Flexible Spending Account (FSA)
A flexible spending account (FSA) is a tax-deferred savings account established by an employer to help employees meet certain medical and dependent-care expenses that are not covered under the employer's insurance plan. Established under Section 125 of the Internal Revenue Code, FSAs were once known as medical Individual Retirement Accounts (IRAs). FSAs allow employees to contribute pre-tax dollars to an account set up by their employer. They can later withdraw these funds tax-free to pay for qualified health insurance premiums, out-of-pocket medical costs, day care provider fees, or private pre-school and kindergarten expenses.
FSAs provide an attractive benefit for many employees, and they also offer tax savings for both employees and employers. As the cost of providing health insurance to employees has risen rapidly over the last decade, many companies have greatly increased the employee portion of the insurance premium. Co-pays and deductibles have increased as well in an attempt to manage the overall premium cost. The use of a health care FSA is one way in which employers may help their employees to self-fund with tax-free dollars the growing costs that they are asked to bear for their partial company-funded health insurance.
TAX BENEFITS OF FSAS
Internal Revenue Service guidelines allow employees to make contributions to employer-sponsored FSAs out of pre-tax income. Thus employees save federal and state income taxes, as well as the employee portion of Social Security taxes, on the amount they authorize their employer to withdraw from their paychecks and place in the FSA each year. By reducing their taxable income, employees can increase their take-home pay. For example, say that an employee of ABC Company whose annual salary was $50,000 contributed $5,000 to an FSA in 2000. This action would reduce the employee's taxable income to $45,000. If the employee typically paid taxes amounting to 30 percent of her income, she would save $1,500 in taxes for 2000. Furthermore, the money contributed to an FSA is not taxable for the employee when it is withdrawn, provided it is used to pay for qualified medical or dependent-care expenses.
Employers also receive a tax benefit by establishing flexible spending accounts. Employers are not required to pay the employer portion of the Social Security tax—which amounts to 7.65 percent of each employee's taxable income—on employee contributions to FSAs. In effect, payroll taxes are reduced by 7.65 percent of the total employee contributions to the FSA.
In the earlier example, say that ABC Company is a small business with 10 employees and an annual payroll of $500,000. Without the tax advantage of an FSA, the company would owe Social Security taxes of 7.65 percent on its total payroll of $500,000, or $38,250, in 2000. But if, in a most optimistic scenario, all 10 employees each contributed the maximum allowable contribution of $5,000, the company's taxable payroll would be reduced by $50,000, and the company would save $3,825 in taxes for the year. Combined with the tax savings of $1,500 per employee, the total tax reduction for the company and its workers resulting from the FSA would be $18,825 for the year.
In reality, a company can expect a participation rate closer to 20 percent. In a 2005 Business Insurance article entitled "Grace Period Complicates FSAs," author Jerry Geisel states that "Currently, about 15 percent of eligible employees contribute to health care FSAs, with employees contributing on average between $1,100 and $1,200 a year."
One potential reason for low participation rates has to do with the "use it or loss it" rule limiting the ability to cumulate funds in an FSA account. Money deposited into an FSA account is forfeit if not used in the benefit year—forfeit by the employee and received back by the company. Until 2005, when the IRS issued an FSA grace period amendment, all funds contributed to an FSA had to be used within one year. The dates for that year were defined as the company's benefit plan year, a period which may or may not correspond with the calendar year. As of 2005, a company may amend its FSA Plan document to incorporate a two and one half-month grace period. This allows an employee to use the first two and half months of the next year to use up his or her FSA balance from the prior year. Anything not used within this period would be forfeit. Proponents of this new grace period hope that it will reduce concerns about losing money and encourage participation in FSA plans.
LEGAL REQUIREMENTS FOR FSAS
Employers are required to follow the guidelines established in Section 125 of the Internal Revenue Code when setting up an FSA. The first step involves preparing a plan document that states the conditions for eligibility, the benefits provided, and the rules that apply to implementation of the FSA. The employer must distribute these rules to eligible employees and follow them consistently. Employers are also required to file Form 5500 with the U.S. Department of Labor each year, as well as complete a series of nondiscrimination tests outlined by the IRS.
