Is a Flexible Spending Account (FSA) taxed in California?

Health FSAs are generally not subject to California income tax - California conforms to the federal IRC §125 cafeteria plan rules. However, there is a critical distinction between FSAs and HSAs that is frequently confused: HSAs are taxable in California even though they are federally tax-free.

Federal Tax Treatment of FSAs

Under IRC §125, FSA contributions through an employer cafeteria plan are excluded from federal income tax, Social Security (FICA), and Medicare tax. Qualified distributions for eligible expenses are also tax-free. This applies to Health FSAs, Dependent Care FSAs, and Limited Purpose FSAs.

California Conformity to FSA Tax Treatment

California conforms to IRC §125 under the California Revenue and Taxation Code. As a result:

• Employee salary reduction contributions to a Health FSA are excluded from California state income tax
• Employer contributions to an FSA are excluded from California taxable wages
• Qualified distributions from a Health FSA are not taxable in California
• Dependent Care FSA contributions (up to $5,000 per household / $2,500 MFS) are also excluded

2025 FSA Contribution Limits

Health FSA: $3,300 per employee (IRS Rev. Proc. 2024-40)

Dependent Care FSA: $5,000 per household ($2,500 if married filing separately)

Health FSA Carryover: Employers may allow up to $660 of unused Health FSA funds to carry over to the next plan year, or instead offer a 2.5-month grace period, but they cannot offer both options.

Important Distinction: FSAs vs. HSAs in California

Unlike FSAs, Health Savings Accounts (HSAs) are not recognized by California. California does NOT conform to IRC §223 - HSA contributions are taxable for California income tax purposes and HSA earnings (interest, dividends, and capital gains) are taxable for California income tax purposes.. This is one of the most significant and commonly misunderstood California tax nonconformities. If you have both an FSA and an HSA, a California-specific adjustment is required on Schedule CA (540) for the HSA.

Key takeaway: FSA = tax-free in California. HSA = taxable in California. These are entirely different account types with different state-level treatment.

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Sources:

IRC §125 - Cafeteria plans

IRS Publication 969 - Health Savings Accounts and Other Tax-Favored Health Plans

IRS Rev. Proc. 2024-40 - 2025 FSA contribution and carryover limits

California R&TC §17501 - California conformity to IRC §125

California FTB - HSA nonconformity guidance

California FTB Schedule CA (540) Instructions - HSA adjustment line

IRC §223 - Health Savings Accounts / federal treatment