Flexible Spending Accounts
A flexible spending account (FSA) is a type of cafeteria plan authorized under Section 125 of the Internal Revenue Code. FSAs allow employees to purchase certain benefits, such as medical or dental expenses, on a pre-tax basis. A FSA can stand on its own or be incorporated into a more comprehensive cafeteria plan. For information on comprehensive cafeteria plans, consult the AFSCME Research and Collective Bargaining Services factsheet on cafeteria plans. FSAs covering dependent care expenses may also be established. These accounts, however, must be separate from other FSAs. For information on this type of FSA, consult the Research and Collective Bargaining Department's factsheet on Dependent Care Assistance Programs. There are also two other main types of pre-tax plans: Health Reimbursement Accounts and Health Savings Accounts. These accounts are combined with high deductible health plans and the combination of plans is typically referred to as a Consumer Driven Health Plan (CDHP). For more information on CDHPs, please refer to the AFSCME Research and Collective Bargaining factsheet on Consumer Driven Health Plans.
Free-standing FSAs can provide benefits to employees without the problems associated with cafeteria plans or consumer driven health plans. For this reason, AFSCME generally supports establishing FSAs. Nevertheless, there are some disadvantages of FSAs of which employees should be aware. The advantages and disadvantages of FSAs are discussed below.
What are qualified benefits under an FSA?
- Under the Internal Revenue Code certain benefits are tax exempt. These are referred to as qualified benefits. An FSA could be established to pay for qualified benefits with pre-tax dollars, such as the employee's contribution toward the cost of health coverage, medical expenses not covered by the health plan, such as deductibles and co-payments, and dental or vision benefits.
- In September, 2003 the federal government ruled that FSA participants may use pretax dollars to purchase most over-the-counter (OTC) drugs, if their employer's FSA plan allows it. Eligible OTC drug expenses must alleviate or treat personal injuries or sickness, such as cold medicines, antacids, allergy medicines, and pain relievers. Expenditures merely benefiting the general health of an individual, such as vitamins or food supplements, are not reimbursable under an FSA. Employers that include OTC coverage can limit that coverage to specific categories, such as allergy, pain and cold medications, OTC drugs that were formally prescription only or OTC medications prescribed by a physician to treat a specific medical condition.
How does an FSA work?
- Voluntary Election — Every year an individual participating in a health care FSA voluntarily and irrevocably elects to reduce his/her gross pay by a specified amount. The amount selected is typically deducted from the individual's paycheck each pay period. If the money is designated to pay for the employee's share of the health care premium, the employer automatically uses the deducted amount to pay the employee's share of the premium. Any money that is designated to pay for other qualified expenses is reimbursed to the employee upon submission of proper documentation showing the expenses incurred. The employee is reimbursed up to the amount committed from gross pay for expenses covered by the FSA.
- Employer Obligation — The employer must make available to the employee the full amount of the benefit whenever reimbursable expenses occur. For example, an employee who designates $1,800 per year (equal to payroll deduction of $150 per month) is eligible for reimbursement of up to $1,800 in the first month of the plan year if qualified expenses in that amount have been incurred — even though only $150 has been paid into the account at that time.
- Amount of Salary Reduction — The employee must choose the amount of salary reduction for the health care benefit prior to the start of the plan year. If the FSA is established only as a premium conversion plan, deductions of the employee share of the premium is usually automatic, unless the employee specifically declines participation. Under IRS regulations, the amount of the reduction cannot be changed during the plan year unless the employee experiences a change in family status (e.g. birth, adoption, marriage, divorce, loss of a dependent, or termination of a spouse's employment). However, IRS regulations do permit the plan to provide that employees have the right to change their elections in the event of a significant change in the health plan cost or coverage.
