“Tax shelter,” a slang description of an account and method to legally defer or eliminate government taxes, is a dirty word to those who forget that favorable tax treatments are legislated to encourage specific behavior or actions that benefit the community as a whole. While many such programs – such as those implemented to encourage drilling for oil – are beyond the use of the average American, using a flexible spending account to reduce taxes on a federal and state level is an option for many.
Flexible spending accounts (FSAs), also known as “cafeteria” or Section 125 plans, were initially established in 1978 and have been amended several times over the subsequent years. An estimated 33 million workers use healthcare FSAs to cover out-of-pocket medical expenses like health insurance co-pays and deductibles.
The provisions allows employers to establish tax-advantaged benefit plans to reimburse employees for qualified medical or dependent care expenses. The intent of the provisions is to allow an employee’s use of pre-tax dollars to pay personal or family costs ranging from medical and dental care, to group life term insurance and dependent care. Some companies have also established FSA plans approved under another IRS section (26 USC § 132) to cover transit or travel employee expenses of getting to and from work.
How Flexible Spending Accounts Work
Employers usually establish FSAs pursuant to salary reduction agreements between the employee and the company, whereby the employee either reduces his or her salary, or agrees to forgo a future increase of pay in return for the employer paying certain costs for the employee’s benefit. The agreed-upon reduction, which reduces the gross income on the employee’s paycheck, is not considered wages for federal or state income taxation, and is not subject to FICA or FUTA (federal unemployment tax).
Effectively, a contribution to an FSA reduces your income by the contribution amount and, consequently, the amount of taxes you owe on the income. While your taxable income decreases by the amount of the contribution, your spendable income is unaffected. However, you must spend all of the money in the account, since any remaining funds are forfeited. If your annual income tax rate is 30% (federal and state tax combined), enrolling in an FSA will save you $30 for every $100 you put into the account.
Employees can generally enroll in their company’s FSA plan either when they begin work or during a specified open enrollment period set by the employer, generally at the end of the year. You are not allowed to make changes in your choice of how much to set aside unless you have a change in your personal financial status, such as a new birth in the family, death, adoption, marriage, divorce, or change in your insurance coverage. For that reason, it is important that you take the time to analyze your personal situation and make the best decisions regarding your likely future income, projected living expenses, health status, and family situation.
Usage of Funds
Unlike health savings accounts (HSAs), which were created in 2003, the unspent funds in an FSA do not roll over to the next year if not spent. Any funds in the FSA at the end of the year are forfeited. This provision is known as the “use it or lose it” rule. While some companies have added a grace period of two and a half months into the following year for later expenses, the requirement to spend all of the fund balance in a single limited period of time has limited the popularity of the FSA, as it is difficult for most people to accurately project their upcoming year’s expenses.
85% of large companies offer a healthcare FSA. However, according to a May 10, 2011 Congressional Research Service study, only 22% of the eligible participants actually enrolled, making an average contribution of less than $1,500 annually – well below the average maximum contribution limit of $5,000. In an effort to encourage greater participation, the IRS is soliciting comments on whether to modify the “use it or lose it” rule so that unused funds can be rolled over and accumulated from year to year, similar to an HSA. Hopefully, a change to allow rollovers and accumulations in an FSA will occur in early 2013.
Until such time that rollovers are available, any forfeited funds remaining in the account are returned to the employer, as they are technically considered to be the employer’s assets anyway. Most employers use the returned funds to defray the costs of administration of the FSA, although the IRS regulations allow the employers to also use the funds to:
- Reduce the account participants’ deducted amount in the coming year. In such cases, the participants in the account will get a bonus amount that has not been deducted from their pay, but is available for them to spend in the new year.
- Increase the annual coverage amount for all participants in the FSA for the coming year.
- Distribute the funds on a pro-rata basis to all fund participants as taxable income.
You need to read the details of the account’s description and administration to determine how your employer handles forfeited funds in your company’s plan.
