Employers can offer employees a way to pay for certain personal costs on a pre-tax basis through flexible spending accounts (FSAs).
Using these accounts means that the amounts employees contribute to FSAs are not included in taxable compensation for federal tax purposes.
1. Different Types of Flexible Spending Accounts
An FSA can be set up for certain purposes:
- Health Flexible Spending Accounts: These accounts can be tapped by employees to cover medical expenses that are not paid by insurance or other health plans (such as health savings accounts). To the extent medical costs are paid through disbursements from these flexible spending accounts, the employee cannot take an itemized deduction for them.
- Dependent Care Flexible Spending Accounts: These accounts can be used to pay for childcare or long-term care costs. The exclusion from income for contributions to these flexible spending accounts must be coordinated with the dependent care credit; the expenses reimbursed from the FSA cannot be used to figure the credit.
2. Dollar Limits Apply
Flexible spending accounts can be set up as salary reduction arrangements which are funded entirely with employee contributions from their paychecks. The tax law limits how much can be contributed annually by employees to their flexible spending accounts.
Health FSA contributions for 2015 and 2016 are capped at $2,550. The dollar limit is subject to increase if there is enough inflation. Plans can adopt a limited carryover, so that up to $500 not used in the current year can be carried over to the next year. The carryover does not impinge on the annual contribution. For example, say an employee has $600 of contributions for 2015 unused by December 31, 2015. Assuming the plan allows it, she can carry over $500 to 2016; she can also contribute $2,550 to her FSA for 2016 (total available to pay for out-of-pocket medical costs is $3,050).
Dependent care FSA contributions are capped at $5,000 annually. The dollar limit is not subject to indexing for inflation. No carryover of unused amounts is permitted.
3. Restrictions on Mid-Year Changes
Usually, employees must commit to their salary reduction contributions by the start of the year. However, certain events permit employees to change contributions. Examples of such events include:
- Marriage, divorce or legal separation, or the death of a spouse
- Birth, adoption, or death of a child
- Employment status of the employee, employee’s spouse, or dependent (e.g., starting or ceasing work, a strike or lockout, or a return from unpaid leave)
- A change in the place of residence for the employee, spouse, or dependent
- Becoming entitled to Medicare or Medicaid
- Obtaining a judgment or decree ordering someone to provide medical child support
It is up to the plan to permit an employee to change contributions; the plan should specify triggering events. The change in contributions by an employee must be consistent with the event, such as reducing contributions upon the death of a spouse.
4. Payroll Taxes
Employee contributions to flexible spending accounts not only reduce their wages subject to income taxes; they also reduce wages for employment tax purposes. Thus, employees and employers save on FICA and FUTA taxes. However, state income tax treatment may vary from the federal rule. For example, in New Jersey, employee contributions are still part of taxable compensation subject to state income taxes.
For reporting purposes, FSA contributions don’t appear on employees’ W-2s nor on the employer’s quarterly tax return, Form 941. However, they are listed on Form 940 for FUTA taxes. The contributions are not subject to FUTA taxes.
5. Cost for Employers
Flexible spending accounts are funded by employee contributions. Employers do not make contributions to employees’ accounts.
The only cost to employers is administrative. Depending on the number of employees with FSAs, an employer can oversee the plan in-house with little or no added administrative costs. Once the number of employees grows (some suggest more than 10 employees), it may be necessary to use an outside administrator, which entails cost. The reason: Think about how to handle reimbursements: reviewing claims submitted by employees and disbursing funds to them for allowable costs.
Flexible spending accounts are an attractive fringe benefit for employees. Small business owners should consider implementing them now for 2016 and beyond so that employees can commit to their contributions for the upcoming year if they want to participate. Talk with your tax advisor and, if necessary, a benefits expert.
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