In the late 1960s, as inflation and other factors increased the cost of employer-sponsored health benefits, employers began instituting annual deductibles and coinsurance on their health benefits plans, and/or excluding coverage for certain medical items that were legally allowed to be covered by IRS regulations (e.g. vision, dental, alternative medicine). Excluding these medical expenses effectively almost doubled the employee cost for these items on an after-tax basis.
Flexible Spending Accounts were Created in the 1970s
To respond to this dilemma, in the 1970s the IRS created Flexible Spending Accounts (FSAs) to allow employees to pay pre-tax dollars for medical expenses and dependent (child) care expenses not covered by their employer-sponsored health plan. With a Medical FSA, employees tell their employer they wish to forego receiving a certain amount of their taxable gross wages each year in return for an equivalent size non-taxable FSA annual allowance to pay for out-of-pocket qualified medical expenses.
If an employer pays for a $100 medical item for an employee it costs the employer $100. The employer would have to pay the employee up to $200 in gross pre-tax wages in order for the employee to have $100 left over after FICA/FUTA and federal, state and local income taxes (e.g. 50% combined tax bracket) to pay for the same $100 item himself. A $100 health benefit paid by an employer is worth up to $200 (100% more) in gross pre-tax wages to an employee. See Why Do Employers Offer Health Insurance.
There are three Types of Flexible Spending Accounts
There are three types of FSAs: Health, Dependent Care, and Adoption. The FSA allowance for a Health FSA must be an annual allowance given on the first day of the plan year, even though the employee will not have foregone the equivalent amount in salary reduction until the last day of the plan year. In contrast, with a Dependent Care FSA, employees can receive benefits only up to the then-current amount of pre-tax salary that has been withheld from their payroll (e.g. $200/month).
Health Flexible Spending Accounts
With a Health FSA, employees direct their employer to lower their pre-tax wages next year by $200/month, and the employee, on the first day of the next plan year, receives a $2,400 FSA allowance for medical expenses. The employee must be given access to the full $2,400 on the first day of the plan year. If an employee spends the full $2,400 in the first month and quits, the employer is not allowed to recover the unpaid balance.
Dependent Care Flexible Spending Accounts
Dependent Care FSAs are similar to a Health FSA that can only be used for dependent care expenses, except that employers may not allow employees access to any FSA funds that have not been already contributed through payroll deduction.
Depending on their individual income tax bracket, employees save a combined 18-50 percent federal, state, and local income and wage taxes on medical expenses funded through an FSA. Equally important, employees receive the intangible benefits of having funds for anticipated out-of-pocket medical expenses available through forced payroll savings.
Flexible Spending Accounts Reduce FICA
Employers also save money with FSAs by not paying wage taxes on FSA contributions. Each $100,000 of salary foregone by employees in favor of FSA contributions saves an employer $7,650 (7.65%) in FICA and FUTA taxes.
~24 Million Employers Offer Flexible Spending Accounts
Employers have generally embraced FSAs. According to a 2005 survey by Mercer Human Resource Consulting, in 2005:
(1) 80 percent of employers with 500 or more employees offered FSAs;
(2) 26 percent of employers with 10 or more employees offered a health care FSA, 35 percent of eligible employees were participating, and the average annual FSA employee contribution was $1,235/year; and
(3) 27 percent of employers with 10 or more employees offered a dependent care FSA, 14 percent of eligible employees were participating, and the average annual FSA employee contribution was $2,630/year.
There are approximately 24 million Health and Dependent Care FSAs.
Health Care Reform Limits Flexible Spending Accounts
The health care reform bill creates the following restrictions on the use of flexible spending accounts (FSAs):
- Beginning in 2011, non-prescribed over-the-counter drugs will no longer be qualified medical expenses
- Beginning in 2013, employee contributions to FSAs through salary reduction will be limited to $2,500 per year and adjusted in subsequent years based on inflation
Some Employees and Employers Dislike Flexible Spending Accounts
Despite their popularity, some employees and employers may dislike Flexible Spending Accounts for several reasons:
- Employees must specify in advance during the prior plan year how much money to take out of their pre-tax wages for their FSA (e.g. $100/month or $1,200/year). The employee loses 100% of any balance they do not spend in the subsequent plan year (or within the grace period following the plan year).
- Employers must make available to employees the full annual Health FSA amount (e.g. $1,200/year) on the first day of the plan year (e.g. January 1). This “Uniform Coverage Rule” means that an employee has access to the full annual FSA amount on January 1 even if an employee hasn’t yet funded any of their payroll contribution. If an employee quits on January 2 after submitting and being reimbursed for a $4,800 claim, the employee does not have to repay such “pre-funded” FSA reimbursements after termination. (The Uniform Coverage Rule applies only to Health FSAs and not to dependent care FSAs.)
- FSAs encourage frivolous end-of-year “use it or lose it” spending, and don’t reward consumers for wellness behavior by allowing them to save what they don’t spend today for their future medical expenses.
- Tax-sensitive employees desiring FSAs are often the same employees wanting Health Savings Accounts (HSAs). However, FSAs are not generally compatible with HSAs. Employees with an FSA cannot make contributions to a Health Savings Account (HSA) unless their FSA has an HSA-Compatible deductible (i.e. "post-deductible" FSA), or unless their FSA covers a limited number of items such as dental, vision, and preventative care allowed under HSA rules for compatible high deductible coverage (i.e. "limited purpose" FSA). Most existing FSA administration platforms cannot handle deductibles and/or differentiate between different categories of medical expenses to comply with HSA qualification rules.
There is a low likelihood of the IRS changing (1) and (4) above because a major tenet of FSAs (and Section 125 Cafeteria Plans) is that they cannot be used to defer the recognition of employee taxable income. Allowing employees to roll forward FSA balances would greatly increase their popularity, encourage tax abuse and have a significant revenue impact on the U.S. Treasury.
The IRS or Congress will also probably not change (2) above (“Uniform Coverage Rule”) because the IRS believes that in order to fall within the parameters of Code sections 106 and 105(b) (which allows FSA contributions to a health FSA and reimbursements from a health FSA to be tax-free), the FSA must operate like “insurance,” with both the employer and the employee bearing some risk.