Benefits of flexible spending accounts

Flexible Spending Accounts (FSAs) are one the numerous tax-advantaged financial accounts that are authorized by the Internal Revenue Service (IRS). With an FSA, employees may save a portion of their earnings to cover for qualified medical expenses and/or dependent care expenses. As money deducted from an FSA is not subject to payroll taxation, employees have substantial payroll tax savings up to 20% thus lowering their taxable income.

FSAs are classified into:

• Health Care FSA (HCFSA)

The Health Care FSA (HCFSA) covers for qualified medical and health care expenses that are not covered or are partially covered by health, dental or vision insurance or by Federal Employees Health Benefits (FEHB) plan.

Common medical coverage includes: doctors’ fees; hospital services; nursing services; labs fees; long-term care services; acupuncture treatments; alcohol and drug addiction treatments; smoking-cessation programs; vasectomies, hysterectomies and birth control; hearing aids; wheelchairs; guide dogs; crutches; prescription medicines; and insulin.

• Limited Expense Health Care FSA (LEX HCFSA)

The Limited Expense Health Care FSA (LEX HCFSA) covers for qualified dental and vision care expenses that meet the IRS definition of medical care. Only employees who enroll in a Federal Employees Health Benefits (FEHB) plan with a High Deductible Health Plan (HDHP) and a Health Savings Account (HSA) are eligible for LEX HCFSA.

Expenses covered under LEX HCFSA are cleanings, fillings, crowns, and orthodontics for dental care and eyeglasses, contact lenses, refractions and vision correction procedures for vision care.

• Dependent Care FSA (DCFSA)

The Dependent Care FSA (DCFSA) covers for eligible dependent care expenses such as child care for children under 13 years old or day care for elderly parents or anyone who is claim as the employee’s dependent based on physical or mental disability.

Advantages of FSAs

One of the major advantages of medical FSAs is their tax benefits. IRS guidelines allow employees to contribute to FSAs using their pre-tax income. In doing so, they can save on federal and state income taxes as well on their portion of Social Security taxes on the amount they authorize their employer to put in the FSA from withdrawing from their paychecks on an annual basis.

By setting aside a specific amount per year for a medical FSA, the entire amount is immediately available, either on January 1st when the program starts or after the first contribution to the FSA is received by the FSA vendor. The money that the employees contribute is not taxable because IRS considers FSAs as ‘health insurance plans for tax purposes’ and therefore, income received from a health insurance plan is not taxable income. Upon termination of employment, employees are not required to continue contributing to the FSA.

As the taxable income decreases, employees can increase their take-home income. To illustrate the tax benefits of FSAs for employees, we assume that an employee of the company X earns $50,000 for the year and contributes $5,000 to an FSA. By contributing 10% of annual salary to an FSA, the taxable income is reduced to $50,000-$5,000 = $45,000. If the employee pays taxes equal to 30% for the year, then he saves $45,000 x 30% = $1,500. Plus the money contributed to FSA is not subject to taxation when withdrawn provided it is used for qualified medical or dependent-care expenses.

Employers are also favored by the FSAs because they are not required to pay their portion of Social Security taxes which is equal to 7.65% of the taxable income of each employee. To illustrate the tax benefits of FSAs for employers, we assume on the above example that the company X employs 10 people with an annual payroll of $500,000. Normally, employers would pay $500,000 x 7.65% = $38,250 to Social Security taxes. However, with the employees’ contribution to the FSAs that equals $5,000 x 10 = $50,000, the company’s taxable payroll is reduced to $450,000 for the year. The company pays $450,000 x 7.65% = $34,425 to Social Security taxes and saves $38,250 – $34, 425 = $3,825 in annual taxes. This amount combined with the $1,500 tax savings per employee results in a total tax reduction for the company from the FSA equal to $1500 x 10 = $15,000 (for all 10 employees) + $3,825 = $18,285 for the year.

Another major advantage of medical FSAs is that it provides coverage of over-the-counter (OTC) medical products and drugs. Because of that, more and more consumers are expressing their interest in flexible spending accounts, thus considerably expanding the range of FSA-eligible purchases.

Some important considerations

Although flexible spending accounts lower the taxable income of employees who participate in such plans, they also involve a risk to employers because of pre-funding. The amount of money that employers lose because of pre-funding may be partially or more than compensated by the amount of money that is not spent in employees’ FSA accounts by the end of the plan year and grace period.

Most FSA providers require that the receipts of OTC purchases show the complete name of the employee and they also require either manual claims or, submission of receipts after the fact. In the context of substantiation, IRS has recently developed the inventory information approval system (IIAS) that classifies items into eligible and ineligible at point-of-sale covering for automatic debit-card authentication. This makes medical FSAs very attractive for OTC purchases.

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