Flexible Spending Accounts (FSAs)

Overview

Flexible spending accounts are paid into with pretax dollars by employees and can be used to purchase qualified healthcare-related expenses. The Internal Revenue Service (IRS) defines what constitutes a qualified healthcare expense in FSAs. The IRS does not limit the amount of money that can be set aside in an FSA. Many employers, however, do set annual limits, often in the range of $5,000 to $10,000, and any monies that are not spent by the end of the year (or by March 15 of the subsequent year, at the discretion of the employer) are lost to the employee. On the other hand, once an employee's FSA is created, he or she may spend the entire annual amount to be deposited. For example, an employee may choose to set aside $100 per month in an FSA for an annual total of $1,200. In January, the employee could spend the entire $1,200 on uninsured orthodontic care.

Moreover, if the employee were to leave the firm later in the same year, he or she would not be required to pay into the FSA. Analogously, however, if an employee were to leave the firm with a positive balance in his or her FSA account, those monies would be lost to the employee.

The provisions of FSAs are in marked contrast to health savings accounts (HSAs). Monies that are contributed to an HSA are owned by the employee and remain with him or her upon separation from an employer. More important, unspent HSA balances roll over to the next year, whereas an unspent FSA balance is forfeited annually. In [Page 405]addition, while an individual may establish an HSA, only an employer can establish an FSA. Furthermore, HSAs require the holder individually or through his or her employer to have a qualified health plan, usually a high-deductible plan. In contrast, a firm that establishes an FSA program for its employees does not need to offer any health insurance plan.

Tax Savings

The tax savings associated with the use of FSAs can be substantial. For example, suppose an individual contributes $100 per month, or $1,200 per year, in an FSA, these contributions are tax sheltered. Additionally, suppose one has a marginal federal income tax rate of 28%, pays Social Security and Medicare payroll taxes of 7.65%, and faces a 5% state income tax rate. The individual or the family has a combined marginal tax rate of 40.65%. By putting $1,200 in the FSA and spending it on qualified health services that the individual would have purchased anyway, the savings would amount to $487.80 in taxes. Even if the individual does not spend the entire $1,200, as long as a balance of less than $487.80 is forfeited, the individual comes out ahead monetarily.

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