Flexible Spending Arrangements (FSAs)
A flexible spending arrangement, also called a flexible spending account or “FSA,” is a popular benefit that employers offer to reimburse employees for medical, dependent care or adoption assistance expenses. FSAs are usually funded through voluntary salary reduction agreements set up by an employer.
- The IRS has released guidance regarding the participation by same-sex spouses in health FSAs, dependent care FSAs, and adoption FSAs. Click here for more information.
- Employers may now allow employees to carryover up to $500 of unused amounts in a health FSA to use in the following plan year. Click here for more information regarding the modified “use-or-lose” rule.
- An IRS memorandum clarifies the rules regarding health FSA carryovers and eligibility for HSAs. Among other things, the memo provides that individuals who are covered by general purpose health FSAs are not eligible to make HSA contributions during the entire plan year of the health FSA, even if they have coverage solely as a result of a carryover of unused amounts in a health FSA from the prior year.
- Effective retroactively as of September 13, 2013, a health FSA that is not offered through a cafeteria plan is subject to the annual dollar limit prohibition under Health Care Reform and will fail to comply with the annual dollar limit prohibition. Click here for more information regarding the application of the annual dollar limit prohibition, as well as the preventive services requirements under Health Care Reform, to health FSAs.
Health FSAs are set up by employers and serve to reimburse employees for qualified medical expenses that are not covered by another health plan. The benefits are subject to an annual maximum and are also subject to a modified “use-or-lose” rule (see below). They are similar to, but have important differences from Health Savings Accounts (HSAs), Medical Savings Accounts (MSAs) and Health Reimbursement Arrangements (HRAs). More on qualified medical expenses and how a health FSA works is covered below.
Dependent Care FSAs
FSAs can also be set up to pay for employees’ qualifying expenses from taking care of a dependent. These expenses typically cover children, such as for day care, but can also apply to elderly care. If an employer provides benefits for dependent care, the maximum income exclusion or deduction is $5,000. Employer-provided dependent care benefits may also reduce the amount of tax credit an individual may take for these kinds of expenses. For more on child and dependent care expenses, please see Publication 503, Child and Dependent Care Expenses.
In addition to medical and dependent care assistance, employers can provide adoption assistance to employees through FSAs. As with medical and dependent care assistance, adoption assistance benefits are provided through reimbursement to the employee. The benefits are subject to an annual maximum and are also subject to an annual “use-or-lose” rule.
Benefits of an FSA
- An employee may enjoy several benefits from having an FSA:
- Contributions made by the employer can be excluded from the employee’s gross income.
- No employment or federal income taxes are deducted from the contributions.
- Withdrawals may be tax free if the employee pays qualified medical expenses.
Qualifying for a Health FSA
Health FSAs are employer-established benefits that may be offered in conjunction with other employer-provided benefits as part of a cafeteria plan. Employers have complete flexibility to offer various combinations of benefits in designing their plan. Moreover, employees do not have to be covered under any other health care plan to participate in an FSA.
Contributing to an FSA
Employees contribute to their FSA by electing an amount to be voluntarily withheld by the employer from their pay. This is sometimes called a salary reduction agreement. The employer may also contribute to the FSA if specified in the plan.
Employees do not pay federal income tax or employment taxes on the salary they contribute or the amounts the employer contributes to the FSA. (In the case of long-term care insurance, however, employer contributions must be included in income.)
Amount of Contribution
For taxable years beginning in 2015, salary reduction contributions to health FSAs are limited to $2,550 annually (indexed for inflation for subsequent plan years).
Distributions from an FSA
Generally, distributions from a health FSA must be paid only to reimburse employees for qualified medical expenses they incurred during the coverage period:
- Employees must be able to receive the maximum amount of reimbursement (the amount they have elected to contribute for the year) at any time during the coverage period, regardless of the amount actually contributed.
- The maximum amount that the employee can receive tax free is the total amount the employee elected to contribute to the health FSA for the year.
