When unused flexible spending account (FSA) balances are forfeited back to employers under the "use-it-or-lose-it" rule, employers have several options for what they can do with the money. Here is what employers need to know after first covering some necessary background information.
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A health care flexible spending account (FSA) is an attractive fringe benefit for employees. Typically, a participating employee allocates part of his or her salary to a special account that is used to pay for qualified health care expenses. The employee chooses which expenses to pay during the year and saves tax on the deal because the contributions are not subject to income or payroll taxes.
Favorable IRS Rules
In a welcome move for employers and employees, the IRS relaxed the rules involved in tax-saving flexible spending accounts. Employees are able to get an extra 2 1/2 months after year-end to spend the money set aside in their accounts before they lose it. (IRS Notice 2005-42) In order to take advantage of the grace period, however, employers must amend FSA plans by December 31 to permit the extra 2 1/2 months -- through March 15 of the following year (this assumes the FSA plan operates on a calendar-year, which is generally the case). Employees can use unspent year-end balances to reimburse themselves for qualified expenses incurred within the grace period.
As an alternative to the 2 1/2 month grace period rule, your employer can amend its healthcare FSA plan to allow you to carry over up to $500 of any unused balance from the current year to the following year. (Health care FSA plans can offer either the grace period rule or the $500 carryover privilege, but not both.) The $500 carryover privilege is only allowed for health care FSAs (not dependent-care FSAs).
Essential to understand: The use-it-or-lose-it rule still exists, but the grace period and the $500 carryover rules allow employees more time to use FSA balances.
In addition to health care expenses, an FSA can also be established for dependent care expenses up to an annual limit of $5,000 per employee.
Here's how an employer-sponsored FSA works: You make an annual election to contribute a designated amount of your salary to a personal FSA. Contributions to fund the FSA are withheld from your paychecks. Then, you use the FSA dollars to reimburse yourself for uninsured medical expenses (insurance deductibles, co-payments, dental care, prescriptions and vision care, etc.).
The total amount withheld from your paychecks for the year is treated as a salary reduction for federal income tax, Social Security, and Medicare purposes (usually for state income tax purposes too). FSA reimbursements for qualified medical expenses are tax-free to you.
This arrangement allows you to pay out-of-pocket medical costs with pretax dollars. In effect, that's the same as getting an income tax deduction with the added attraction of cutting your Social Security and Medicare tax bills. The tax savings can really add up (the worksheet below can show you how).
What's more, because an FSA reduces adjusted gross income, it may make you eligible for other valuable tax benefits. However, unless an employer takes certain steps to amend its plan, any amounts contributed to the account and not spent by the end of the year are forfeited to the employer (see the right-hand box for more information.)
Similarly, FSAs can be valuable to employers, since they can be used to attract and retain top-flight talent. The contributions are not subject to payroll taxes and the savings from the employer's portion of payroll taxes are generally enough to cover the administrative costs.
Limits and Additional Details
For companies with FSAs, enrollment is generally only open to employees once a year. On the application form, you designate how much to deduct from your paycheck and deposit into the account.
If you don't enroll in your employer's FSA plan, you can't collect any tax savings. These savings are not just a timing difference -- they are permanent. However, there are limits. For 2014, the maximum amount you can contribute to a health care FSA is limited to $2,500.
Reminder: Due to the "use it or lose it" feature of FSAs, check to see if your employer has amended your organization's plan to offer the 2 1/2 month grace period or the $500 carryover privilege. If not, at the end of the year, make sure you use up all funds by making routine dental visits, scheduling elective procedures and refilling prescriptions.
To Estimate FSA Tax Savings
Use this worksheet to estimate the amount of taxes you could save by participating in an FSA plan. Note: The savings estimated are permanent, not just a deferral of taxes.
If you're a parent, a student or even a grandparent, valuable deductions, credits and tax-advantaged savings opportunities may be available to you or to your family members. Some child- and education-related breaks had been scheduled to become less beneficial in 2013, but the tax-saving outlook is now brighter because the American Taxpayer Relief Act of 2012 (ATRA) extended most enhancements (in many cases, making them permanent).