HR 101: The ABCs of FSAs

Healthcare coverage has been a vital employee benefit for decades. By the late 1960s, most Americans were getting coverage through employer-sponsored programs. Inflation and rising costs saw most businesses instituting annual deductibles and copayments to lower costs, putting more of the responsibility for payment on the employee.

Flexible Spending Accounts (FSAs) were created to help workers offset these costs. The Revenue Act of 1978 reformed tax law, allowing workers to set aside a portion of their pretax income to fund medical expenses. FSAs have been helping American workers ever since.

The tax act outlined:

• What amount of their pretax income employees could set aside
• When and how the money can be used
• What types of expenses were covered

There are currently two main types of FSAs — medical and dependent care accounts. Each has specific guidelines and limits of use, and several updates have been made over the decades.

Who benefits from FSAs?

There are no laws requiring businesses to offer FSAs to their staff. Still, both employees and employers benefit when workers set aside money in flexible spending accounts. Because the funds are pretax dollars, businesses save 7.65% on tax and FICA contributions for every dollar deposited into the accounts.

For most businesses, the savings on taxes offset the administrative cost of managing the FSA. Companies can write off any administrative costs they incur as regular business expenses for managing employee FSAs.

Employees benefit from tax savings, as well. Their payroll tax is reduced for every dollar they contribute to their FSA.

When employees use their FSA funds, each dollar is worth more and goes further. For example: Let’s say an employee is at a 25% payroll tax rate. For every $100 they deposit into their FSA, they save $25 in tax payments. That means their $100 earnings go further to offset spending.

How do employees contribute to an FSA?

As part of the Tax Reform Act of 1986, dependent care flexible spending accounts were added to the tax code. These accounts let workers set aside pretax dollars to pay for the care of dependent children and adults.

The two main types of flexible spending accounts have their own rules. There are limits to how much can be added to the fund and what types of expenses are legitimate. Employees should be told how they’re allowed to use the funds before determining how much to set aside.

During annual open enrollment, employees notify HR or their payroll department how much they want to contribute for the coming benefit year. New employees hired throughout the year can enroll at their start date. Employees who have had a qualifying event (marriage, divorce, birth, or placement of a child) may also enroll or make changes to their FSA contributions.

Once open or special enrollment has closed, the employee will have to wait until the following benefit enrollment cycle to enroll or make changes to their accounts.

How do FSAs for medical expenses work?

For healthcare accounts, employees are limited to contributing $2,850 per year per employer. These funds can pay eligible expenses for the employee, their spouse, and their dependents for:

• Medical
• Vision
• Dental

Funds pay for medically necessary expenses, like:

• Deductibles
• Copayments
• Prescription drug copays
• Payments for prescription drugs (this also includes insulin expenses that don’t require a physician’s prescription)
• Dental work and copays
• Glasses, contact lenses, and even some LASIK surgery
• Acupressure
• Chiropractic care
• Ambulance trips

However, things like cosmetic surgeries or procedures are not considered eligible expenses. FSAs cannot be used to pay for health insurance premiums, either.

If a doctor recommends an over-the-counter medication, employees can be reimbursed for those costs if the doctor writes a prescription.

Medical equipment is also covered, including:

• Crutches
• Blood sugar test kits
• Bandages
• Expenses for equipment necessary to adapt an auto for a person with a disability are also allowed under FSA guidelines.

The IRS has a complete listing of eligible expenses employees can use to determine how much to set aside and when to ask for a reimbursement.

When are the FSA funds accessible?

When employees make an election to set aside funds in a healthcare FSA, their employee provides them the total amount at the beginning of the year. Employees can draw from the account, with verifiable receipts, for any amount — even amounts higher than in the fund.

Over the course of the year, payroll deductions eventually reimburse the company for the total withdrawn. However, the employer loses the funds deficit if the employee leaves the company after taking more out of their FSA than was deposited.

How do FSAs for dependent care work?

Dependent care FSAs are for funds set aside to pay for daycare, nannies, or other in- or out-of-home caregivers for children and dependents. Employees can set aside up to $5,000 for individuals or married couples who file their taxes jointly. For a married person filing separately, the maximum is $2,500.

These accounts are available for single parents or couples if both parents are working. There are limited exceptions if one parent does not work but is incapable of self-care or if they have a disability.

Dependent care FSA amounts are funded per paycheck. Employees determine, at open enrollment, how much they wish to fund for the coming year. Following that decision, a portion is deducted each payday.

Unlike healthcare flexible spending accounts, employees can only be reimbursed up to the amount currently available in their account. Dependent care FSAs are available for expenses related to:

• Children younger than age 13
• Spouses who are unable to work and care for themselves
• Other adult dependents unable to work or care for themselves who the employee claims as an exemption on their taxes

Covered expenses include:

• In-home care such as nannies, babysitters, and au pairs
• Off-site facilities, like preschool, daycare, or adult care facilities
• Before and after-school care and summer camps
• Application fees (typically for daycare)
• Transportation fees for caregivers
• School fees

Although overnight camps or enrichment programs (like music or sports lessons) are not eligible for reimbursement. Neither are meals or housekeeping costs.

How is a qualified caregiver defined?

Relatives who care for the child or adult are eligible, providing they report the income on their taxes. Older siblings, even if they’re paid to babysit, are not considered a reimbursable expense.

To qualify as an eligible caregiver, the paid caregiver (even a relative) or facility must report income on their taxes. Employees must provide the plan administrator with the following:

• Caregiver or facility name
• Dates and type of service
• Cost and the child or adult’s name

Employees will need either a caregiver’s social security number or a facility’s employer identification number to qualify for reimbursement.

What is the use it or lose it rule?

