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Flexible spending account (FSA) guide
Need a health plan to help keep your employees healthy and productive?
A recent benefits survey conducted by ADP found that 28 percent of workers have less than 500 dollars saved for emergency expenses. This lack of financial security increases stress, which in turn, can lead to poor engagement, decreased morale and increased absenteeism. Employers can help stem the tide by making flexible spending accounts (FSAs) an available option during open enrollment. FSAs are tax advantageous for employees and can help them set aside money to cover qualified medical and dependent care expenses throughout the year.
Table of Contents
What is a flexible spending account?
An FSA is an account in an employee’s name that reimburses the individual for qualified health care or dependent care expenses. The employee can receive cash reimbursement up to the total value of the account for covered expenses incurred during the benefit plan year and any applicable grace period. These reimbursements are funded with pretax dollars deducted from the employee’s paycheck.
Types of FSAs
There are two different types of FSAs – health care accounts and dependent care accounts. Employees can elect to have both types, but must fund the accounts separately. For instance, an employee cannot be reimbursed for dependent care expenses from a health care account.
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Health care FSA
A health care FSA only reimburses employees for money spent on medical care, as defined under Section 213(d) of the U.S. Tax Code. This definition encompasses payments for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body.
Qualified expenses
Eligible expenses covered by an FSA aren’t limited to health insurance deductibles and copayments. Employees can also reimburse prescription drugs, physical exams, dental expenses, eye glasses and contacts, certain medical equipment and much more. A complete list of qualified medical expenses is available in IRS Publication 502.
Note: Employers may define eligible medical expenses more narrowly than the IRS.
Contribution limits
The IRS restricts the amount of pretax dollars employees can contribute to a health FSA each year. Employers may impose their own contribution limits as long as theirs do not exceed the IRS maximum.
Uniform coverage rule
An employee’s annual health FSA election amount (minus any reimbursements already made) must be available to the individual at any time during the plan year. This rule applies regardless of how much has been contributed to that point. For example, if an employee elects to contribute $750 to an FSA, the entire $750 must be available for reimbursement immediately, even though the contributions will be divided throughout the year.
“Use it or lose it” model
Employees forfeit any unused funds in their health FSA account at the end of the year. However, the IRS allows employers to offer participants an extension, or grace period, of 2 ½ months after the end of a plan year. Thus, for a plan year ending December 31, employees would have until March 15 to spend the funds in their FSAs.
In addition, employers may allow employees to carry over a portion of their unused funds to the next year. The carry-over limit is adjusted annually by the IRS for inflation. This provision is an available option only if the employer does not take advantage of the grace period.
Dependent care FSA
Dependent care FSAs allow employees to set aside pretax dollars to cover expenses associated with the care of dependent children under age 13 and disabled spouses, parents or children over age 12. These accounts are similar to health FSAs because there are annual contribution limits, and unused funds are forfeited at year’s end. However, dependent care FSAs have two notable distinctions:
- Uniform coverage does not apply, which means the money in a dependent care account is not available until it has been deposited by the employee.
- Dependent care expenses cannot be reimbursed until they are actually incurred. Therefore, coverage does not extend to child care centers that require customers to pay in advance.
Qualified expenses
Qualified dependent care services only apply to employees who live with tax-dependent children under age 13 or tax-dependent parents, spouses or children over age 12 who are incapable of caring for themselves. The care must be needed so that employees and their spouses (if applicable) can go to work, and it cannot be provided by another dependent. Thus, a sibling babysitting on a Saturday night would not qualify.
Some common examples of eligible expenses include:
- The cost of child or adult dependent care
- The cost for an individual to provide care either in or out of the employee’s house
- Nursery schools and preschools (excluding kindergarten)
How does an FSA work?
When electing an FSA during open enrollment, employees must specify how much they would like to contribute to the account for the year. The goal is to choose an amount that will adequately cover medical or dependent care expenses without exceeding the expected total so that money is not forfeited at year’s end.
Employers subsequently deduct the contributions from their employees’ wages on a pretax basis throughout the year and deposit them in the FSA. When the employees have an eligible health care or dependent care expense, they submit a claim form, along with an itemized receipt for reimbursement from their accounts.
A health care FSA will reimburse employees for the full amount of their annual election (less any reimbursement already received) at any time during the plan year, regardless of the amount actually in the account. A dependent care FSA will only reimburse participants for the amount that is in the account at the time they submit a claim.
FSA vs. HSA
A health savings account (HSA) is another type of tax-exempt trust that can help employees pay qualified medical expenses. The following table summarizes some of the key differences between HSA and FSA:
|
|
HSA |
Health FSA |
Dependent Care FSA |
|
Who owns the account? |
Employee |
Employer |
Employer |
|
Who may fund the account? |
Employer and employee |
Employer and employee |
Employer and employee |
|
What plans must be offered with the account? |
A high deductible health plan (HDHP) that satisfies minimum annual deductible and maximum annual out-of-pocket expense requirements. |
Group health plan coverage. Additionally, the FSA must qualify as an excepted benefit under the Affordable Care Act (ACA). |
None. Dependent care FSAs are standalone plans. |
|
Is there an annual contribution limit? |
Yes |
Yes |
Yes |
|
Can unused funds rollover? |
Yes |
No, but employers have the option to offer employees a grace period or a limited rollover adjusted annually for inflation. |
No, but employers have the option to offer employees a grace period or a limited rollover adjusted annually for inflation. |
|
What expenses are eligible for reimbursement? |
Section 213(d) medical expenses, including COBRA premiums, QLTC premiums and health premiums while receiving unemployment benefits. If the employee is Medicare eligible due to age, health insurance premiums (except medical supplement policies) may also be reimbursable. |
Section 213(d) medical expenses. Expenses for insurance premiums are not reimbursable, and employers can define “eligible medical expenses.” |
Expenses for the care of one or more qualifying dependents. The expenses must be incurred so employees and their spouses can be gainfully employed. |
|
Must claims be substantiated? |
No |
Yes |
Yes |
|
May the account reimburse non-medical expenses? |
Yes, but the reimbursements are taxed as income and subject to a 20% penalty (no penalty if distributed after death, disability or age 65). |
No |
Yes |
|
Does the uniform coverage rule apply? |
No |
Yes |
No |
Frequently asked questions about flex spending accounts
Who can offer an FSA plan?
Any business that sponsors group health insurance may offer an FSA plan to its employees. Plan designs are flexible, allowing employers to determine employee eligibility, contribution limits and expenses eligible for reimbursement. However, they must comply with various laws that govern FSAs, including the ACA and the Employee Retirement Income Security Act (ERISA).
Who may contribute to an FSA?
Employers and employees may contribute to an FSA. Employee contributions are deducted from gross wages and not subject to taxation.
Can an FSA be offered with any health plan?
Typically, health FSAs are offered as a benefit under an employer’s cafeteria plan (or Section 125 plan) to allow employees to contribute on a pretax basis. HSAs, in contrast, can only be offered with high-deductible plans.
What happens to FSA funds if an employee quits?
FSAs are owned by employers, not employees. As such, if an employee resigns from the company, they forfeit their remaining balance. Employers should refer to the IRS’ regulations for Section 125 plans and ERISA’s exclusive benefit rule for guidance on how to manage forfeitures.
This article is intended to be used as a starting point in analyzing the FSA meaning and is not a comprehensive resource requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
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