"Use it or lose it"
- What Happens to Money Not Used During the Plan Year? Since FSA's were first allowed, the IRS has required that any money remaining in the employee's account at the end of the plan year be forfeited to the employer. Anything can be done with this money, except giving it back only to the persons who have forfeited it. If unused money is returned to employees, it must be done on an equitable basis to all participants. The two ways most frequently considered equitable are 1) distributed equally to all plan participants and 2) pro-rated to all plan participants based on the amount that each one contributed during the year. The money cannot be returned based on the amount each employee forfeited.
The Treasury Department subsequently announced that, beginning in plan year 2005, workers have and extra 2 ½ months after the plan year ends to spend their FSA funds. For example, if the plan operates on a calendar year basis, and the employer adopts the new rule, workers will have until March 15, 2006 to spend the money in their 2005 year accounts. This new grace period also covers dependent care accounts, though it is the health care accounts that are most problematic since health care costs vary more than child care costs.
- Although most employers keep forfeited funds, the Union should attempt to negotiate language providing that forfeited amounts be credited on a pro-rata basis to the accounts of all participants in the FSA program for the following plan year, or be used to reduce future health care benefit costs (such as employee premium contributions) for all employees.
- Under the original FSA regulations, the employer was required to keep unused money. Although this is no longer true, most employers still require that employees forfeit unused amounts. Typically, the employer claims that the money is used to defray administrative expenses. However, this is not a valid argument since the employer can use the tax savings generated by FSAs to cover administrative costs.
Advantages to employees
- Under an FSA, employees can reduce their taxable income and use the income reduction to pay for expenses that otherwise would have been paid with after tax dollars.
- Employee tax savings include federal income tax, and in most jurisdictions, state and local income taxes. In addition employees do not pay Social Security and Medicare tax (7.65%) on the amount excluded from income.
Advantages to the employer
- Benefit Savings — When salaries are reduced, the cost to the employer for benefits related to salary may also decrease. The greatest savings to the employer is often the employer portion of Social Security and Medicare, which currently equals 7.65% of each dollar of salary reduction (1.45% for those covered only by Medicare and not by Social Security). Other salary-related benefits that may result in employer savings include the following: unemployment and workers compensation, short and long term disability coverage, life insurance, and pension. Unless the pension statutes or ordinances are revised, the employer's funding and the employee's pension benefit in many plans will be based on the reduced salary. In most jurisdictions, AFSCME has been successful in bargaining for benefits to be based on full salary.
- Investment Income and Forfeitures — Any investment income earned on the value of the employee account balances, as well as any employee forfeitures, belong to the employer. As noted above, forfeitures can be returned to employees on a pro-rata basis or used to reduce employees' future benefit costs.
Disadvantages to employees
FSAs to present certain risks to the participants. The union should be aware of the following possible risks when considering the implementation of an FSA.
- Pension — If a benefit is based on salary, the benefit will be reduced unless plans are revised to avoid reductions. The pension is probably the first benefit to review. Employees close to termination of employment or retirement will be impacted most severely because pension benefits are often based on average salary for the last several years of employment.
- Life Insurance/Disability — Life insurance and disability benefits are also typically based on salary. The employer has the discretion to determine whether the full or reduced salary is used to compute these benefits. Because FSAs are advantageous to employers, they are usually willing to base these benefit amounts on the full salary to encourage participation.
- Workers Compensation/Unemployment — Workers compensation and unemployment benefits are based on the average monthly wage. For those who earn above the maximum monthly wage, benefits would not be reduced. However, for lower income employees, the reduction in potential benefits could be substantial. State law may dictate whether or not these benefits can be based on full salary.
- Social Security — Because Social Security benefits are based on salary throughout an employee's career, retirement benefits should not be significantly reduced, particularly if the FSA reduction does not occur over the employee's entire career. However, a young employee who has elected a large reduction and becomes disabled could receive a significantly lower Social Security disability benefit. Likewise, the survivor benefits could also be significantly lower.
For more information on FSAs, contact Mary Meeker at the Research and Collective Bargaining Services Department at 202/429-1058.
June, 2005