Why Offer an FSA?
According to a recent Hewitt Associates survey on this issue, the most common reason employers gave for offering a health care FSA was to ease the impact of employee cost sharing in group medical plans. As health care costs continue to escalate, many employers have shifted the increasing burden of health care costs through increased deductibles and copayments. Since the deductible and copayment amount paid by the employee can be reimbursed through an FSA, the impact of these larger costs can be minimized. The net result is that the employee is paying for a portion of his or her medical cost on a pretax basis.
The most common reason employers gave for offering a dependent care FSA was to meet the demand for a day care benefit, the survey found. As the number of dual wage earner and single-parent families continues to increase, the demand for day care also rises. Since day care costs are reasonably high, employees are looking for some relief from these expenses. A dependent care FSA provides the opportunity for employees to pay for their dependent care expenses on a pretax basis.
The Win-Win of FSAs
Flexible spending accounts are one of the few plans that can be a win-win situation for both employers and employees. From a cost perspective, there certainly will be initial start-up costs to the employer to cover legal documentation and communication expenses, but most ongoing administration expenses can be offset if the plan is designed to have expenses paid by employee forfeitures. Additionally, employees do not pay FICA taxes on any amounts deferred in an FSA. Since the employer matches the FICA tax paid by the employee, the employer saves the expenses of those FICA taxes.
The benefits to the employee are the taxes not paid on both dependent care and health care expenses. For example, if an employee is incurring $5,000 of dependent care expenses plus $1,000 of health care expenses, this employee could save up to $2,319 in taxes annually. This assumes a federal tax rate of 28% ($1,680), a state tax rate of 3% ($180), and the combined FICA/Medicare tax rate of 7.65% ($459).
In the above example the employee avoids $2,319 in taxes. If the employee were to defer the same $6,000 of income in a 401(k) plan, the employee could defer only the payment of $1,860 in taxes, since FICA taxes must be paid on amounts deferred in a 401(k) plan. Therefore, in an FSA the employee is avoiding taxes that would have been paid on the amount deferred, compared with the 401(k) plan in which the payment of taxes is deferred and the amount of taxes is lowered - but not eliminated.
How Does a Health Care FSA Work?
Employees are given the opportunity annually to decide to participate in the health care FSA and, if so, at what level. Plans will generally specify a minimum and maximum amount that employees contribute to an FSA health care account. According to surveys, the average employee contribution is $564, while the average maximum contribution for a health care FSA is approximately $2,900. Contributions to the FSA are taken from each paycheck throughout the year.
Once an employee makes a decision regarding the amount to contribute, that amount cannot be changed nor can contributions be suspended unless there is a change in "family status". A family status change includes marriage or divorce; death of spouse or dependent; birth or adoption of child; a significant change in health coverage of the employee or spouse due to the spouse's unemployment; or an unpaid leave of absence taken by the employee or employee's spouse.
Any change in FSA contributions must be consistent with the specific family status change. For example, if a child is born, one would expect the amount contributed to the account to increase.
Expenses that may be reimbursed from the health care FSA are medical expenses incurred during the specific plan year that are not reimbursed by an insurance plan. Expenses also must meet definitions outlined in Section 213(d) of the Internal Revenue Code. These regulations have been interpreted to mean those expenses incurred primarily for the prevention or alleviation of a physical or mental defect or illness.
Employers must decide whether their plan will reimburse all expenses as outlined in Section 213(d), or an employer may choose to be more restrictive in defining the items to be reimbursed.
Typical items which are considered as eligible expenses under such plans include
- Medical and dental plan deductibles and copayments
- Eye exams, contact lenses and eyeglasses
- Expenses for hearing care
- Prescription drugs
- Uncovered orthodontia or other dental expenses.
Examples of items that would not be considered covered medical expenses include non-prescription drugs and vitamins, health club memberships, or programs not prescribed by a doctor for health reasons.
Once an employee incurs an eligible expense, the proper documentation is sent to the plan administrator for reimbursement. IRS guidelines provide that employees be reimbursed on at least a monthly basis and when the total amount of reimbursable expenses equals a specified reasonable minimum amount (e.g. $50).
A key element of an FSA - and one that concerns many employees is the "use it or lose it" rule. What this means is that employees who don't use all of their FSA funds by the end of the coverage period forfeit any remaining funds.
How Can Employers Afford an FSA?
These forfeitures can be used to offset the employer's expenses of administering the plan, to reduce a participant's contribution to the plan in the following year, or may be returned to all plan participants as dividends or premium refunds.
When making such refunds, though, the allocation to employee accounts cannot be based on actual claims experience of the participants. 16% of participants on average failed to use the entire amount available in their accounts in 1991, with an average forfeiture of $102.