Each part of the process of implementing and administering an FSA plan for employees involves legal requirements. These requirements apply to the plan document, summary plan description, nondiscrimination testing, government filings, claims administration, and plan updates. Since compliance with these requirements tends to be complex, and since the IRS imposes serious penalties for noncompliance, most companies outsource FSA administration to a third party. The costs of outsourcing these administrative tasks are high. Many experts say that such costs may be off-set by the tax saving that FSA plans generate along with the savings associated with any funds forfeit by participants.
Any employer considering an FSA for her firm must be careful to plan for the potential cash flow needs that may be generated by early disbursements. If an employee agrees to have $2,500 withheld from his paychecks for deposit into his FSA account during the year, those funds must be available to him as needed, which may be within the first month of the year. Since the money going into his account will be collected over a twelve-month period, the company must have cash reserves set aside to address cash disbursements that occur prior to collections.
USING FSAS FOR DEPENDENT CARE EXPENSES
Employers can set up FSAs in a number of ways, depending on what options their employees would find most valuable. For example, FSAs can cover only health insurance premiums, or they can only be used to reimburse medical expenses not otherwise covered by the employer's health insurance plan. FSAs can also cover only dependent care expenses, or they can offer a full plate of benefits including both health care and dependent care.
Dependent care reimbursement FSAs have become increasingly common in recent years. Employees with children can use these accounts to cover day care and educational expenses up to and including private kindergarten.
With a dependent care FSA, employees can begin making pre-tax contributions when a child is born and continue until the child completes kindergarten. The maximum contribution is $5,000 annually per child. The employee decides how much to contribute based on his or her anticipated child-care expenses for each year. The employer deducts that amount in installments from the employee's gross pay each pay period, and sets the money aside in an FSA. The employee's income taxes are calculated based on his or her remaining pay, which reduces taxable income. The employee can withdraw money from the FSA tax-free to make tuition payments. In most cases, employees are required to submit proof that their deductions are put toward qualifying dependent care expenses.
see also Child-Care; Employee Benefits; Health Insurance Options
Geisel, Jerry. "Grace Period Complicates FSAs." Business Insurance. 22 August 2005.
Gould, Jay. "Flexible Spending Accounts Benefit Both Employees, Employers." San Antonio Business Journal. 24 November 2000.
"How Tax Savings Play Out." Inc. March 2000.
"Letting Easy Money Slip Away." Work & Family Newsbrief. November 2005.
"One-Third of Employers to Extend FSA Deadlines." Managing Benefits Plans. October 2005.
Seiden, Richard. "IRS Offers 'Use It or Lose It' Grace Period for Flexible Spending Accounts." San Fernando Valley Business Journal. 29 August 2005.
"Some Good News About Health Care Flexible-Spending Accounts." Managing Benefits Plans. February 2006.
Hillstrom, Northern Lights
updated by Magee, ECDI
Flexible Spending Accounts
Flexible Spending Accounts
Flexible spending accounts (FSAs), sometimes called reimbursement accounts, are accounts set up by employers. These accounts allow employees to make annual, pre-tax contributions that can be used to pay for certain health care and dependent care expenses that are not paid for by insurance companies. FSAs are offered under the umbrella of cafeteria benefit plans and are sometimes called cafeteria plans. FSAs must comply with all applicable rules and regulations governing benefits under cafeteria plans. FSAs are commonly associated with health savings accounts, or HSAs. Health savings accounts are a specific type of account made available to employees, usually a type of FSA. They are permanent and tax exempt, and are used specifically for medical insurance purposes.
Employers must establish flexible spending accounts so that they comply with all applicable federal legislation. Once an FSA is established, employees have the opportunity to sign up for the plan during the annual “open enrollment” period. During the sign-up period that precedes the plan year, employees must estimate the relevant costs they are likely to incur during the year and indicate the amount of money they want set aside in the FSA for the year. Usually, the money is set aside using regular payroll deductions from the employee's paychecks. The deductions from employees' wages are pre-tax, thus reducing the employee's tax liability. Employees must carefully consider the amount they elect to contribute to the FSA, because amounts unused at the end of the plan year cannot be carried over to the next year and are forfeited by the employee if a balance remains at the end of the year. There is no legal limit to the annual amount that can be set aside, but employers can set their own limit if they wish.
