A flexible spending account (FSA) is a benefit that an employer can offer to help their employees pay for medical and/or dependent care and child care expenses using pre-tax dollars. FSAs lower your employees’ taxable income at year-end, so they also lower your business’ payroll taxes.
You can offer your employees an FSA instead of health insurance or in addition to their existing health care plan to help them save out of pocket costs. However, any contributions made to an FSA must be used that year or the employee will lose access to the funds.
If you want an easy way to offer an FSA to your employees, we recommend using Gusto. Gusto is an employee benefits provider that also provides payroll and HR management. Click here for a free 30 day trial.
In this article, we will explain what an FSA is, describe the two kinds of FSAs in detail, and help you determine whether it makes sense for your business to offer FSAs to your employees.
The 2 Kinds of Flexible Spending Accounts
A flexible or flex spending account is a short-term savings account where an employee can set aside money each month, pre-tax. They can then use those pre-tax dollars for approved expenses in that year, such as medical co-pays, in-home health care for a family member, or child care expenses.
FSA accounts reduce an employees’ tax liability by using pre-tax dollars. In turn, your business payroll taxes are also likely to be lower since your taxable payroll is reduced. There are two different kinds of flexible spending accounts you might consider offering.
A healthcare FSA is set up to help employees use pre-tax dollars to pay for medical expenses like:
- Health insurance deductibles
- Office visits or co-pays
- Eyeglasses or hearing aids
- Transportation costs to/from medical appointments
- Medical insurance premiums
For businesses that can’t afford to offer a healthcare plan to their employees, even through the SHOP exchange, they can offer a healthcare FSA that allows the employee to buy their own health insurance or pay out of pocket health expenses using pre-tax dollars.
Dependent Care FSA
A dependent or child care FSA is also known as a dependent care assistance account (DCA or DCAP). This kind of FSA can be used by employees to pay for any form of dependent care. For example, a dependent care FSA can be used to pay for the following types of care for your dependents:
- Childcare and after school care for children under age 13
- In home care, nursing home, or childcare for disabled or seriously ill children of any age
- In home caretaking, medical care, or senior home care for a disabled or ill parent
- In home assistance, medical care, or nursing home care for a disabled or ill spouse
In addition to dependent and child care expenses, a dependent care FSA can be used for adoption assistance. If you have employees who are considering adoption or who have children in day care, offering a dependent care FSA can provide them significant year-end tax savings and help you business retain those employees.
How to Offer a Flexible Spending Account
Similar to other employee benefits you provide to your staff, you may want to work with a benefit provider to offer a flexible spending account.
There are four options to help you set up FSAs for your employees:
- An online HR software provider that also offers FSA benefits like Gusto. This option is best if you’re currently only doing payroll and want to add on benefits without spending much more than you’re currently paying.
- A professional employer organization (PEO) like Justworks. This option is best if you want to give your employees benefit options similar to what larger companies offer.
- A private insurance broker that offers FSAs in addition to health insurance. This option is best if you’re already working with a broker and don’t mind doing the administrative paperwork yourself. The broker likely wouldn’t manage FSA enrollment paperwork and payroll deductions for you.
- A large insurance carrier like Aetna or Blue Cross who can help manage FSAs. This option is best if you already use these healthcare companies to provide your employee’s existing health insurance. You can then ask the carrier to add on the FSA option.
For small businesses, the first option may be best since working with a payroll provider that also provides HR and benefits can help you solve other issues — like having access to HR onboarding, payroll processing, employee benefits, or worker’s compensation at the same time.
Regardless, you will want to work with a certified benefits company or professional in order to make sure that you offer one or both kinds of flexible spending accounts in the right way. Often, these providers can also help you explain the concept of a flex spending account to your employees. The can clarify what FSAs are and how they work, and they can help you get employees signed up.
How Flexible Spending Accounts Work
Once your employees’ flexible spending accounts are set up, you and/or your employees can contribute up to the maximum limits of $2,650 for a healthcare flex account (HCA) and $5,000 for a DCA or DCAP. These limits are for 2018 and may increase annually.
If you want to help out your employees, you can contribute company money to their FSA accounts — subject to the limits we’ll review below.
It’s important to note that FSA contributions are subject to an annual “use-it-or-lose-it” rule for employees. No more than $500 per employee per account can be rolled over at year-end. However, you do have the option to offer employees a grace period of 2 ½ months, to allow them to use up the prior year’s funds by March 15th of the following year. In addition, employees have until March 31st of the following year to submit their receipts.
If your employees quit or are terminated during the year however, they forfeit any unused funds back to your business.
4 Important FSA Rules
We’ve summarized the rules regarding FSA accounts to help you understand the pros and cons of offering FSAs to your employees, and to help you to explain to your team how they work.
Healthcare FSA Contribution Limits
For 2018, the IRS has a limit of $2,650 on the amount of pre-tax dollars that can be put into an healthcare FSA pre-tax — either by the employee alone or with your help. That’s $50 more than in 2017. Once that limit is hit, either you or the employee can still contribute, but the additional money over and above the limit will be taxed at its marginal rate.
To help your employees, you can contribute to their medical FSA. Employer contributions are capped at $500 per employee unless the employee contributes more than $500 themselves. In that case, you can match the employee contribution dollar for dollar, but no more. Here are three examples:
- Carlos contributes $350 a year to his FSA. You, the employer can contribute up to, but no more than, $500.
- Julia contributes $1,325 a year. You can match that amount 1:1 with your employer contribution, bringing the total to the pre-tax healthcare FSA limit of $2,650.
- Pat contributes $2,000 a year. You can contribute no more than $650, since the limit is $2,650.
