The advantages of setting up a benefits' system of flexible spending accounts.
A benefits plan that translates into bottom-line corporate profits
Swezey & Newins Inc., which operates the small chain of Swezey's department stores on New York's Long Island, faced a dilemma. Expanding costly and complex employee benefits coverage seemed like business suicide. Yet the company needed a comprehensive benefits plan to compete with corporations for educated, motivated employees.
Here's what Swezey's did. Controller William Knapp Jr., a great-grandson of the company's founder, set up a system of flexible spending accounts (FSAs), arguably the best-kept secret in the employee benefits arena. The money that goes into FSAs is pretax income (which reduces employees' taxable income); the money that goes out can be spent only on such specified expenses as day care, elder care, or medical bills.
FSAs are a win-win strategy for everyone except the Internal Revenue Service. Companies get to shift part of medical costs and other expenses to their employees, while reducing their employees' own costs and year-end tax bills. The plans are a snap to administer; best of all, because of an often-overlooked tax benefit, they can even generate positive cash flow once they've been in operation for just a year or so.
It took Knapp and James Wallerstein -- a vice-president at the Garden City, N.Y., office of Noble Lowndes, a benefits consulting firm -- two months to design an FSA package for 200 qualified Swezey's employees. It allows any employee who has worked at least 20 hours a week for two months to siphon off a portion of his or her salary into any or all of three FSA plans:
* The premium account. Money deposited here can be used to pay premiums for medical, dental, or health maintenance organization coverage. (Employees of Swezey's with individual coverage pay 20% of their premium costs; for family coverage their share is 40%.)
* The health-care reimbursement account. These dollars can pay for deductibles, unreimbursed portions of medical bills, or items not otherwise covered by the health plan, such as vision or well-baby care.
* Dependent-care reimbursement. This account can be used for day care, after-school care, baby-sitting, or camp expenses for children under 13; it can also cover the costs of nursing or other care for employees' dependent parents.
Originally, Knapp was interested only in the premium account. "The company's insurance premiums were going to go up by 80%," he says, "so we had no choice but to shift some of the cost to our employees. This seemed like a relatively painless way of doing it, since FSAs would allow them to save 25 or 30 in taxes for every dollar they'd have to spend." Wallerstein also persuaded him to set up the two other plan options permitted by the IRS.
Knapp was hooked by the overall cost projections: "We were going to spend $3,000 or $4,000 to set up our FSA plans and then file plan descriptions with the IRS. Then it was going to cost us another $3,500 for software so that our bookkeeping department could handle the record keeping." (See "Resources," page 2.) "Those were our only projected expenses, since the dollars going into the FSAs would come out of employees' paychecks."
Here was the kicker: because the company's taxable payroll would be reduced by the amount of FSA contributions, its FICA taxes would also drop. "The more popular the plan, the more we'd save in taxes," says Knapp with a smile.
Not surprisingly, employees were suspicious at first. So Noble Lowndes prepared worksheets to help them figure out their own potential benefits. The numbers were impressive: a $25,000-a-year employee who deposited $1,640 into an FSA -- instead of paying it out directly for premiums, deductibles, and the like -- could be expected to take home $19,782 after taxes -- a full $370 more than if he'd stuck to the old system.
In all, 50 employees signed up for the premium account during 1990, the first year of operation. It is generally the most popular account, since there's no guesswork or risk involved in contributions: workers are told the size of their weekly premium bill, then their share of the bill is deducted from paychecks and paid into the FSA accordingly.
Thirty-three employees signed up for the health-care reimbursement account, depositing between $50 and $1,000, divided into regular weekly payments. So far, only a handful have signed up for dependent care, but Knapp expects it to become more popular as people become comfortable with the system.
Employees contributed a total of $50,630 to the FSA plans -- "which we figure gave them more than $12,000 worth of tax savings," reports Knapp. "We're going to save $3,800 in FICA taxes. Even at this initial level of staff participation, the plan will pay for itself in two years."
What about the risks? As Wallerstein sees it, there's only one for corporations: "The way the IRS's rules are set up for health-care reimbursement FSAs, an employee could decide to contribute, say, $2,000 over the course of a year, spend that money on medical procedures during the first two months of the year, and then quit, leaving his company holding the bag for any funds that hadn't yet been deducted from his paycheck."
To minimize that risk, Knapp limits workers' contributions to that particular account to a total of $1,000. And he plans to monitor results over the next couple of years. Fortunately, there's no corporate exposure with the premium or dependent-care accounts, since employees can spend only those dollars they have already contributed.
Employees face a different risk. They must use or lose any FSA contributions they make. In fact, once the work year has begun, they're locked into whatever payroll-deduction mechanism they've chosen for the year, unless there is a change in their family status. This encourages workers to be conservative in estimating their FSA contributions.
Meanwhile, Knapp remains confident about the benefits of FSAs for both his company and his employees. "There's no reason we shouldn't have 100% participation -- and I'm going to keep explaining that to our staffers until they see that I'm right."
THE SIMPLE SOLUTION
How to set up a flexible spending account
Setting up flexible spending accounts is relatively simple. Here's what's involved:
* Plan documentation. The only reasons you'll need to hire a benefits specialist are to help you choose the FSA options that make the most sense for your employees, set up a streamlined system, and write a formal plan description to be filed with the IRS. Expect to spend $2,500 to $5,000 on the process.
* Participation agreements. Keep them simple. Provide people with worksheets that illustrate the advantages of FSAs. Then circulate a document -- to be signed before the beginning of the new fiscal year -- stating exactly how much money the employee would like to contribute to each FSA account the company offers.
* Payroll deductions. Time the FSA contributions to coincide with your pay schedule. Funds must be segregated into separate FSA accounts with current bookkeeping entries that list the contributions and expenditures of each participating employee.
* FSA payments. Think of these as insurance payments without the middleman. Employees submit completely documented bills; once they're determined to be legitimate expenses, your book-keeping department writes checks, debiting FSA balances as appropriate.
* Tax returns. Just as it does with other employee benefits, your company will have to file separate Form 5500s annually for its flexible spending accounts. No big deal: you'll have to list which plans are offered, how many employees participate, and how many of them are highly compensated.
Here's the software Knapp relies on to handle his FSA record-keeping needs:
The Cafeteria Plan Management System, a pricey but highly efficient system that can handle all FSA-plan options. Mayer Hoffman McCann, 420 Nichols Rd., Kansas City MO 64112, (800) 433-2292; IBM compatible; $3,450.