years later, Notice 2013-71 went further. Employers could let participants carry over up to $500 of unused health FSA funds into the next plan year, with no deadline to spend the carryover amount. The carryover did not count against the next year’s contribution cap.6IRS.gov. Modification of Use-or-Lose Rule For Health Flexible Spending Arrangements (FSAs) – Notice 2013-71
A plan can offer a grace period or a carryover for the same benefit, but not both. Employers had to pick one.
The Affordable Care Act Reshapes Health FSAs
The Patient Protection and Affordable Care Act, signed in March 2010, made two structural changes.7HHS.gov. About the Affordable Care Act (ACA)
Starting January 1, 2011, employees could no longer use FSA funds to buy over-the-counter medications, such as cold medicine, pain relievers, or allergy pills, without a prescription. Insulin remained eligible without one.8IRS.gov. Application of Affordable Care Act to Over-the-Counter Medicines and Drugs – Notice 2010-59
The second change was the first federal cap on health FSA contributions. Before the ACA, employers set their own limits, and some allowed $5,000 or more per year. Section 125(i), added by the ACA, imposed a $2,500 annual ceiling on employee salary reduction contributions for plan years beginning after December 31, 2012. The cap has been indexed for inflation since 2014.1Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans
Pandemic-Era Changes
Two 2020 laws changed FSA rules in response to COVID-19.
The CARES Act, signed in March 2020, reversed the ACA’s prescription requirement for over-the-counter medications. The change applied retroactively to purchases made after December 31, 2019. The same law made menstrual care products eligible FSA expenses for the first time.9Internal Revenue Service. IRS Outlines Changes to Health Care Spending Available Under CARES Act
The Consolidated Appropriations Act of 2021, signed December 27, 2020, gave employers temporary flexibility for the pandemic years. Participants could carry over all unused health and dependent care FSA funds, not just $500, for plan years ending in 2020, 2021, and 2022. Employers could also let workers change election amounts mid-year without a qualifying life event.10Social Security Administration. President Signs the Consolidated Appropriations Act, 2021
These provisions were optional. Employers who adopted them saw the standard rules return once the applicable plan years passed.
Where the Limits Stand in 2026
The health FSA contribution limit for 2026 is $3,400, up from $3,300 in 2025. Plans that allow a carryover can permit up to $680 to roll into the next year.11Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026, Including Amendments From the One, Big, Beautiful Bill
The dependent care FSA also changed for the first time since 1981. The One, Big, Beautiful Bill Act permanently raised the household cap from $5,000 to $7,500 ($3,750 for married couples filing separately).