The Pros and Cons of Flexible Spending Accounts

If your company doesn’t provide health insurance — or if you do provide coverage but your employees are faced with increasing deductibles, co-pays or out-of-pocket expenses — there’s no time like the present for taking a look at flexible spending accounts (FSAs).

A form of cafeteria plan under Section 125 of the Internal Revenue Code, a health care FSA allows employees to set aside pre-tax dollars from their paychecks to pay medical and dental expenses that are not reimbursed from an insurance plan. Eligible expenses are then reimbursed from the employee’s account. You can also offer flexible spending accounts for dependent care expenses.

Flexible spending accounts offer several advantages to your company and your employees. However, there are also some disadvantages to be aware of. One of the best known is the “use it or lose it” feature. Any amounts contributed to an account and not spent by the end of the year are forfeited to the employer. However, an IRS ruling issued a few years ago softened this deadline considerably. Employees can be given an additional two-and-one-half months after the end of the plan year to spend FSA funds, if the employer amends its plan to allow for this extension. (See the right-hand box for more on this subject.)

Here are some more pros and cons of flexible spending accounts for your company and its employees:

From the Employer’s Perspective

• Decreased taxable salary income for employees, as a result of contributions to reimbursement accounts, results in decreased employer expenditures for FICA tax, unemployment insurance, workers’ compensation and other wage-based expenses.
• Some or all of the cost for administration is typically offset by the FICA tax savings.
• The primary area of concern for employers is the “at risk” provision associated with health care reimbursement accounts. The “at risk” provision requires that you reimburse an employee for incurred eligible expenses up to the full amount that he or she has elected to set aside for the entire plan year — regardless of how much he or she has actually contributed up to that point.

For example, let’s say an employee has elected to contribute $2,400 for the plan year and incurs $2,400 of eligible expenses at the end of the second month. At this point, the employee has only contributed $400 to his account, yet he is entitled to $2,400 in reimbursement. If the employee remains with your organization, he will contribute the remaining $2,000 by year’s end. However, he has no repayment obligation if he leaves his job before the end of the year.

You can cap your company’s liability by limiting the amount that employees set aside. Some employers use a two-tiered capitation: Limiting first-year participants to $1,000, for example, while they become accustomed to the program, and then capping future participation at a higher amount, say $3,000.

There is also a flip side to this issue. An employee who leaves in the course of the year without having expended any or all of what he has contributed to his account relinquishes the remaining account balance to the employer, unless he continues participating through COBRA. Employees also forfeit to their employers any unspent amounts left in their accounts at the end of the year under the “use it or lose it” rule.

From the Employee’s Perspective

• Reduced taxable salary income means employees reduce their federal income tax, FICA tax and frequently, state income tax. Because an FSA reduces adjusted gross income, it may make an employee eligible for other valuable tax benefits.
• Employees can be reimbursed with pre-tax dollars for out-of-pocket deductibles, co-pays and procedures that are not covered by their health care insurance (if they have coverage).
• For many employees, FSAs are the only way to get a tax break for medical expenses. That’s because medical expenses are generally only deductible to the extent they exceed 10 percent of adjusted gross income in 2014 (unchanged from 2013).

Note: If you or your spouse is age 65 or older at year end, the new 10 percent-of-AGI threshold will not take effect until 2017. You can still use 7.5 percent.

• Covering medical expenses with pre-tax dollars via FSAs provides employees with more spendable income.
• Employees are concerned about the “use or lose it” provision of health care accounts. If an employee elects to contribute $2,400 for the plan year, but incurs only $2,000 of eligible expenses, the remaining $400 reverts to the employer. However, planning and past experience can result in accurate contribution-estimates. And the savings on taxes may offset any loss.

While the “use it or lose it” provision can apply to dependent care accounts as well, there is generally less risk. Employees find it easier to estimate what they will spend for dependent care on an annual basis.

Also, be aware of several important changes for health care FSAs included in the Patient Protection and Affordable Care Act. Under the health care legislation, over-the-counter drugs and medicines are now excluded, unless prescribed by a health care professional. Also, the maximum annual contribution to a health care FSA is now capped at $2,500.

If you are interested in learning more about FSA plans, talk with your MKS&H tax adviser or benefits consultant. Keep in mind that if you decide to implement an FSA plan, employee education is a critical component for maximum participation.