As an employer, you can offer various benefits to your employees. There are pre-tax and post-tax benefits for employees to enjoy. One plan you can offer employees is an FSA. So, what is an FSA?
What is an FSA?
An FSA, also known as a flexible spending account (or arrangement), is a tax-free fund that employees can contribute to and use on qualifying medical and health care costs. There is an annual IRS contribution limit on FSAs.
FSAs are voluntary benefits you can offer in your business. Likewise, employees can choose to contribute to an FSA plan. You must establish an FSA at your business for employees to open accounts. Self-employed individuals are not eligible to have an account, and there are highly compensated employee 401(k) restrictions. An FSA is a qualifying benefit under a Section 125 plan, or cafeteria plan.
You can offer FSA plans to employees as a stand-alone benefit or in conjunction with traditional health insurance or high-deductible health plans.
There are other savings accounts used for health and medical expenses, like an HSA (Health Savings Account) and MSA (Medical Savings Account).
If you’re interested in offering an FSA, you must understand flexible spending account rules.
What can employees use FSA plans on?
You must specify qualifying medical expenses in the FSA plan you establish. Employees can pay for qualifying medical and dental expenses with their FSA funds.
FSA eligible expenses include the following:
- Copays or deductibles
- Qualifying prescriptions
- Certain medical equipment
Different procedures or situations that let employees use their funds include an ambulance, physical examination, psychologist, or operation.
Medicines or drugs qualify as medical expenses if they require a prescription, are over-the-counter medicines that are prescribed, or are insulin.
FSA-eligible items also include things like bandages, crutches, or artificial teeth.
The employee, their spouse, dependents, or child under the age of 27 can incur medical expenses.
For a full list of qualifying medical expenses, consult the IRS’s Publication 502.
Does the employer have to contribute?
You can choose to contribute to an employee’s FSA plan. Employer contributions are not mandatory.
If you do contribute, do not include employer FSA contributions in the employee’s gross income.
FSA contribution limits for 2021
Each year, the contribution limit for an FSA plan changes. For 2021, employees can contribute up to $2,750 per year to their account according to FSA rules.
Are FSA plans taxable?
For example, an employee earns $1,200 with each paycheck. They contribute $35 to their FSA plan. The employee’s taxable wages are only $1,165 ($1,200 – $35).
When does an employee determine their contribution amount?
The employee determines how much to contribute to the account at the beginning of the year. You must withhold their contribution amount from their wages for their FSA plan.
If the employee has a qualifying life event (e.g., marriage, divorce, birth of a child), they can change their contribution amount during the year. Otherwise, they are stick with the amount they decided at the beginning of the year.
However: The IRS is allowing certain mid-year election changes for plan years ending in 2021.
When does an employee have access to funds?
The employee has access to the full amount they plan on contributing instantly, regardless of if they have contributed that amount or not.
For example, an employee decides to contribute $2,000 to their flexible spending account. It’s February, and the employee needs $500 from their FSA plan. So far, you’ve only taken out $80 from their wages for the account. However, the employee has full access to the $2,000. So, they can take $500 to cover their expense.
How do employees receive distributions from their account?
After an employee spends on a qualifying expense, they must provide two written statements:
- One written statement from an independent third party that details the employee’s expense and the amount
- One written statement that says the expense hasn’t been covered by a different plan
If you control your employees’ FSA plans (which is the case unless you outsource them), you can use a debit, credit, or stored value card to reimburse your employee.
Can employees carry money over?
For the most part, the money in an FSA plan is forfeited back to your company when the year ends. However, there are two optional FSA carryover rules you can choose from to offer employees:
- Grace period: The FSA plan you establish can offer a 2.5 month grace period after the plan year. If the employee has medical expenses within the grace period, they can use the funds. After the 2.5 months end, the employee loses the remaining balance, and the FSA forfeiture goes to your business.
- Carryover: You can include a carryover condition that lets employees add up to $550 of unused funds to next year’s plan (2021 limit). The carried-over funds are in addition to the contribution limit. You decide the carryover limit. Any amount over the carryover limit is forfeited to your business.
Special Rule Alert! On February 18, 2021, the IRS released new rules regarding FSA flexibility. Due to the COVID-19 pandemic, many FSA holders had unused health FSA amounts at the end of 2020 (and will also have unused funds at the end of 2021). Therefore, the IRS is allowing employers to make the following plan changes for 2020 and 2021 plan years:
- Grace period: Extending the grace period to up to 12 months after the end of the plan year
- Carryover limit: Allowing employees to carry over their entire unused funds to the next year
These special rules only apply to 2020 and 2021 plan years. For more information on these changes, check out IRS Notice 2021-15.
Are there reporting requirements?
Employees do not need to report FSA contributions or use on their tax returns. This differs from an HSA or Archer MSA, which requires the employee to report the contributions on Form 1040.
Benefits of an FSA
Having an FSA can provide a tax benefit to both you and your employees. As an employer, you withhold federal income tax and FICA tax (Social Security and Medicare taxes) from employee wages. You might need to withhold state and local income taxes if applicable.
FICA tax consists of employee and matching employer portions. Since an FSA plan reduces the employee’s taxable wages, you and the employee pay less in FICA taxes.
An FSA is counted under a cafeteria plan. Small business employee benefits are important to many workers, which can attract candidates to a job and improve retention rates.
For more information on FSA plans, consult the IRS’s Publication 969.
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This article has been updated from its original publish date of September 28, 2011.
This is not intended as legal advice; for more information, please click here.