As employees incur eligible expenses throughout the plan year, they must obtain and retain all receipts and documentation. Employees then provide required documentation that they have incurred eligible expenses (usually by providing receipts for the expenditures) and are reimbursed from the accumulated money in their account. Employees can turn in requests for reimbursement throughout the plan year or save all their documentation and turn in their request at the end of the plan year. Recent innovations in FSAs include the introduction of debit cards by some employers. These debit cards allow employees to obtain immediate reimbursement for eligible expenses rather than compiling receipts and documentation, submitting the paperwork, and waiting for the employer to cut them a check.
EXPENSES ELIGIBLE FOR COVERAGE UNDER FSAS
Flexible spending accounts can be used to pay for eligible costs related to health care and dependent care for children or elderly parents. FSAs cover insurance premiums, deductibles, co-payments, prescription drugs, and many health-related expenses not covered by an employee's health insurance. For example, employees can pay for procedures and items such as laser eye surgery, orthodontia, hearing aids, and contact lenses with their FSAs. Flexible spending accounts can also be used to pay for certain expenses related to child and elder care. In 2003, the government expanded the drug coverage under FSAs to include certain types of over-the-counter drugs, such as pain relievers, cold medicines, nicotine patches, and allergy medications.
HEALTH CARE AND DEPENDENT DAY CARE ACCOUNTS
FSAs are commonly divided into two different categories, the health care account and the dependent day care account. The health care account is an FSA used for various health expenses, especially those not covered by a normal health care plan.
Dependent day-care accounts are used to set aside pre-tax funds for medical aid to any eligible dependents the employee may have, such as children.
ORIGINATION OF FLEXIBLE SPENDING ACCOUNTS
Although flexible spending accounts have been available since the enactment of Section 125 in the late 1970s, for many years employers didn't offer them and only a small percentage of eligible employees utilized them. There were various reasons for their lack of popularity. Employers were initially put off by what they perceived as the complexity and administrative costs associated with cafeteria plans in general, and flexible spending accounts in particular. Employees were reluctant to participate because of the forfeiture rule, which requires a participating employee to “use or lose” the funds set aside in the FSA each year. The advent and spread of managed care plans, such as health maintenance organizations (HMOs) and preferred provider organizations (PPOs) in the 1980s and 1990s also hampered the growth of flexible spending accounts. Managed care plans often included a low (or no) deductible, low co-payments, and coverage for preventive care. Employees' “out-of-pocket” health care expenses were often reduced; thus there was less incentive for employees to set aside money to cover non-reimbursed medical or dependent care expenses.
However, rising health care costs and dissatisfaction with managed care plans in the 1990s and early 2000s caused many organizations to look for ways to cut health care costs. Many found it necessary to raise the premiums employees pay for health insurance, the deductible employees pay before health expenditures are covered, and the copayments that employees pay once deductibles are met.
Thus, employees' out-of-pocket expenses rose. The flexible spending account offers a way for employees to cover some of these extra expenses with pre-tax dollars, which lowers their out-of-pocket expenses.
A 2004 survey by the Society for Human Resource Management found that over 70 percent of member organizations offer flexible spending accounts as part of a cafeteria benefits plan. Small employers, however, are much less likely to offer such plans. For example, one Bureau of Labor Statistics report estimated that only 4 percent of employers with fewer than 100 employees offer flexible spending accounts.
HEALTH REIMBURSEMENT ARRANGEMENT
An HRA, or health reimbursement arrangement, is an extra account that can be used with nearly any health plan, and it is most commonly established with high-deductible health plans. HRAs are employer-funded accounts that reimburse employees for certain medical expenses. Where some flexible spending accounts, such as HSAs, do not need employer contribution or can be made with a combination of employer and employee dollars, HRAs are made only of employer contributions, and cannot be taken by employees when they leave their company. However, HRAs tend to be more flexible than HSAs, since many employers allow employees to rollover unused funds in HRAs for the next year or move them to a different account.
HIGH-DEDUCTIBLE HEALTH PLANS
Some companies have also begun to use high-deductible health plans, or HDHPs. These plans have a minimum deductible of $1,000 dollars for individuals and $2,000 for families. They are used in conjunction with the other plans discussed and are intended to create more awareness of health insurance choices. Employees, forced to pay higher deductibles, become more conscious of the form of health care they use, and make better choices in what kind of accounts they want, which benefits the company overall.
SEE ALSO Employee Benefits; Health Savings Accounts
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