Special Note: Changes to Tax-Favored Accounts under the Affordable Care Act
Application of Annual Dollar Limit Prohibition and Preventive Services Requirements to FSAs
According to agency guidance, if an employer provides a health FSA that does not qualify as excepted benefits, the health FSA generally is subject to the so-called “market reforms” of the Affordable Care Act, including the preventive services requirements. A health FSA that does not qualify as excepted benefits is not integrated with a group health plan, and thus, it will fail to meet the preventive services requirements. In addition, effective as of September 13, 2013, a health FSA that is not offered through a cafeteria plan is subject to the annual dollar limit prohibition and will fail to comply with the annual dollar limit prohibition.
Distributions for Medicine Qualified Only if for Prescribed Drug or Insulin
Under the Affordable Care Act (ACA), reimbursements from HSAs, Archer MSAs, FSAs or HRAs qualify only if made for a medicine or drug that is a prescribed drug, or insulin. Over-the-counter medicine obtained with a prescription will continue as a qualified medical expense.
Tax Increase on Nonqualified Medical Expense Distributions from HSAs
The ACA increases the excise tax, to 20%, on distributions from a Health Savings Account or Archer MSA if the distributions are not for a qualified medical expense (including over-the-counter medicines and drugs purchased without a prescription).
New Threshold in 2013 to Itemize Medical Expenses as Deduction
Under the ACA, the threshold to itemize unreimbursed medical expenses as a deduction on tax returns increased in 2013 from 7.5% to 10% of adjusted gross income (AGI). Note: There is a temporary exemption from January 1, 2013 to December 31, 2016 for individuals age 65 and older and their spouses. The threshold remains at 7.5% of AGI for those taxpayers until December 31, 2016. Click here for more information.
Qualified Medical Expenses
Qualified medical expenses are those specified in the plan that would generally qualify for the medical and dental expenses deduction. These expenses are explained in Publication 502, Medical and Dental Expenses. Non-prescription medicines (other than insulin) are not considered qualified medical expenses.
- An FSA cannot make distributions for the following expenses:
- Amounts paid for health insurance premiums
- Amounts paid for long-term care coverage or expenses
- Amounts that are covered under another health plan
Modified Use-It-or-Lose-It Rule
The “use-it-or-lose-it” rule generally requires that amounts in an employee’s health FSA that are not spent by the end of a plan year be forfeited, subject to a grace period. However, subsequent agency guidance provides employers with the option of amending their plan documents to provide for a carryover of up to $500 of any unused amounts, for use in the immediately following year. The carryover may be used to pay or reimburse medical expenses incurred during the entire plan year to which it is carried over.
- If an employer amends its plan to adopt a carryover, the following requirements must be met:
- The same carryover limit must apply to all plan participants; and
- A plan incorporating the carryover provision may not also provide for a grace period in the plan year to which unused amounts may be carried over.
- (The carryover does not count against or otherwise affect the indexed $2,550 salary reduction limit.)
- Employers may adopt this carryover provision for current plan years and/or subsequent plan years by amending the plan documents in the manner and within the time frames described in the guidance.
Grace Period- 2 ½ Months
An FSA plan can provide for a grace period of up to 2½ months after the end of the plan year. If there is a grace period, any qualified medical expenses incurred in that period can be paid from any amounts left in the account at the end of the previous year. Employers are not permitted to refund any part of the balance to employees. As an alternative to the grace period, employers may adopt a carryover option of up to $500, discussed above.
Written Statement of Medical Expense
In order to receive a distribution, employees are required to provide the health FSA with a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expense. The employee must also provide a written statement that the expense has not been paid or reimbursed under any other health plan coverage. In other words, the FSA cannot make advance reimbursements of future or projected expenses.
Debit cards, credit cards, and stored value cards that an employer can give to an employee can be used to reimburse participants in a health FSA. If the use of these cards meets certain substantiation methods, the employee may not have to provide additional information to his or her health FSA.
For a health FSA to maintain its tax-qualified status, employers must comply with certain requirements that apply to cafeteria plans. For example, there are restrictions for plans that cover highly compensated employees and key employees. The plans must also comply with rules applicable to other accident and health plans.