A flexible spending account (FSA) is a tax-deferred savings account established by an employer to help employees meet certain medical and dependent-care expenses that are not covered under the employer's insurance plan. Established under Section 125 of the Internal Revenue Code, FSAs were once known as medical Individual Retirement Accounts (IRAs). FSAs allow employees to contribute pre-tax dollars to an account set up by their employer. They can later withdraw these funds tax-free to pay for qualified health insurance premiums, out-of-pocket medical costs, day care provider fees, or private pre-school and kindergarten expenses.

FSAs provide an attractive benefit for many employees, and they also offer tax savings for both employees and employers. As the cost of providing health insurance to employees has risen rapidly over the last decade, many companies have greatly increased the employee portion of the insurance premium. Co-pays and deductibles have increased as well in an attempt to manage the overall premium cost. The use of a health care FSA is one way in which employers may help their employees to self-fund with tax-free dollars the growing costs that they are asked to bear for their partial company-funded health insurance.

TAX BENEFITS OF FSAS

Internal Revenue Service guidelines allow employees to make contributions to employer-sponsored FSAs out of pre-tax income. Thus employees save federal and state income taxes, as well as the employee portion of Social Security taxes, on the amount they authorize their employer to withdraw from their paychecks and place in the FSA each year. By reducing their taxable income, employees can increase their take-home pay. For example, say that an employee of ABC Company whose annual salary was $50,000 contributed $5,000 to an FSA in 2000. This action would reduce the employee's taxable income to $45,000. If the employee typically paid taxes amounting to 30 percent of her income, she would save $1,500 in taxes for 2000. Furthermore, the money contributed to an FSA is not taxable for the employee when it is withdrawn, provided it is used to pay for qualified medical or dependent-care expenses.

Employers also receive a tax benefit by establishing flexible spending accounts. Employers are not required to pay the employer portion of the Social Security tax—which amounts to 7.65 percent of each employee's taxable income—on employee contributions to FSAs. In effect, payroll taxes are reduced by 7.65 percent of the total employee contributions to the FSA.

In the earlier example, say that ABC Company is a small business with 10 employees and an annual payroll of $500,000. Without the tax advantage of an FSA, the company would owe Social Security taxes of 7.65 percent on its total payroll of $500,000, or $38,250, in 2000. But if, in a most optimistic scenario, all 10 employees each contributed the maximum allowable contribution of $5,000, the company's taxable payroll would be reduced by $50,000, and the company would save $3,825 in taxes for the year. Combined with the tax savings of $1,500 per employee, the total tax reduction for the company and its workers resulting from the FSA would be $18,825 for the year.

In reality, a company can expect a participation rate closer to 20 percent. In a 2005 Business Insurance article entitled "Grace Period Complicates FSAs," author Jerry Geisel states that "Currently, about 15 percent of eligible employees contribute to health care FSAs, with employees contributing on average between $1,100 and $1,200 a year."

One potential reason for low participation rates has to do with the "use it or loss it" rule limiting the ability to cumulate funds in an FSA account. Money deposited into an FSA account is forfeit if not used in the benefit year—forfeit by the employee and received back by the company. Until 2005, when the IRS issued an FSA grace period amendment, all funds contributed to an FSA had to be used within one year. The dates for that year were defined as the company's benefit plan year, a period which may or may not correspond with the calendar year. As of 2005, a company may amend its FSA Plan document to incorporate a two and one half-month grace period. This allows an employee to use the first two and half months of the next year to use up his or her FSA balance from the prior year. Anything not used within this period would be forfeit. Proponents of this new grace period hope that it will reduce concerns about losing money and encourage participation in FSA plans.

LEGAL REQUIREMENTS FOR FSAS

Employers are required to follow the guidelines established in Section 125 of the Internal Revenue Code when setting up an FSA. The first step involves preparing a plan document that states the conditions for eligibility, the benefits provided, and the rules that apply to implementation of the FSA. The employer must distribute these rules to eligible employees and follow them consistently. Employers are also required to file Form 5500 with the U.S. Department of Labor each year, as well as complete a series of nondiscrimination tests outlined by the IRS.

Each part of the process of implementing and administering an FSA plan for employees involves legal requirements. These requirements apply to the plan document, summary plan description, nondiscrimination testing, government filings, claims administration, and plan updates. Since compliance with these requirements tends to be complex, and since the IRS imposes serious penalties for noncompliance, most companies outsource FSA administration to a third party. The costs of outsourcing these administrative tasks are high. Many experts say that such costs may be off-set by the tax saving that FSA plans generate along with the savings associated with any funds forfeit by participants.

Any employer considering an FSA for her firm must be careful to plan for the potential cash flow needs that may be generated by early disbursements. If an employee agrees to have $2,500 withheld from his paychecks for deposit into his FSA account during the year, those funds must be available to him as needed, which may be within the first month of the year. Since the money going into his account will be collected over a twelve-month period, the company must have cash reserves set aside to address cash disbursements that occur prior to collections.

USING FSAS FOR DEPENDENT CARE EXPENSES

Employers can set up FSAs in a number of ways, depending on what options their employees would find most valuable. For example, FSAs can cover only health insurance premiums, or they can only be used to reimburse medical expenses not otherwise covered by the employer's health insurance plan. FSAs can also cover only dependent care expenses, or they can offer a full plate of benefits including both health care and dependent care.

Dependent care reimbursement FSAs have become increasingly common in recent years. Employees with children can use these accounts to cover day care and educational expenses up to and including private kindergarten.

With a dependent care FSA, employees can begin making pre-tax contributions when a child is born and continue until the child completes kindergarten. The maximum contribution is $5,000 annually per child. The employee decides how much to contribute based on his or her anticipated child-care expenses for each year. The employer deducts that amount in installments from the employee's gross pay each pay period, and sets the money aside in an FSA. The employee's income taxes are calculated based on his or her remaining pay, which reduces taxable income. The employee can withdraw money from the FSA tax-free to make tuition payments. In most cases, employees are required to submit proof that their deductions are put toward qualifying dependent care expenses.

BIBLIOGRAPHY

Geisel, Jerry. "Grace Period Complicates FSAs." Business Insurance. 22 August 2005.

Gould, Jay. "Flexible Spending Accounts Benefit Both Employees, Employers." San Antonio Business Journal. 24 November 2000.

"How Tax Savings Play Out." Inc. March 2000.

"Letting Easy Money Slip Away." Work & Family Newsbrief. November 2005.

"One-Third of Employers to Extend FSA Deadlines." Managing Benefits Plans. October 2005.

Seiden, Richard. "IRS Offers 'Use It or Lose It' Grace Period for Flexible Spending Accounts." San Fernando Valley Business Journal. 29 August 2005.

"Some Good News About Health Care Flexible-Spending Accounts." Managing Benefits Plans. February 2006.