3.16 Flexible Spending Arrangements
A flexible spending arrangement (FSA) allows employees to get reimbursed for medical or dependent care expenses from an account they set up with pre-tax dollars. Under a typical FSA, you agree to a salary reduction that is deducted from each paycheck and deposited in a separate account. The salary-reduction contributions are not included in your taxable wages reported on Form W-2. As expenses are incurred, you are reimbursed from the account. Reimbursements used to pay qualified medical expenses are excluded from your income even though the contributions to your account were also not taxed to you.
The tax advantage of an FSA is that your salary-reduction contributions are not subject to federal income tax or Social Security taxes, allowing your medical or dependent care expenses to be paid with pre-tax rather than after-tax income. The salary deferrals are also exempt from most state and local taxes; check with the administrator of your employer’s plan.
In the case of a health FSA, paying medical expenses with pre-tax dollars allows you to avoid the 7.5% adjusted gross income (AGI) floor (17.1) that limits itemized deductions for medical costs.
However, to get these tax advantages, you must assume some risk. Under a “use-it-or-lose-it” rule, if your out-of-pocket expenses for the year are less than your contributions, the balance is generally forfeited although your employer can give you an additional 2½ months to spend the funds, as discussed below.
FSA election to contribute generally irrevocable.
The IRS has imposed restrictions on FSAs that make them unattractive for many employees. An election to set up an FSA for a given year must be made before the start of that year. You elect how much you want to contribute during the coming year and that amount will be withheld from your pay in monthly installments.
Once the election for a particular year takes effect, you may not discontinue contributions to your account or increase or decrease a coverage election unless there is a change in family or work status that qualifies under IRS regulations.
Use-it-or-lose-it deadline may be extended 2½ months by employer.
The use-it-or-lose-it rule in IRS regulations generally prevents employees from using salary-reduction contributions made in one year to pay expenses incurred after the end of that year. Any unused account balance as of the end of the year must be forfeited to the employer.
The use-it-or-lose-it rule has been criticized for discouraging participation in FSAs and encouraging participants to incur unnecessary expenses at the end of the year to avoid forfeiture of unused contributions. In response to pressure from Congress, the IRS relaxed the rule by permitting unused amounts from a health-care FSA or dependent care FSA to pay or reimburse expenses incurred within a 2½-month (two months and 15 days) grace period following the end of each plan year. The grace period is allowed only if the employer amends the cafeteria plan document (which includes the FSA option) to allow it.
For the grace period to apply to the current plan year, the employer must amend the plan before the end of the plan year. For example, if a calendar year plan is amended before the end of 2012, employees with unused health FSA funds at the end of 2012 may use them to reimburse qualified medical expenses incurred during the grace period beginning January 1 and ending March 15, 2013. If the expenses incurred by March 15, 2013, did not cover the unused amount from 2012, the balance would be forfeited to the employer. The end-of-year balance of health FSA funds may only be applied to health expenses incurred during the grace period and not to dependent care or other expenses. Similarly, unused dependent care FSA amounts may be used only for dependent care expenses incurred during the grace period. During the grace period, unused amounts may not be cashed out or converted to any other benefit (taxable or nontaxable). The employer may allow additional time following the end of the grace period to submit reimbursement claims for qualified expenses paid during the plan year and the grace period.
Planning Reminder
Health-care FSA.
The IRS does not impose a dollar limit on contributions to health FSAs, but employers limit employee salary-reduction contributions. However, a provision of the 2010 health-care reform legislation will limit the maximum salary-reduction contribution for 2013 to $2,500, with possible inflation adjustments for years after 2013.
Funds from a health FSA may generally be used to reimburse you for expenses that you could claim as a medical expense deduction (17.2) such as the annual deductible under your employer’s regular health plan, co-payments you must make to physicians or for prescriptions, and any other expenses that your health plan does not cover. These may include eye examinations, eyeglasses, routine physicals, and orthodontia work for you and your dependents. Over-the-counter medications such as cold remedies, pain relievers, and allergy medications can be reimbursed tax free from an FSA only if a physician provides a prescription for the medication; this restriction does not apply to insulin.
In addition, a health FSA may not be used to reimburse you for premiums paid for other health plan coverage, including premiums for coverage under a plan of your spouse or dependent. Also, expenses for long-term care services cannot be reimbursed under a health FSA. You may not receive tax-free reimbursements for cosmetic surgery expenses unless the surgery is necessary to correct a deformity existing since birth or resulting from a disease or from injury caused by an accident. Nonqualifying reimbursements are taxable.
At any time during the year, you may receive reimbursements up to your designated limit, even though your payments into the FSA account up to that point may add up to less. For example, if you elect to make salary-reduction contributions of $100 per month to a health-care FSA and you incur $500 of qualifying medical expenses in January, you may get the full $500 reimbursement even though you have paid only $100 into the plan. Your employer may not require you to accelerate contributions to match reimbursement claims.
Law Alert
Employees on medical or family leave.
Employees who take unpaid leave under the Family and Medical Leave Act (FMLA) to deal with medical emergencies or care for a newborn child may either continue or revoke their coverage during FMLA leave. If the coverage continues, the maximum reimbursement selected by such an employee must be available at all times during the leave period. If the coverage is terminated, the employee must be reinstated under the FSA after returning from the leave, but no reimbursement claims may be made for expenses incurred during the leave.
Dependent care FSA.
You may contribute to a dependent care FSA if you expect to have expenses qualifying for the dependent care tax credit discussed in Chapter 25, but if you contribute to a dependent care FSA, any tax-free reimbursement from the account reduces the expenses eligible for the credit (25.7). If you are married, both you and your spouse must work in order for you to receive tax-free reimbursements from an FSA, unless your spouse is disabled or a full-time student (3.5).
The maximum tax-free reimbursement under the FSA is $5,000, but if either you or your spouse earns less than $5,000, the tax-free limit is the lesser earnings. If your spouse’s employer offers a dependent care FSA, total tax-free reimbursements for both of you are limited to $5,000. Furthermore, if you are considered a highly compensated employee, your employer may have to lower your contribution ceiling below $5,000 to comply with nondiscrimination rules.
You must use Part III of Form 2441 to figure how much of your reimbursement is tax free and how much must be included in your income. Unlike health FSAs, an employer may limit reimbursements from a dependent care FSA to your account balance. For example, if you contribute $400 a month to the FSA and in January you pay $1,500 to a day-care center for your child, your employer may choose to reimburse you $400 a month as contributions are made to your account.
Filing Instruction