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Understanding Flexible Spending Accounts [2024]

By December 13, 2023No Comments

From Employer Perspective

What is a flexible spending account (FSA)?

A flexible spending account (FSA) allows employees to pay for certain qualifying expenses with pretax dollars. With an FSA, your employees contribute pretax earnings to the plan, usually through salary reduction, and submit qualifying expenses to the plan for reimbursement. Qualifying expenses can include either medical expenses or dependent care expenses.

In addition to providing your employees with tax savings, an FSA is also a cost-efficient way of providing employee benefits. Because your employees fund the FSA, associated costs are minimal. In addition, employee contributions reduce your taxable payroll, thereby decreasing your payment of Social Security, Medicare, and federal unemployment taxes.

Tip: An FSA can be offered as a stand-alone plan, or as part of a more comprehensive cafeteria plan.

How does an FSA work?

Employees make an FSA election

Employees elect to contribute a specified amount to the FSA plan each plan year. This election generally must be made before the start of each plan year, and is irrevocable. Employees must, therefore, estimate qualifying expenses for the coming plan year. Participation in an FSA is voluntary — an employee does not have to contribute to the FSA.

Tip: While employee contribution elections are irrevocable, a plan may allow participants to change contribution amounts in specific situations. For example, a plan may allow a participant to change a contribution election during the plan year if the participant gets married or divorced or has a child.
Employees submit qualifying expenses for reimbursement

The FSA reimburses employees for qualifying expenses that are properly submitted. Only expenses that are incurred during the plan’s period of coverage will be reimbursed. The period of coverage generally means the plan year (while this is often a calendar year, it does not have to be). However, the terms of a plan may allow the period of coverage to provide a “grace period” of up to 2½ months after the end of the plan year.

Tip: FSA plans that allow an extra 2½ months effectively have a 14-month and 15-day coverage period.
Tip: Plans may also allow an additional period of time to submit expenses for reimbursement after the close of the coverage period. So an FSA that operates on a calendar year might provide for reimbursement of expenses incurred through March 15 (2½ months after the end of the plan year), but might allow employees to submit those expenses through April 15.

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Tip: An FSA can be offered as a stand-alone plan, or as part of a more comprehensive cafeteria plan.
Health-care flexible spending accounts

A health-care flexible spending account reimburses employees for qualifying medical and dental expenses. Expenses that can be reimbursed by a health-care FSA include the annual deductibles for a health-care plan, as well as any qualified medical and dental expenses that your health plan does not cover.

With a health-care FSA, an employee can receive reimbursement for expenses before sufficient funds are withheld from the employee’s pay, as long as total expenses submitted don’t exceed the contribution amount elected by the employee. As a result, the employer runs the risk of having an employee terminate his or her employment at a time when expenses reimbursed exceed contributions to his or her flexible spending account.

Example(s): John, an employee at Company X, elects to contribute $1,200 to the Company X health-care FSA. As a result, $100 is deducted from John’s pay each month and contributed to the FSA plan. One month into the plan year, John pays $1,200 in qualifying medical expenses, and submits the expenses for reimbursement. Even though John has paid only $100 to the FSA at the time he submits the expenses for reimbursement, the FSA will reimburse John for the full $1,200 in qualifying expenses. If John leaves employment before the end of the plan year, Company X will not receive the full $1,200 in compensation from John.

Tip: For 2024, the FSA annual contribution limit is $3,200. Note that employers may impose their own lower limits.
Dependent-care flexible spending accounts

A dependent-care FSA reimburses employees for qualifying expenses relating to the care of eligible individuals. Qualifying expenses are non-medical expenses that allow the employee, or the employee’s spouse, to work or attend school full time. These expenses include day care, nursery school, day camp, babysitters, before/after school programs, and caregiver expenses for disabled individuals who live with the employee.

Tip: Eligible individuals include qualifying dependents who are children under the age of 13, a spouse who is physically or mentally incapable of caring for him or herself, or a disabled individual who requires full-time care because of a physical or mental incapacity.
Tip: An employee can contribute up to $5,000 each year to a dependent-care FSA (individuals who file their federal income tax returns as married filing separately can contribute up to $2,500 each year).
Unused funds are forfeited (“use it or lose it”)

Employee funds remaining in an FSA after all qualifying expenses for the coverage period have been paid are generally forfeited. This is commonly known as the “use it or lose it” rule. However for 2024, the IRS will allow up to $640 to be carried over to the following plan year. Plan participants can then use these funds to reimburse qualified expenses incurred during that following year. Note that any plans adopting the carryover provision cannot also permit a grace period. Plans must be amended to both add the carryover provision and omit the grace period, if one applies.

The $640 carryover is in addition to the maximum $3,200 (2024 limit) employees can set aside for qualified medical expenses. Note that employers can choose to impose lower limits.

Employers are generally able to use forfeited funds to pay administrative costs of the plan.

Tip: Why are employees required to forfeit unused funds? Internal Revenue Code (IRC) Section 125, which governs flexible spending accounts, prohibits the deferral of compensation. Were an FSA to allow an employee’s unused funds to “roll over” to the next period of coverage, the employee would effectively be deferring compensation.

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Source:

Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.

 

Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable —we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.