Ins and Outs of Flexible Spending Accounts

Popular fringe benefit for employees

Flexible spending accounts (FSAs) can be a low-cost addition to your company’s benefits package. You can provide FSAs for your employees to cover health care expenses, dependent care expenses—or both—within certain tax law limits.

Background: An FSA is funded with pretax dollars, so there are significant tax savings for employees. Furthermore, as the employer, you don’t have to pay Social Security and Medicare (FICA) taxes or federal unemployment (FUTA) tax on the amount that employees contribute to their FSAs. Those benefits may offset some or all of the cost of administering an FSA. It’s a win-win situation for employers and employees.

Although the rules vary slightly between health care and dependent care FSAs, the basic premise is the same. Distributions that are made for qualified expenses—for example, to have LASIK eye surgery or to pay a day care center—aren’t subject to tax. But any withdrawals made for nonqualified expenses are fully taxable.

Under the Affordable Care Act of 2010 (ACA), the maximum amount that can be annually contributed to a health care FSA is $2,500. Prior to 2013, there was no limit at all on FSAs used for health care expenses. This figure, which is now indexed for inflation, is $2,550 for 2016 (the same as it was for 2015). Conversely, the maximum amount allowed for a dependent care FSA is $5,000. Note that this figure is not indexed for inflation. With either type of FSA, the savings can be significant.

Example: One of your firm’s employees earns $100,000 a year. She sets aside $4,000 a year in her FSA to pay for her children’s after-school care. Assuming she uses the entire $4,000 and she is in the 28% tax bracket, the employee saves $1,120 in federal income tax (28% of $4,000), plus another $306 in FICA taxes (7.65% of $4,000), for a total of $1,426. Your firm also saves $306 on the employer’s share of the FICA tax. Multiply these savings by the number of participants.

Employees must decide how much to contribute to their FSAs. Typically, this decision requires some advance planning, especially when you factor in the use-it-or-lose-it rule. Generally, if an employee doesn’t withdraw the funds from the FSA before the end of the year, any remainder is forfeited. However, if your firm allows a grace period, employees may take an extra 2½ months to use the FSA funds. Therefore, the effective deadline for the 2015 tax year may be March 15, 2016.

Alternatively, an employer may allow an employee to carry over up to $500 of unused FSA funds to the next year. For instance, if an employee has $300 left over in a health care FSA from 2015, he or she can carry over the $300 to the FSA for 2016. But employers cannot permit both the grace period and the carryover—it has to be one or the other.

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