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Flexible Spending Accounts (FSAs)

As part of your employee benefits package, you may wish to add a Flexible Spending Account (FSA), sometimes called a "cafeteria plan" or a "Section 125 Plan," after the section of tax code that governs them. Flexible spending accounts are a valuable pre-tax benefit that you can offer your employees without incurring out-of-pocket costs, because of the immediate FICA tax savings to your company. 

The questions and answers presented below provide an overview of Flexible Spending Accounts and how they work.

  1. What is a Flexible Spending Account?
  2. What are the advantages to an employer of having a Flexible Spending Account?
  3. What are the advantages to an employee of having a Flexible Spending Account?
  4. Who can sponsor an Flexible Spending Account?
  5. Who can participate in an FSA?
  6. How do these plans work?
  7. Do employees enroll each plan year ?
  8. Can employees change elections during the plan year?
  9. Can funds remaining in an FSA be carried over to the next plan year?
  10. How do I set up an FSA?

What is a Flexible Spending Account (FSA)?

A Flexible Spending Account (FSA) is an account that can be used for paying out of pocket health and dependent care expenses with pre-tax dollars. FSAs can be funded by the employee, the employer, or both, but are most often funded by the employee, who agrees to contribute a portion of his or her salary on a pre-tax basis to pay for unreimbursed medical costs. Elected contributions are generally made through regular, equal payroll deductions.

While employers may offer a number of different types of reimbursement accounts (e.g., Health Care Flexible Spending Accounts, Dependent Care Flexible Spending Accounts, Individual Premium Flexible Spending Accounts, and Adoption Assistance Accounts), most employers structure their FSAs to include the following two types of accounts:

  • Health Care Flexible Spending Accounts for payment of non-reimbursed medical, dental, vision and prescription drug expenses; and

  • Dependent Care Flexible Spending for the reimbursement of day care expenses.

Health Care Flexible Spending Account (HCFSA)

The high cost of medical care is a fact of life. Health care costs can add up and be a significant part of an employee's annual expenses. Although the health insurance plan you provide your employees offers protection against incurring major medical expenses, employees still have a number of ordinary health care expenses that are not covered under any benefit plan. A Health Care Flexible Spending Account offers a way to better manage these expenses.


A Health Care Flexible Spending Account (HCFSA) allows for certain out-of-pocket health expenses to be paid for on a pre-tax basis. At the beginning of the plan year each employee who wishes to participate in the HCFSA determines the amount that they wish to have deferred from their salary to a Health Care Flexible Spending Account. Their elections are then deducted from payroll and placed in their account. These payroll deductions are free of federal, state and (in most cases) FICA taxes, and they do not appear on the employee's W-2 as reported income. The IRS does not currently set specific monetary limits on the medical/dental expenses that can be reimbursed with a Health Care Flexible Spending Account. Instead, federal regulations require each employer offering this plan to establish annual contribution maximums.


Employees are able to receive their full election amounts anytime during the plan year by submitting claims for payment of qualified medical expenses.


Eligible Health Care Expenses


Reimbursements are only issued for eligible expenses incurred by the employee, their spouse or their dependents. Eligible expenses are those that qualify as federal income tax deductions under Section 213 of the federal tax code. If an expense is not reimbursable under Section 213, it cannot be reimbursed by a FSA. Click here to view a listing of eligible and ineligible expenses.


Expenses reimbursed through the Section 125 plan cannot be itemized and resubmitted through an income tax return since they are already paid for with pre-tax dollars.


Dependent Care Flexible Spending Account (DCFSA)

The Dependent Care Flexible Spending Account (DCFSA) allows working parents who are paying daycare costs for a dependent under age 13 (or for any adults or other eligible dependents who cannot take care of themselves, because they are physically or mentally unable) to pay for those expenses with pre-tax dollars with funds from this account.

Eligible Dependent Care Expenses

An employee can deposit up to $5,000 each year on a tax-free basis to pay for eligible dependent care expenses. Click here to see a list of of eligible and ineligible dependent care expenses.


What are the advantages to an employer of having a Flexible Spending Account?

Establishing an FSA can benefit your company by:

  • Reducing your employment taxes: FICA, unemployment, and Workers Compensation.

  • Providing an outstanding corporate-sponsored benefit at virtually no cost if participation in the FSA is high.

  • Enhancing your employee benefit package, which helps your in recruiting new employees and reducing turnover.


What are the advantages to an employee of having a Flexible Spending Account?

For an employee, participation in an FSA:
  • Reduces taxable income (On the amount of money the employee allocates to their FSA, they save FICA withholding tax, as well as federal and state income tax).
  • Increases spendable income.
  • Offers an easy and convenient way to pay for expenses not covered by insurance; funds are available when expenses are incurred.


Who can sponsor an FSA?

Regular Corporations, Partnerships, S Corporations, Limited Liability Companies (LLCs), Sole Proprietorships, Professional Corporations and Not-For-Profits can sponsor FSAs for their employees.


Who can participate in an FSA?

Only employees may participate in an FSA. Regulations prohibit sole proprietors, partners, members of an LLC (in most cases), or individuals owning more than 2% of an S corporation from participating in the FSA plan. These individuals, however, may still sponsor a plan and benefit from the savings on payroll taxes.


How do these plans work?

The employer identifies who is eligible (i.e. all employees with over ninety days of service) within discrimination requirements, what the maximum contributions are for the plan (i.e. $5,000.00 for dependent daycare expenses), and the duration of the plan year (typically a period of twelve consecutive months). There is no statutory limit on the amount of money that can be contributed to a Health Care Flexible Spending Account. However, some companies place a limit of $2,000 to $3,000 on these accounts.

Each eligible employee elects whether or not to participate in the plan and how much they wish to contribute. Those employees who participate receive pre-tax payroll-deductions and submit claims for reimbursement of expenses throughout the year.


Do employees enroll each plan year?

Yes. New new elections are made and new enrollment forms must be turned in each plan year.


Can employees change elections during the plan year?

Once an employee is enrolled in the Flexible Spending Account, the elections they have made cannot be changed during the plan year, unless there is a qualifying event (i.e. change in marital status or change in number of dependents) as determined by the employer and specified in the plan document. 


Can funds remaining in an FSA be carried over to the next plan year?

Flexible-spending accounts are "use-it-or-lose-it" accounts; any unused amounts remaining in an account at the end of the plan year cannot be carried over into the next plan year. These funds are forfeited (remain with the employer) and are not available for reimbursements. A recent ruling, however, reduces the risk of the use-it-or-lose-it rule for Section 125 plans. This ruling allows an additional 2-1/2 months after the end of a cafeteria plan year, during which a participant may incur expenses that can apply against the prior year‘s level of available benefits or contributions.


How do I set up an FSA?

You will need to retain the services of a Third Party Administrator to create your plan documents and to administer your FSA on an ongoing basis. Benefit Magic can help you select a Third Party Administrator, who will provide these services for you at a reasonable price, and we will help educate your employees regarding how to use the FSA to their best advantage.



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