Requirements to Set Up an FSA
Only your employer can set up and administer an FSA under the IRS code subject to detailed rules. The guidelines cover requirements for the legal documents, including the plan description, its benefits to participants, eligibility and nondiscrimination, and the administration of the plan once established. Employers have a fiduciary and legal responsibility to provide funds to the enrolled employees when called upon; failure to provide those funds could result in severe civil, and possibly criminal, punishments.
The administration of an FSA is complex, and errors, omissions, or noncompliance with the rules can be expensive. Rules regarding medical record confidentiality (detailed by the HIPAA Privacy Rule) affect healthcare FSAs and complicate administration, intensifying the use of robust software systems and extensive security protections. As a consequence, most employers outsource the establishment, marketing, plan communication, required filings, and administration to independent third parties.
Types of FSA Accounts
FSAs can be established to cover either childcare (dependent) expenses or healthcare expenses. If your employer offers a program that includes both FSAs, you can enroll in either or both FSAs through separate enrollments and identified reductions in your compensation for each.
The two types are similar in some ways, but differ in their purpose, the amount of contribution allowed each year, and qualified expenditures:
- Purpose: The account is limited to the payment of medical and healthcare expenses not paid for by insurance – usually deductibles, co-payments, and coinsurance for the employer-provided health plan. Generally, any medical expenditure that can be deducted from your gross income for taxes is allowed.
- Annual Contribution Limit: Prior to the passage of the Patient Protection and Affordable Care Act (APA), there was not a statutory limit on the amount of funds an employer could contribute to an FSA. Employers that establish the accounts, however, can cap employee contributions in a single year; few plans allow more than a $5,000 annual contribution. The APA limits annual contributions to $2,500 per employee (future maximum amounts will be indexed to inflation) beginning in 2013.
- Immediate Fund Availability: The total amount that you agree to contribute to the FSA in the coming year is available to you on the first day of the year. In other words, if you agree to reduce your income by $2,400 in the coming year to participate in the account, the full $2,400 is available to you for qualified expenses on January 1st, even though your pay will be reduced $200 in each of the following 12 months of the year. This aspect of the FSA is an assumed risk of the employer in that you may not remain with the company for the full 12 months of deductions. Any amounts paid over and above your actual contributions will be at the expense of the employer. This is one reason why smaller employers or companies with high turnover rates are reluctant to offer healthcare FSAs.
- Eligible Expenses: The plans are intended to generally cover your out-of-pocket medical, dental, vision, and pharmacy expenses. In 2011, the law was changed to limit the latter to those drugs requiring a physician’s prescription; it does not include over-the-counter drugs. Fortunately, there are a wide variety of treatments and equipment that do qualify if medically necessary. IRS Publication 502 contains a detailed list of expenses that are eligible and ineligible, as well as an explanation of what is deemed to be “medically necessary” and the documents required to prove such status.
- Administration: Many employers issue debit cards to employees with FSA plans to pay for all eligible expenses. Some also require that the employees who use the cards provide itemized receipts to the plan to verify eligibility. Fortunately, the method of payment and the accounting requirements are not cumbersome for most FSA participants, and should not be a determinant in the decision of whether or not to participate in the plan.
- Coordination With a Healthcare Savings Account: Generally speaking, you cannot participate in both a healthcare FSA and a healthcare savings account (HSA). However, there are exceptions and specific rules that apply which may affect you. For example, the FSA or the HSA might be limited to vision, dental, and/or preventive care services only, eliminating the possibility of a “double dip.” You need to talk to your company’s human resources department and your accountant to be sure that you safely navigate the rules governing both types of accounts.
Dependent Care FSA
- Purpose: Expenditures in this type of FSA are limited to tax-deductible daycare expenses incurred to care for your dependent children or a senior citizen who lives with you and is claimed as a “dependent” on your personal tax return. This includes children under the age of 13, as well as children or adults who are physically or mentally incapable of caring for themselves.
