As a small business owner, offering an FSA to employees is a win-win. It helps reduce the tax burden for both employees and employers, plus minimizes out-of-pocket spending on healthcare items.
Here's what you need to know:
- FSAs are set up by the employer
- An FSA can be used to pay for expenses not covered under a medical, dental, or vision plan
- There are 2 types of FSAs: Healthcare Flexible Spending Accounts (HFSA) and Dependent Care Flexible Spending Accounts (DCFSA)
Flexible spending accounts — or FSAs — are a tax-advantaged benefit set up by business owners for their employees. Employees are able to set aside a portion of their earnings to pay for a variety of healthcare and dependent care expenses.
These accounts save employers and employees a portion of their payroll tax because the contributions are made with pre-tax dollars.
What is a Flexible Spending Account?
An FSA can be used to pay for expenses not covered under a medical, dental, or vision plan, plus some over-the-counter expenses, and expenses related to child, elder, or dependent care.
The Internal Revenue Service allows businesses to deduct a portion of an employee’s salary to be placed in an FSA. The money is deducted before income taxes, which reduces an employee’s taxable income.
The Revenue Act of 1978 established flexible spending accounts to help offset the cost of medical care. Several updates have been made to the original ruling.
Today, employees are limited in the amount of contributions they make to the fund(s) as well as the types of expenses that can be reimbursed.
There are 2 types of FSAs:
Each has its own rules and limitations concerning reimbursement — but both allow for pre-tax contributions, saving the business and the employee a portion of the payroll tax due.
How does a Flexible Spending Account work?
When employees elect to participate in an FSA, they notify their employer how much they would like to contribute for the coming calendar year. There are limits to the amount that can be saved pre-tax, depending on the type of account.
Employers deduct a portion of the employee’s wage equal to the annual amount per paycheck, setting the funds aside in a separate account for reimbursement.
To participate, employees must determine how much they want to contribute to the fund during 1 of 4 enrollment opportunities:
- When the employer starts a new plan
- Within 30 days of their hire date
- If the employee experiences a qualifying life event (generally birth, death, marriage, or divorce)
- During open enrollment
Throughout the year — as employees incur eligible expenses — they submit receipts to their employer, who reimburses them the amount from the employee’s FSA.
Why encourage employees to enroll in an FSA?
Flexible spending accounts benefit the employee in several ways, and although they mean a bit of administration from business, they benefit employers as well.
For employees, setting aside a portion of their salary for anticipated expenses ensures they have the money to pay for things such as doctor visit copays, daycare, and other costs.
Because the money is set aside before taxes are withheld, employees are allowed to save (and use) a bit more than they would otherwise have earned.
- An employee who works 40 hours per week earning $15 per hour would earn $31,200 per year
- If single, their tax rate for 2020 would be 12%, owing $3,744 in payroll taxes
- If the employee contributes $1,200 ($100 per month) to their FSA for that year, their taxable income is reduced to $30,000 per year, with $3,600 in payroll taxes
- That’s a savings of $144 on taxes and available funds for medical and other expenses
For businesses, the reduction in employee taxable income means a reduction in employer payroll tax contributions. When employees participate in the plan, their payroll taxes go down and so does the employer’s contribution to taxes and FICA.
What is a Healthcare Flexible Spending Account?
An HFSA is an account set aside to pay for eligible medical, dental, and vision care expenses. Staff members who are covered by their company’s healthcare plan — and even those who are not — are eligible to participate in these savings accounts.
An HFSA has a maximum contribution of $2,700 per person for 2019. Employees can elect to contribute any amount they think will cover their expenses without exceeding the annual threshold.
What can HFSA funds be used for?
HFSA funds can be used for doctor and emergency room visit copays, deductibles, and prescription medications. Over-the-counter medicines can also be reimbursed if a doctor prescribes them. Insulin does not require a prescription for reimbursement.
Some medical equipment is also reimbursable, including crutches, bandages, and blood sugar tests. The accounts are generally for medically necessary and prescribed services and products.
Dental care and copayments are also reimbursable, including bridgework and dentures.
For vision care, eye exams and glasses are reimbursable under an HFSA plan. The list of reimbursable items is extensive and is updated frequently. Employees should check to see if costs they anticipate they might incur are covered.
