F is for FSA.
Benefits stink at a lot of businesses these days. As a business owner, though, I understand why: the underlying costs of providing benefits to employees are, in some cases, enormous. At my firm, the cost of providing health insurance to my employees costs more than the rent and all utilities for the firm combined.
One way that businesses are trying to increase benefits to employees – while keeping costs low – is to offer FSAs. FSAs are flexible spending accounts. The most common FSA is a health flexible spending arrangement and that’s what this article focuses on. You should be aware, though, that FSAs exist for dependent care and other benefits like parking and transit (look for more on those in a future post).
FSAs are set up by an employer as a benefit plan and can be offered together with other benefits (often, they are used in tandem with high deductible or high co-pay health insurance plans). They can be funded by an employer, an employee or both. The most common arrangement involves voluntary contributions to a plan taken out of your paycheck; an employer may also contribute an amount into the plan on your behalf.
Since employee contributions are taken out of your paycheck, no employment taxes or federal income taxes are deducted from that amount; in other words, those are pre-tax dollars. In additional, contributions made by the employer can be excluded from gross income. This makes the plan quite tax advantageous to employees. And, unlike HSAs (health savings accounts) or Archer MSAs (medical savings accounts) which must be reported on a form 1040, there are no reporting requirements for FSAs on your income tax return.
Under the terms of the health FSA, the funds inside the plan are used by employees to be reimbursed for qualified medical expenses. If the funds in the plan are used to pay qualified medical expenses, those withdrawals are income tax free.
Qualified medical expenses are those paid out for you and your spouse; all dependents that you claim on your tax return; any person that you could have claimed as a dependent on your tax return (even if you didn’t) except that the person filed a joint return, had gross income of $3,700 or more, or because you or your spouse could be claimed as a dependent on someone else’s return for 2011; and for your child under the age of 27 at the end of the tax year.
Beginning in 2011, qualifying medical expenses for medicines and drugs are defined as those that require a prescription. It also includes medical expenses which available without a prescription (an over-the-counter medicine or drug) but for which you have a prescription (like aspirin, prescribed for your heart, for example). For 2011, the IRS has also designated insulin as a qualifying medical expense, even without a prescription.
You may not use funds from an FSA to pay health insurance premiums, long-term care premiums or expenses and amount that are covered under another health plan.
Distributions from a health FSA which are not used for qualifying medical expenses will be subject to tax and a penalty.
There’s also no double-dipping: you cannot be reimbursed for qualifying medical expenses and then deduct those same qualified medical expenses as an itemized deduction on your Schedule A.
For 2011, there are no limits on the amount of money that you can put into the plan (that will change for 2012 and beyond when contributions are capped beginning at $2,500.). However, when the plan is set up by the employer, there must be limits set up, either as a dollar cap or a percentage of your compensation. It’s important to choose wisely when determining the amount to contribute to a FSA since funds not used by the end of the plan year are forfeited. This is sometimes referred to as the “use it or lose it” rule.
Health related FSAs aren’t for everyone. Under the rules, self-employed persons cannot participate. Additionally, there may be limitations on the plans as they apply to highly compensated participants and key employees.
Taxpayers and employees who can use them, however, can see some significant tax benefits. Consider this: a $2,500 pre-tax contribution can result in a $625 income tax savings for taxpayers in a 25% bracket (and another $155 in payroll taxes). It’s especially advantageous for taxpayers who don’t have quite enough in medical expenses to meet the 7.5% of AGI requirement necessary to deduct expenses on a Schedule A.
If you’re not participating in a FSA (or related plan), ask your tax professional whether such a move makes sense for you. And if you’re not sure whether your employer offers such a plan, ask your HR person.
For more about medical expenses, check out this video: