Learn how healthcare FSAs work and their advantages and disadvantages.
- A healthcare flexible spending account (FSA) is an employer-owned, employee-funded savings account that employees can use to pay for eligible healthcare expenses.
- FSA contributions are untaxed, resulting in tax savings for employees and employers.
- Employees often forfeit their unused FSA funds at the start of a new plan year or if they leave the company.
- This article is for employers or human resources professionals who want to learn more about healthcare FSAs before offering this benefit to their employees.
To attract and retain top talent, small businesses can offer their employees comprehensive employee benefits with competitive healthcare coverage, and those benefits often go beyond medical insurance. To help cover the cost of eligible medical, dental and vision expenses, many employers offer their employees supplemental healthcare accounts, and one such option is called a healthcare flexible spending account (FSA). Read on to learn what an FSA is and to find out its advantages and disadvantages for both employers and employees.
What is a healthcare flexible spending account?
There are two main types of flexible spending accounts: a healthcare FSA and a dependent care FSA (also known as a dependent care assistance program, or DCAP). A healthcare FSA is an employer-owned savings account that an employee funds through untaxed contributions. Employees can use FSA funds to pay for eligible healthcare, dental and vision expenses for them, their spouse and eligible dependents. A DCAP also offers tax-free savings, but it focuses on covering employment-related expenses for child care.
Individuals can contribute up to $2,750 per year of pretax income to their healthcare FSA. Unless otherwise specified by the employer, any unspent money is forfeited at the end of the plan year. Employers can permit employees to roll over up to $550 of unused funds or grant them a grace period of up to 2.5 months to spend unused funds at the start of the new plan year. If an employee leaves the company, they often lose the remaining FSA funds unless they are eligible for and choose COBRA continuation coverage.
Key takeaway: An FSA is an employer-owned savings account that employees fund with tax-free contributions. The account is used to pay for eligible medical expenses.
How does a healthcare FSA work?
Employees and employers can contribute pretax income to a healthcare FSA, and the money can be spent throughout the year on qualified medical expenses, often via a debit card. For employees to be eligible for an FSA, you must offer them a traditional group medical plan and establish a Section 125 Cafeteria Plan.
- Employees elect their contribution amount. Employees choose an FSA annual contribution amount before the start of each 12-month plan year. Elections cannot be changed during the year, except in connection with specific events (e.g., marriage, the birth of a child or the adoption of a child).
- The contribution amount is evenly withheld from each paycheck. The election amount is withheld from the employee's paycheck, before taxes, in equal installments throughout the year. For 2020, the annual limit is $2,750 per employee. However, employers can choose to set lower limits.
- Employees use FSA funds to pay out eligible claims. Claims are paid up to the employee's annual election amount, even if the employee has not contributed the full amount yet. This is called the "uniform coverage rule."
- Unused FSA funds are forfeited or rolled over at the end of each year. Employees forfeit their FSA balance at the end of the year if they have not used it for healthcare claims. This is called the "use or lose" rule. Employers may allow a limited grace period or carryover provision to help soften the impact.
- Employees forfeit unused funds if they leave the company. IRS rules for cafeteria plans and Department of Labor rules for group health plans apply, including requirements for plan documents, nondiscrimination tests and COBRA administration. Employees who leave the company lose access to any remaining FSA balance unless they elect COBRA and keep making contributions. COBRA is not available to employers with fewer than 20 workers.
Although FSAs are primarily employee-funded accounts, employers can also make contributions (either up to $500 or up to an amount matching the employee's contribution). Employee contributions aren't reported on employee income tax returns, and they can't be claimed as tax deductions. If an employee has both an FSA and a health reimbursement arrangement (HRA), they can't use both accounts to reimburse the same expense; HRA funds are generally used first.
Key takeaway: To set up an FSA, establish a Section 125 Cafeteria Plan, elect contributions, deduct pretax contributions from the employee's salary and allow the employee to use funds on eligible claims.
What kinds of expenses are covered under an FSA?
FSAs are often used to pay for the remaining medical, dental or vision costs that aren't covered by insurance, like co-payments and deductibles. There are several other expenses, benefits and treatments that can be covered by an FSA as well. For example, FSAs can be used to reimburse or pay for over-the-counter prescriptions, vaccines, corrective lenses, dental implants, prescription supplements, acupuncture treatments and more.
When an employee has a healthcare flexible spending account, they are entitled to use the entire election amount as soon as the plan begins, regardless of how much money they have contributed. Employers Council representatives noted an example of when this might happen: An employee needs to have emergency surgery at the beginning of their plan year and must immediately pay a $2,500 deductible.
If the employee previously elected to contribute $2,500 to their FSA over the next 26 pay periods, they could use their entire FSA election amount to pay their deductible, and the employer would continue to withhold the FSA deductions for the remainder of the year.
Key takeaway: FSAs can be used for eligible medical, dental and vision expenses for the employee, their spouse and their eligible dependents. These expenses include deductibles, co-pays and prescriptions, among others.
What are the benefits of offering FSAs to your employees?
A healthcare flexible spending account can be a desirable benefit to include in your employee benefits package, as FSAs have advantages for both employers and employees. Consider the advantages and how they may affect your bottom line.
Benefits for employers
The primary advantage of offering an FSA to your employees is the financial savings. Because FSA contributions aren't taxed, you avoid the 7.65% payroll tax (Medicare and Social Security tax) on employee contributions to FSAs. Although you will be responsible for the cost of maintaining the account, that small amount can be offset by the tax savings and forfeitures.
"The employer's cost of maintaining FSAs is relatively minimal (which costs are offset by the employer's tax savings), and FSAs are a staple of benefit offerings to employees from a recruiting and retention perspective," said Amy Christen, employee benefits attorney and member of Dykema Gossett.
Benefits for employees
FSAs also result in tax savings for employees. FSAs can also give employees some peace of mind because they can use the entire election amount to pay for qualifying claims, even before they make the total contributions. Although employees must continue making those contributions throughout the year, it can be a great benefit to know that they have the money in case of an emergency.
Key takeaway: The main advantage of offering FSAs (for both employers and employees) is the tax savings.
What are the disadvantages of offering FSAs to your employees?
Although FSAs can be a great addition to any employee benefits package, there are a few limitations. For example, a healthcare FSA is considered a group health plan, which is subject to several federal laws.
"For instance, the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) require that FSAs meet reporting and disclosure requirements (e.g., written plan document and summary plan description requirements)," Christen said.
Other potential disadvantages of healthcare FSAs include that they must comply with HIPAA privacy and security rules, they operate under a "use it or lose it" policy, they are not portable (meaning employees forfeit the FSA balance if they leave the company) and they are subject to annual nondiscrimination testing under the IRC to ensure the arrangement is not discriminating in favor of highly compensated or other key employees (which can be troublesome to resolve if you fail).
Key takeaway: Some downsides of FSAs are that employees lose the FSA balance if they don't use it or they leave the company and that FSAs are subject to federal laws and requirements.