New Hampshire Town and City
Flexible Spending Accounts: How They Benefit Employers and Employees
New Hampshire Town and City, March 2006
By Charlene Wallace
Section 125 of the Internal Revenue Code, initially implemented by Congress in 1978, allows employers to offer employees the choice between cash compensation and certain nontaxable (qualified) benefits. Premium contributions toward a qualified benefit are excludable from an employee’s gross income, thus allowing these expenses to be deducted prior to the calculation of Social Security or federal income tax responsibilities. Healthcare, vision care, dental care, group life and long-term disability coverage are considered qualified benefits for these purposes.
The Internal Revenue Code (IRC) has three distinct salary redirection components: IRC §125 addresses the Premium Conversion portion of a flexible benefits plan, IRC §105 governs Healthcare Flexible Spending Accounts (FSA), and IRC §129 governs Dependent Care Reimbursement Accounts. Specifically, these codes allow employers to offer FSAs for qualified healthcare and dependent care expenses. Contributions to these accounts are also excludable from an employee’s gross income, thus saving Social Security and federal income taxes on these amounts. Employers also reduce their Social Security and federal unemployment tax responsibilities on the contributions employees make toward either of these accounts.
Employer and Employee Responsibilities
In order to offer these tax advantaged programs, an employer needs to establish a formal plan document that outlines the specific qualified benefits being offered, identifies the type of employees considered eligible for the plan and exhibits the optional benefits selected.
Employers can administer these programs themselves or hire an administrator for this purpose. Privacy and security regulations under the Health Insurance Portability and Accountability Act (HIPAA) of 1996 do apply. Employers are cautioned to examine their internal processes to ensure adherence to these requirements.
Per the IRC, employers are considered the Plan Administrators of FSAs. As such, employers have the responsibility to assist employees with adherence to regulations of these plans. They are also charged with enforcing guidelines regarding the establishment of plan contribution minimums and maximums, plan notifications of related events (such as open enrollment), reimbursement requirements for payment of ineligible claims, timelines for claim submission, plus ensuring non-discrimination and determining the plan’s legal and tax status.
Employees have a responsibility to use the plan appropriately in terms of eligible expenses, eligible providers and other forms of compliance.
Premium conversion is the simplest form of a flex plan. It allows employers to deduct an employee’s share of the health insurance premium prior to tax responsibilities. Premium conversion plans are easy and relatively inexpensive to implement. Employee contributions toward other insurance programs, such as dental, life, disability, vision and/or accidental death and dismemberment, are also eligible for this pre-tax treatment.
In the case of disability coverage, if premiums are paid utilizing pre-tax dollars then benefits are considered taxable income. As most disability programs only provide a portion of pre-disability income as a benefit, it is generally in the employee’s best interest to pay for disability insurance premiums with after-tax dollars in order to receive full disability benefits.
Per New Hampshire RSA 275:48, employers are allowed to reduce an employee’s wages, upon the employee’s written request, for contributions to a flexible benefits plan. It is required that employers require written confirmation from employees, at least upon their initial eligibility for premium conversion benefits. After such initial election, employers can continue to reduce the employee’s wages by such premium contributions until or unless the employee provides a written statement of their intent to not participate.
Healthcare FSAs are funded by employee salary reductions and/or employer contributions and must be utilized for qualifying healthcare expenses incurred during a plan year. A qualified healthcare expense is one that is: considered medically necessary; is incurred by the employee, their spouse or qualified dependent; and is not otherwise reimbursable through a group health plan, insurance or any other source.
Annually, employees elect the amount of their annual contribution toward the healthcare FSA. Employers can impose both minimum and maximum contribution limits on employee contributions. During the course of the year, this amount is deducted from the employee’s paycheck in equal installments and deposited into their healthcare FSA. Once an employee incurs an eligible expense, they can submit a reimbursement request. An expense is considered incurred at the time the care or service is provided and not when being billed, charged, or paying for the care or service.