Elective medical, dental, and vision procedures and products are typically excluded.
What is a Dependent Care Flexible Spending Account?
A DCFSA is an account used to fund for the care of children under age 13, the elderly, or those who cannot care for themselves. Staff members who anticipate their child or loved one will be in care for the coming year can fund up to $5,000 to their DCFSA.
If married, the maximum contribution for both spouses is $5,000. To be eligible for reimbursement, the provider must report their income to the IRS.
What can you use DCFSA funds for?
DCFSA funds can be used for daycare and childcare, including in-home services. If employees are paying a relative to care for their child, only a relative that is not dependent on their taxes can be eligible for reimbursement.
Nursery schools, preschools, nannies, and even transportation costs to and from eligible care are reimbursable under the tax code. The list of reimbursable items under DCFSA is not as extensive as for healthcare accounts, but the IRS gives guidelines for employees to plan for their expenses.
FSA contribution limits
There are contribution limits to the amount employees can set aside pre-tax for their FSA. For healthcare accounts, each employee may fund $2,700 per year. Married couples cannot exceed $5,400 of total contributions per year.
For dependent care accounts, the maximum is $5,000 per year for single parents or married couples. If both parents work, combined they may only contribute to the $,5000. limit.
The fine print of FSA accounts
As with all tax codes, there are some fine print items to remember when signing up for and administering flexible spending accounts.
FSA fund carryover
In most instances, employees must use all the funds in their HFSA or DCFSA plan during the plan year — these accounts are using it or lose it. Employees must submit receipts for reimbursement for services and products purchased during the plan year.
Most employers find December is typically the busiest month for FSA administration. Employees ask what’s left in their accounts and scramble to use up any remaining funds.
There are 2 exceptions to the use-it-or-lose-it rule. Businesses can allow 1 of 2 options so staff can keep or spend some of the money not used during the plan year:
- Businesses can allow a “grace period” of up to 2.5 extra months to use the funds
- Businesses can allow employees to carry over up to $500 per year to use in the following plan year
Companies can offer one of these options — but not both — but they are not required to offer either. At the end of the plan year or grace period, any money not used or rolled over is forfeited to the employer. It’s important for employees to plan carefully and not overfund their accounts, or they risk losing that income.
Under the IRS, an employer cannot limit the amount of reimbursement because there is not enough funds in the employee’s account.
- A staff member’s account is funded January 1 with deductions of $10 per week
- On January 15, they incur an emergency room copayment of $125
- Even though the staff member has only contributed $20 to the fund, employers must reimburse the entire $125
- If the employee leaves the company before the $125 has been saved, the employer cannot recover the overpayment
Some small businesses work around this potential loss by limiting the amount an employee can be reimbursed for a single expense during the plan year. Others require advance payments to FSA funds for such an instance. Others ask employees to submit 50% of their planned contribution during the first month of the year (with the remainder paid through the rest of the year) to cover any expenses early in the year.
These can be complex scenarios, and it is advisable for businesses to discuss their options with a tax professional.
New employees can double dip
A new employee can contribute the maximum amount into their fund, even if they had a flexible spending account from another employer during the same coverage year.
In rare instances, if an employee contributed the maximum amount in a plan year through another employer, their accounts go to 0 and they can start again with a new company.
Separated employee losses
Employees who leave their company and do not submit receipts for covered expenses forfeit their account funds to their employer. Those expenses must be incurred during the time the employee worked for that company. Any receipts for expenses incurred after they left the company do not have to be reimbursed.
Opting out in the middle of the plan year
For the most part, employees may not change their elections for FSA accounts until the next open enrollment or qualifying life event. Similar to healthcare coverage, the contributions and fund stays in effect for the entire plan year. There are some exceptions to this rule.
- If an employee is funding a DCFSA for childcare, and the child reaches the maximum age of 13 to be eligible for reimbursement, contributions can be stopped
- If child or elderly care providers raise their rates significantly during the plan year, or if employees need to change a provider who has a higher rate, increases in contributions can be made
Flexible spending accounts help employees plan for expenses in the coming year in addition to saving a bit on their tax burden.
For business, the administration of these accounts typically results in a net gain — the more employees enrolled in FSA plans, the less payroll and FICA tax the employer has to pay.
They’re a smart way to save and plan for the future.