It is interesting to note the approach taken by employers regarding what was done with the excess in the plan. The previously mentioned Hewitt survey found that the most common practice by far was to pay administrative expenses (53%), and "keeping it" was the second most common practice (19%).
A recent change in the regulations for health care FSA's (revised IRS regulations became effective for 1990 plan years) provides for what is called a "prefunded account", which also is called the "uniform coverage" requirement. What this means is that employees must be entitled to their full amount elected annually on the first day of the plan year. Employers may not limit reimbursements to the amount actually contributed to date. A prefunded account is best explained by an example.
An employee enrolls in the company's health care FSA plan for an annual amount of $1,200. Fifty dollars is deducted from each paycheck and contributed to the employee's reimbursement account. During January, the employee incurs $800 of unreimbursed medical expenses and submits those expenses to the FSA plan administrator in early February. At this time, a total of only $100 had been contributed to the employee's account. However, the employer is obligated to reimburse the employee for the full amount of expenses (in this case, $800) up to his annual projected contributions.
When the regulations regarding prefunded accounts were announced, employers with FSA plans promptly announced their concerns about the potential of absorbing additional costs under these plans. Some actions taken by employers in response to these regulations included:
- Reducing the maximum allowable contribution to the plan
- Limiting those items that may be reimbursed under the plan
- Implementing longer eligibility waiting periods for participation in the health care FSA
According to an ECFC/Mercer study conducted three years ago, the actual impact of the regulations during the first full year of operation was very favorable. Ninety-four percent of companies reported that financial results were equal to or better than they expected when the regulations were proposed. The main reason for excess reimbursements was due to employees terminating employment.
How Does a Dependent Care FSA Work?
A dependent care FSA generally works in the same manner as a health care FSA. The major differences between the health care and dependent care FSA are:
- Annual maximums for a dependent care plan generally are higher
- The "prefunded account" does not apply to the dependent care plan. Reimbursements are only made with respect to contributions accumulated
- An employee can spend the accumulated funds in a dependent care account after the employee's termination
The annual maximum amount that can be contributed to a dependent care account is $5,000, or $2,500 if an individual is married and filing a separate tax return. If an employee and spouse both participate in dependent care reimbursement accounts, the total maximum contribution to both accounts is $5,000. For example, if an employee contributes $3,000 to a dependent care FSA, the spouse could not contribute more than $2,000.
According to IRS guidelines, an employee and spouse must be at work during the time the eligible dependent is receiving care. Expenses must be for a dependent claimed on one's federal income tax return. Eligible dependents include:
- A child, under age 13, whom the employee claims as a tax exemption
- A dependent who is physically or mental incapable of caring for himself or herself - This includes an elderly parent who is handicapped or ill
- Another requirement is that the dependent must spend at least eight hours a day in one's home
Although the "use it or lose it" concept also applies to dependent care FSAs, there is a difference as to how these accounts operate. In the health care FSA, an expense must be incurred while an employee is employed in order to be eligible for reimbursement from the account. With the dependent care account, expenses can be incurred after termination of employment and still be reimbursed from the account. Another significant difference with the dependent care account is that the prefunded account requirement does not apply. Therefore, reimbursements are limited to the amount actually contributed to the employee's account.
Implementing the FSA Plan
If you are interested in implementing an FSA, you need to keep in mind that the IRS regulations in Sections 125 and 129 determine most of the plan design. The IRS code determines...
- Eligible expenses
- Maximum contribution for dependent care ($5,000)
- "Use it or lose it" rules
- "Prefunded account" or uniform coverage requirements
Key plan design decisions that must be made include:
- How soon employees can participate. The key decision for enrollment is if you have a single annual enrollment or if you will allow new employees to enroll when hired
- Plan minimum contribution. You usually would want to set a minimum to avoid very nominal amounts, like $120 per year
- Frequency of reimbursement. Under a dependent care FSA, bi-weekly reimbursement is the norm since the employee is dependent on the reimbursement to make the payment to the dependent care provider. Monthly is more common for health care FSAs
- How excess funds will be disposed. As indicated earlier, use of these funds to pay for the plan's administrative expenses is the norm
In closing, employees who utilize an FSA greatly appreciate the benefit. What other benefit plan can you offer to employees where they can totally avoid paying taxes on a portion of their income?
eflexgroup.com, Inc., a TPA firm based in the Madison (Wisconsin) area which only administers FSA plans, has excellent content on its site concerning FSAs which you might want to check out. eflexgroup.com, Inc. is a "best of class" TPA that we refer clients to who wish to establish FSAs.
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Last Updated ( Monday, 28 April 2008 10:21 )
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