Flexible Spending Plans (FSA) Can Benefit Both Employees and Employers

Although the future of the Affordable Care Act (ACA) is still unclear, it’s likely that health insurance costs will continue to increase in the future regardless of the outcome.

Business owners are finding that they are requiring greater employee contributions or needing to offer reduced coverage as costs increase. In addition, the ACA has made it more difficult for individuals to deduct medical outlays:

For most taxpayers, only medical expenses over 10% of adjusted gross income (AGI) are tax deductible, versus a 7.5% hurdle under prior law. (The 7.5% rule remained in place through 2016 for individuals 65 and older and their spouses.)

In this environment, business owners stand to benefit substantially by offering a health flexible spending account (FSA). These FSA plans allow employees to set aside up to $2,600 per year (as of 2017) that they can use to pay for health care expenses with pretax dollars.

Example 1:  The Acme Corporation offers a health FSA plan to its employees. Hank, a forklift operator at Acme, puts $2,600 into his health FSA at the beginning of the year. Each month, $216 will be withheld from Hank’s paychecks, and he’ll owe no income tax on those amounts. Going forward, Harvey can be reimbursed through his health FSA for qualified medical expenses that are not covered by his health plan at Acme.

Possible examples include health insurance deductibles, co-payments, dental treatments, eyeglasses, eye surgery, and prescription drugs. Such reimbursements are not considered taxable income. This will enable Hank to pay those medical bills with pretax rather than after-tax dollars.

Health FSA Plans and the Affordable Care Act

Under the ACA, there are limitations on an employer offering a health FSA plan to their employees.  Standalone health FSAs (without having a major medical health plan) can only be offered to provide limited scope dental and vision benefits. An employer can only offer a health FSA that provides more than that if the employer also offers group major medical health coverage to its employees.

Additionally, an employer can make contributions to an employee’s health FSA. The maximum employer contribution the plan can offer is $500 or up to a dollar-for-dollar match of the employee’s salary reduction contribution.

Employer Benefits

The benefits of a health FSA plan to employees are clear. But what will the business owner receive in return? Chiefly, the same advantages that come from offering any desirable employee benefit. Recruiting may be strengthened, employee retention can increase, and workers’ improved morale will make your company more productive.

There’s even a tax benefit for employers, too. When Forklift Hank reduces his taxable income from, say, $75,000 to $72,400 by contributing $2,600 to his FSA, he also reduces the amount subject to Social Security and Medicare withholding by that amount. Similarly, Acme won’t need to pay Social Security or Medicare tax on that $2,600 going into his FSA.

Counting the Costs and Risks

However, drawbacks to offering a health FSA to employees do exist. The plan, including reimbursements for eligible expenses, must be managed. Many companies save headaches by hiring a third-party administrator to handle a health FSA, but there will be a cost for such services. In addition, companies offering health FSAs to employees should have enough cash to handle a large demand for reimbursement, especially early in the year.

Example 2: Jane also works for Acme, and she chooses to contribute $1,800 to her health FSA plan at the beginning of the year through $150/month payroll deductions. Just after her first contribution of the year, Jane breaks a tooth eating a bagel and needs expensive dental care. She submits paperwork to her FSA for a $1,000 reimbursement to cover the cost of the dental procedure. She is immediately eligible for the entire amount, despite the fact that she has only contributed $150 so far this year.

Acme takes the risk that Jane will stay at the company long enough to cover the reimbursement through payroll deductions. But if she leaves before then they are on the hook for the total amount.

Using It, Losing It

Employers also should be sure that employees are well aware of all the implications of health FSA plan participation. For years, these plans have been “use it or lose it.” Any unused amounts would be forfeited at year end. But a change occurred in late 2013—the $500 option.

Under this option, FSA plans can be amended to allow each employee a carryover of up to $500, from one year to the next. Plans with this $500 carryover provision cannot allow a grace period as well. If your company now has a health FSA with this optional grace period, it will have to amend the FSA to eliminate the grace period in order to add the $500 carryover provision.

In addition to explaining all the rules on possible forfeitures, employers offering a health FSA should be sure their employees know about a possible impact on Social Security benefits. As mentioned, health FSA contributions aren’t subject to Social Security; those contributions aren’t included in official compensation for Social Security purposes. Employees should know that reduced compensation today might reduce Social Security benefits tomorrow. Companies that spell out all the FSA implications to workers may reduce misunderstandings and future complaints.

For more information, see IRS Notice 2013-54 about how the Affordable Care Act affects health FSAs and other health plans, at www.irs.gov.

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