CRS Report details tax advantages of and changing contribution limits to FSAs

Congressional Research Service (CRS) Report, “Health Care Flexible Spending Accounts.”

A recently updated Congressional Research Service (CRS) Report highlights current limits and rules applicable to flexible spending accounts (FSAs), the basis for their tax treatment, and the extent of their use. The Report also reminds taxpayers of the upcoming $2,500 contribution limit beginning in 2013.

Background. Health care FSAs are benefit plans established by employers to reimburse employees for health care expenses, such as deductibles and co-payments. They are usually funded by employees through salary reduction agreements, although employers may contribute as well. Contributions to and withdrawals from FSAs are tax-exempt.

Unused FSA contributions left over at the end of a plan year have historically been forfeited to the employer under the so-called “use-it-or-lose-it rule.” However, a plan can (but is not required to) provide an optional grace period immediately following the end of each plan year, extending the period for incurring expenses for qualified benefits to the 15th day of the third month after the end of the plan year (i.e., March 15th for a calendar-year plan). Benefits or contributions not used as of the end of the grace period are forfeited.

The Report also highlights the following characteristics of health care FSAs:

... FSAs are limited to employees and former employees;

... IRS currently imposes no dollar limit on health care FSA contributions, but employers generally do;

... FSAs generally can be used only for unreimbursed medical expenses that would be deductible under the ICode, but not for health insurance or long-term care insurance premiums; and

... employers may impose additional restrictions.

FSA changes made by PPACA. The Patient Protection and Affordable Care Act (PPACA, P.L. 111-148) made several key changes to the FSA rules. Significantly, PPACA:

... modified the definition of “qualified medical expenses” to remove over-the-counter medicines (except those prescribed by a physician), effective 2011; and

... limited the amount of contributions to health care FSAs to $2,500 per year (indexed for inflation after 2013), effective in 2013 (Code Sec. 125, as amended by PPACA).

Tax treatment of FSAs. FSAs are a type of flexible benefit arrangement that generally qualify for tax advantages as a Code Sec. 125 “cafeteria plan,” under which employees choose between cash (i.e., take-home pay) and certain nontaxable benefits without paying taxes if they select the benefits.

FSAs are considered part of a cafeteria plan when they are funded through voluntary salary reductions. However, if they are funded by nonelective employer contributions, then they are not governed by the cafeteria plan provisions, but the benefits are excludible under Code Sec. 105 and Code Sec. 106.

The federal income tax savings opportunities from health care FSAs essentially depend upon the amount set aside by the employee and the employee's tax bracket. Since FSAs are funded with pre-tax dollars, the tax savings are the amount of tax that would have been paid on the set-aside amount. So, an employee in the 30% tax bracket who set aside $1,000 would save $300 in federal income taxes.Thus, the higher tax bracket the employee is in, the greater the potential tax savings.Any tax savings should be carefully weighed against the potential risk of forfeiture under the use-it-or-lose-it rule.

Prevalence of FSAs. According to the Bureau of Labor Statistics (BLS) National Compensation Survey, 39% of all workers in 2010, and 56% of workers in firms with over 100 employees, had access to a health care FSA. However, in establishments with fewer than 100 employees, only 20% of the workers could choose to participate in an FSA. According to a 2010 Mercer study, 37% of employees with the option of participating in an FSA did so, with an average annual contribution amount of $1,420.

According to the CRS Report, reasons for low FSA participation include employee perceptions of complexity, concerns about end-of-year forfeitures, and limited employer encouragement. Younger employees may also not have enough health care expenses to make their participation worthwhile. Further, for low-income employees, the tax savings might be inconsequential.

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