- Annual Contribution Limit: The annual contribution is capped at $5,000 per year per household, regardless of the number of dependents covered. The amount paid by your employer on your behalf is not limited to your deducted wages, but any amounts paid by your employer in excess of the $5,000 will be attributed as income to you at the end of the year and subject to taxes. For example, your employer might agree to pay $1,000 monthly for your childcare, even though the amount that can be excluded from your gross income for tax purposes is limited to $5,000 per year (or $2,500 for married employees filing separate returns). As a result, the $7,000 excess representing the difference between the $12,000 paid by your employer and your $5,000 maximum exclusion will be reported as income to you for taxes, FICA, and FUTA. If married, both spouses must work to use a dependent FSA (unless the non-earning spouse is either disabled or a full-time student).
- Limited Fund Availability: Unlike the healthcare FSA, the dependent FSA is not “pre-funded.” Your employer only pays out funds as they would be collected from your paycheck had you not made the election. For example, if you have agreed to reduce your income by $400 each month, the dependent FSA would provide for a $400 reimbursement of eligible costs each month, even if actual expenses were greater.
- Eligible Expenses: The purpose of the FSA is generally to cover those expenses that are incurred in order to keep working – not expenses, no matter how beneficial, worthy, or justifiable to the dependent person. For example, the costs of a babysitter in your home or in someone else’s home while you are working is eligible; the costs of a babysitter at any other time for any other purpose is not. The wages of a housekeeper is not eligible; the portion of a housekeeper’s wages for the time he or she cares for a dependent is eligible. The costs of a nursery school is an approved expense, while kindergarten tuition is not. IRS Publication 503 details and explains approved and non-approved expenses.
- Administration: Most dependent care FSAs function as reimbursement accounts, unlike healthcare FSAs, which often make payments directly to providers. Each plan administration is different and may require different reimbursement forms and receipts. If you are considering enrolling in a dependent flexible spending account, contact your human resources department and/or the administrator of the account to be sure you understand and comply with the requirements of the plan for reimbursement.
- Coordinating With Federal and State Tax Credits: Under current tax law, there are a number of income tax credits that are available to help you pay the expenses of a child or elderly person who is claimed as your dependent. The child and dependent care tax credit provides maximum federal tax credits up to $2,100 per families under certain conditions, while the child tax credit provides up to a $1,000 credit for each qualifying child based upon your income. It is possible to take advantage of both credits and use a dependent FSA. However, you may want to consult with an accountant or CPA to avoid making a mistake in claiming either of them and incurring possible penalties.
The higher your income, the greater the benefit you can receive by coordinating the use of the various credits and exclusions available to you. It is not a question of either/or, but how to maximize the benefits of each in your favor.
FSA or HSA?
As healthcare expenses rise, programs to assist Americans pay those expenses are constantly changing, as are the strategies available to maximize your benefit. While the following conditions may guide you generally in making a decision about whether to implement or change from one plan to another, there is no substitute for good personal financial advice from a qualified professional investment or insurance advisor.
- If your employer doesn’t offer an FSA, your only option is the HSA, in which employer participation is not required.
- If you’re older than 65, you cannot deduct health insurance premiums in an HSA. However, you can deduct them in an FSA.
- If you don’t have health insurance (a condition I urgently recommend you amend), you can still participate in an FSA. A condition of establishing an HSA is the purchase of a high-deductible health insurance policy.
- If you have difficulty projecting the coming year’s healthcare expenses, the “use it or lose it” provision currently affecting the FSA is a major consideration. A healthcare savings account allows you to roll over any funds not spent during one year to the next, thereby accumulating a balance that can be used in later years.
- If you wish to direct the investment of your contribution or earn a return on it, you must use an HSA. Earnings on individual fund balances are not allowed in the FSA.
Regarding the 1935 case of Gregory v. Helvering, U.S. Court of Appeals Judge Learned Hand famously wrote, “Over and over again, the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
It is hard to imagine a strategy that allows one to better maximize his or her spending power to the benefit of self and family than a flexible spending account. If your employer presently offers either a healthcare FSA or a benefit FSA, be sure to investigate it and consider enrolling during the forthcoming enrollment period.