Employees have access to their entire annual election from the first day of the plan year. This component of the plan does have some risk to employers. Should an employee leave employment prior to the end of the plan year after applying for and receiving reimbursement for theirentire healthcare FSA annual contribution, the IRS imposes strict guidelines regarding how employers can obtain reimbursement from the non-employee. For example, the IRS does not allow employers to attach unpaid wages for repayment of this amount. Occasionally, employers are left holding this unpaid debt. Recognizing this risk, the IRS implemented “use-it-or-lose-it" requirements on FSA contributions that specify employees to use all of their FSA contributions during the plan year or applicable grace period (see “New Options" section of this article), or they will lose these contributions. Amounts so forfeited revert back to the employer as the Plan Administrator.
Dependent Care Reimbursement Accounts
Dependent Care Reimbursement Accounts (DCRA) are funded by employee salary reductions and must be used to reimburse qualifying dependent care expenses provided by a qualified care provider. In order to qualify, dependent care expenses must be provided for a single parent, or both spouses, working or attending school on a full-time basis. A qualified expense must be incurred during the plan year or applicable grace period. An expense is considered incurred when the service is actually furnished, not when the employee is being billed, charged for or pays for the service.
Employees are required to make elections on an annual basis with salary deductions in equal installments throughout the plan year. The IRS clearly defines contribution maximums for DCRAs. The maximum “calendar year" contribution is considered the lowest of the employee’s earned income, the spouse’s earned income or $5,000 (or $2,500 for married employees filing separate tax returns). Employers who chose a “fiscal year" for their flexible benefits plan year must still adhere to the calendar year maximums outlined above. Most FSA software packages have reporting available to assist employers with meeting this requirement.
There is little risk to an employer in offering a DCRA. Unlike Healthcare FSAs, reimbursements from a DCRA are only available for amounts up to what is currently credited to the account. “Use-it-or-lose-it" requirements also apply to DCRAs.
Over the last few years, the IRS has relaxed its FSA regulations in a couple of ways.
• Debit Cards – Many employers and FSA administrators are offering debit card accessibility to healthcare and dependent care FSAs. This option provides employees with the benefit of paying for their eligible expense at the time the expense is incurred with the actual funds they have elected to set aside for this purpose. Thus, employees do not have to pay for the expense out-of-pocket and then apply for reimbursement. While this option eases some of the administrative burdens associated with FSAs, it is important to note that employees are still responsible for substantiating these expenses by submitting receipts, bills, or other written statements from an independent third party confirming that the expense has been incurred.
• Over-the-Counter Medications – Certain over-the-counter medications are now considered eligible expenses for reimbursement in a healthcare FSA. Employers have the ability to decide whether or not to consider these expenses as a part of their plan and must amend their plan documents in order to do so.
• Grace Period – In response to previous concerns with the federal government’s “use-it-or-lose-it" requirement associated with FSAs, employers can now allow employees an additional 2½-month grace period immediately following the plan year to incur expenses for the immediately preceding plan year.
In summary, FSAs and/or flexible benefit plans provide employers with a way to offer employees an additional benefit with little or no additional expense, sometimes even at a savings to the employer. Through them, employers can maintain a competitive employee benefits program, respond to the needs of a diverse work force and increase employee awareness and appreciation of employer-provided benefits. Correspondingly, employees have the ability to select benefits that are more in tune with their personal circumstances, save on their tax responsibilities, and develop a better understanding of their full compensation package.
New Hampshire Local Government Center (LGC) is pleased to now offer Flexible Spending Account Administration to Member Groups at competitive rates. For more information on how this offering can work for your group, visit www.nhlgc.org and click on the “FSA Offerings Now Available" link, or contact your LGC Account Representative directly. You may also e-mail us at firstname.lastname@example.org to request more information.
Charlene Wallace is Account Manager at LGC and a 17-year veteran of the organization. She has also served LGC as an Account Executive and is a graduate of the International Foundation of Employee Benefit Plans’ Certificate of Achievement in Public Plan Policy program.