At first glance, healthcare Flexible Spending Accounts (FSAs) sound great: employees can fund accounts through salary reduction and can withdraw funds at will to pay for medical bills. There is no statutory maximum contribution, and funds set aside escape both income and Social Security taxes. Some flexible spending accounts even cover childcare expenses.
About 85 percent of large companies (with 500 or more employees) offer flexible spending accounts, but only 22 percent of eligible employees took advantage of the benefit, according to a recent Mercer Survey.
Why so low? Many employees are wary of the one big FSA drawback: If they deposit more than they spend on qualified expenses in these accounts, they forfeit the unused funds. Although the number of times this actually happens is small — only about four percent of employees lose money, the rule is still a deterrent, according to an article in The New York Times.
To soften the blow, some companies and employees are taking advantage of a two-and-a-half month grace period that the IRS has implemented for end-of-year expenses.
This use-it-or-lose-it aspect makes FSAs a gamble but not a bad bet. It simply means that employees have to be vigilant on account balances and employers must be better at communicating the rules of FSAs.
If your company doesn’t provide health care insurance or if you do provide coverage but you’re faced with increasing deductibles, co-pays or out-ofpocket expenses, flexible spending accounts can help you increase the value of your benefits program.
Pro and cons for employers
Employers have much to love about FSAs. Because employees fund their accounts with the decreased employee taxable income lowers employers’ expenditures for FICA, unemployment insurance, workers’ compensation and other wage-based benefits. The savings on payroll taxes typically offsets the cost for administration, and you can earn interest on account balances. And while employers may contribute to employees’ accounts, they don’t have to.
On the flip side, the FSA “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 during the 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.
It all may break even because an employee who leaves in the course of the year without having spent all of what he has contributed to his account relinquishes the balance, 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.
Apart from the offsetting tax savings, you can cap your company’s liability by limiting the amount that employees set aside. Some employers use a two-tiered limit: 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.
What about smaller employers?
The U.S. Bureau of Labor Statistics reported that as of 2006, about 8 percent of those employed by smaller employers were eligible for FSAs. (More professional and technical employees at smaller employees had access to these plans, about 14 percent.) Despite their advantages, many small employers fear the administrative burdens of an FSA will outweigh any benefits.
The IRS requirement that FSAs “substantiate” expenses before reimbursing them poses an administrative challenge to smaller employers. New developments, such as debit cards linked to employees’ FSAs that employees can use at specific health care providers, can make administration a bit easier. In addition, some health insurers will provide FSA administration services for employer groups of at least 200. You can also contract with third-party administrators that can administer your program and pay claims.
Still, for some smaller employers, the Health Savings Account linked to a highdeductible health plan (HDHP) might offer similar tax advantages with fewer administrative hassles for employee health benefits. You may want to reserve FSAs for transportation or dependent care costs.
Bottom line
If you decide to implement an FSA plan, be prepared to engage in active administration or outsource these functions, and to educate employees for maximum participation and fewer disappointments.
For more information on FSAs, HSAs and other healthcare arrangements, please contact us.