Under IRS guidelines, employees are required to use their FSA deposits, for either their health or dependent care account, in the year the monies were set aside.

Historically, there was a use-it-or-lose-it rule: if the funds weren’t spent by the end of the year, they were forfeited to the employer.

Businesses have the option (not a requirement) to offer employees two ways to use funds not spent by the end of the year. Employers may choose to offer either option but cannot agree to both.

• A carry-over option allows employees to roll over up to $570 into their coming year’s healthcare spending account. That amount does not reduce the allowed $2,850 contribution for the coming year.
• A grace period option allows employees to continue to submit receipts for the previous year for reimbursement up to March 15.

Some updates to the code have given employers a way to help staff use any unspent dollars in their accounts.

Who should administer FSAs?

The administration of flexible spending accounts can be complex. Employers who manage them in-house will need to file documents with the IRS. A plan document must be created, submitted to the IRS for approval, and distributed to employees. The plan document outlines:

• How employees become eligible
• When they can enroll
• How and for what they can be reimbursed

As new rules are implemented, the document will need to be updated, and employees notified.

How should FSAs be administered?

Another challenge for businesses that administer their own FSA plans is managing claims and requests for reimbursement. Admins need to understand what costs are reimbursable and allowed under the law and which are not. Approvals and denials must be documented, and employees have a right to dispute initial rulings. Detailed records must be kept for each employee, separate from their personnel file.

FSA administration also requires employers strictly adhere to HIPAA and ERISA regulations. Administering employee medical receipts requires examining personal healthcare records. The administrator must maintain strict confidentiality and meticulous records.

Discrimination testing for plans will also be necessary. Businesses should keep records for at least three years.

Most small businesses don’t have the time or expertise to manage these accounts. For them, a third-party provider is the best solution. These professionals are fluent in FSA law, have plan documents in place, and can answer employee questions definitively.

The cost is generally affordable – sometimes, it’s free with payroll services. Check with your payroll processing company to find a service that works for you and your employees.

How do businesses administer FSAs?

During open enrollment, employees make their elections regarding FSA funding. Businesses either deduct a portion of that annualized amount every pay period or instruct their third-party payroll administrator to do so.

As employees incur expenses, they submit receipts for reimbursement. The admin will review the receipts to assure the costs are allowed under the law. Once the administrator approves expenditure, the employee then receives payment for the amount of the receipt(s) submitted.

Near the end of the year, most employers send reminders to staff to turn in any receipts they haven’t already submitted for reimbursement by December 31. For some staff members, these serve as a reminder to go for an annual vision check or dental exam.

Some employers allow a grace period to submit receipts (typically through March 15) or rollover of unused funds. If the team member didn’t use the payroll-deducted funds held in the FSA — either because they missed deadlines or didn’t submit receipts — those monies are forfeited back to their employer. These surrendered funds serve to offset the administration costs of managing FSA accounts.

How much should employees contribute to their FSA?

There is no correct answer on how much staff members should contribute to their funds. Employees will often turn to their HR or payroll professional for advice.

Because the expenses are typically a fixed weekly or monthly amount, it can be easier to anticipate how much will be needed for dependent care expenses, such as:

• Babysitters
• Daycare centers
• Other caregivers

Encourage employees to put the maximum amount allowable by law into their FSA (as long as it’s affordable) if they know that their child or dependent adult will be in care.

Most childcare costs more than the maximum of $5,000 for married couples or $2,500 for single parents. Encouraging employees to maximize their contribution can help them save on taxes.

For healthcare FSAs, it can be more challenging to plan ahead. Employees who routinely take medicines can begin planning based on the cost per month they typically pay. Consider adding in funds for each eligible family member to cover the following:

• Copayment on annual doctor appointments
• Dentist expenses
• Vision exams

Employees should try to avoid over-funding their healthcare FSA. Even with the generous rollover terms and grace periods, there is a chance they’ll have to forfeit any unused funds.

How COVID changed FSAs

During the pandemic, the IRS loosened many of its rules concerning FSAs. It was impossible for employees to submit receipts for reimbursement during the pandemic because daycare and adult care facilities were closed. Employees could carry over unused dollars in their FSA accounts through December 31, 2022, by taking advantage of the COVID-related Taxpayer Certainty and Disaster Tax Relief Act of 2020.

There is currently no plan to extend those carry-overs into 2023.

Are there other types of FSAs?

There are also other types of flexible spending accounts available. Employees enrolled in a high-deductible health plan (HDHP) can cover medical costs by setting aside pre-tax dollars using Health Savings Accounts (HSAs). The employer and the employee fund HSAs. This option is only allowed when the employee is enrolled in a plan with:

• Annual deductible at least $1,400 for single coverage/$2,800 for family coverage
• Total out-of-pocket expenses maximum $3,650 for single coverage/ $7,300 for family coverage

Employers who purchase benefits through the Affordable Care Act exchanges may find the coverage meets the thresholds for an HSA. Employers (or a third-party provider) set up the HSAs, or the worker may set it up through an approved insurance plan. HSAs have an annual contribution limit of $3,650 for single coverage and $7,300 for family coverage. Workers and employers may contribute pretax dollars into the account but cannot use HSA funds to pay insurance premiums.

Employees own their HSA accounts. Team members can keep the account and continue contributing to and using it even if they separate from their employer.

FSAs are a valuable benefit

Flexible spending accounts have been helping employees increase their buying power for health and dependent care expenses for over 50 years. They also help employers reduce payroll tax obligations.

FSAs are a valuable benefit that workers and job seekers want. In 2021 the Bureau of Labor Statistics reported that about half of American households used either a health or dependent care FSA.

To attract and retain top talent, businesses can advantage from leveraging FSAs.