Dependent Care FSA Contribution Limits
The 2018 IRS limit for a child or dependent care FSA is $5,000, which is higher than the healthcare FSA that’s capped at $2,650. Again, this amount can be funded by you, the employee, or both.
For example, if your employee sets aside $2,000 a year for their dependent care FSA, you can contribute up to $3,000. There’s no 1:1 match like there is for the healthcare FSA, but the pre-tax contribution total can’t exceed $5,000.
Rollover Limit — Employees Must Use It or Lose It
What makes an FSA different from an HSA is that your employees need to use the funds during the plan year or risk losing them. In contrast, an HSA is more like a 401k retirement plan where the employee can keep the money forever.
An FSA account expires at year-end, allowing no more than $500 to be rolled over. Therefore any amount over $500 that employees leave in their account at year-end (or after the March 15th grace period, should you choose to provide that) will revert to you, the employer. Therefore, employees with FSAs need to be reminded toward year-end to use any remaining money in their FSA accounts to avoid losing the dollars they’ve saved.
An FSA is Employer-Owned
An FSA is owned and run by you, the employer. There is no option for an employee to get an FSA on their own in the marketplace (unlike an HSA that an employee could secure outside of the workplace). So if an employee leaves the job for any reason, the FSA balance returns to you, the employer. Employees who quit or are terminated lose all of their unused contributions.
Also, any unused non-rolled over FSA funds over $500 return to you, the employer, at year-end. That’s because you are the owner of the FSA account, not the employee.
Top 4 Benefits of a Flexible Spending Account
Here are the top three benefits that a flexible spending account can offer you as the employer:
Easy to Use
Once an employee registers and funds are available in their FSA account, they will most likely get a debit card from the FSA account provider such as a benefits company or financial institution. Using a debit card is easy. When they use the FSA debit card for an approved purchase, such as paying for a prescription, the money comes out of their FSA account. This ease of use will save you headaches from having to explain how to access their FSA or having to process receipts for reimbursement.
Easy to Plan For
At the start of your benefits plan year, each employee gets to decide how much they want to contribute to their FSA. You’ll have to calculate their pre-tax FSA deductions correctly — payroll software can help with this calculation. The contribution amount is fixed the entire year, so that means they can only change the FSA contribution amount annually. Set it up once, and you’re done for the year.
Wide Variety of Uses
Your employees will be thrilled that they can use their medical FSA on any approved medical expenses. This could mean their child’s dental exam, contact lenses for themselves, or prescriptions — anything medically-related probably qualifies. However, a medical FSA can’t be used for over-the-counter medications, like Aspirin, unless a physician has requested or prescribed them. With a health care FSA, employees can even pay for their insurance premiums.
The dependent care FSA can be used to pay for an adoption, in addition to a babysitter, daycare, or nanny. Be sure your employees understand all the benefits they can get by using pre-tax dollars to pay for these expenses.
Great Way to Attract & Retain Talent
An FSA allows you to help employees save pre-tax dollars. That’s a perk. If you have fewer than 50 employees, you don’t need to provide health insurance by law. So if you don’t or can’t provide health insurance, an FSA is a great way to help your employees afford individual health insurance or pay for health expenses using pre-tax dollars. Many young millennial workers (who don’t often get sick) may actually prefer an FSA to a health insurance plan. And by offering a dependent care FSA you may be able to attract working parents, or those caring for family as well.
Top 3 Drawbacks of Offering Flexible Spending Accounts
No employee benefit is perfect and a flexible spending account is no different. The top three potential downsides to an FSA for an employee are:
Employees Must Use it or Lose it
Employees can get frustrated with the fact that they have to use their contributions before the year is over or they may lose any remaining funds. It’s hard to predict what your expenses will be for the year. Therefore, you may need to repeatedly remind your staff to use those funds. For example, you can remind them to get new eyeglasses or schedule their family dental appointments before year-end so they don’t leave much (or any) balance in their account.
On the other hand, as the business owner, you get to keep whatever is leftover in their FSA. However, leftover funds must go towards the administration of the FSA. This can be a major perk for your business as it can reduce your FSA administration costs to zero or you can use excess funds to increase your business FSA contributions to your employees in the following year. Imagine how they’ll feel when you increase your contributions to their FSA? It’s like a tax-free raise for your staff.
Employees Cannot Change Contribution Amounts
Once an employee sets a contribution amount for the year, they’re unable to change it regardless of circumstances. This may cause some bitter sentiment from your employees to you as the business owner, so make sure all your employees are clear on the rules of their FSA.
Employees Can’t Take FSA Funds With Them
If you terminate your employee’s employment or they quit, they can’t take their FSA with them. Unlike an HSA, which the employee owns, the FSA is owned by you the employer. That’s not a problem for you, but make sure your employees understand this before they sign up for an FSA. For example, if they have $2,000 in their account and they up and quit, that $2,000 stays with you.
If a healthcare FSA feels too restrictive, you may want to consider looking at cafeteria benefits instead. One cafeteria benefits option is called a premium only plan (POP) and like an FSA it allows you to contribute pre-tax funds to help pay for employee health insurance (but you can’t use a POP to pay for other health expenses or for dependent care expenses). Here’s a link to our section 125 cafeteria benefits article for more information.
The Bottom Line on Flexible Spending Accounts
A flexible spending account can be a great value-added benefit for your employees by using pre-tax dollars to offset their healthcare, dependent care, or childcare costs. Once employees understand how to use their FSA, it can be a win all around for your employees and you. Their FSA not only reduces their healthcare costs and childcare expenses, but also lowers their year-end income tax liabilities. Chances are, your payroll taxes will also go down.