All Things Financial Planning Blog

Flexible Spending Account Changes Looming

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What is a FSA?

Health care Flexible Spending Accounts, FSA’s, are benefit plans established by employers to reimburse employees for health care expenses, such as deductibles and co-payments. 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. Although they are usually funded by employees through salary reduction agreements, employers may contribute as well. 

FSAs are considered part of a cafeteria plan when they are funded through voluntary salary reductions. However, if they are funded by non-elective 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.

Some FSA Statistics

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.

FSA Rules Now and Looming

Contributions to and withdrawals from FSAs are tax-exempt. 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. 

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. So any tax savings from participating should be carefully weighed against the potential risk of forfeiture under the use-it-or-lose-it rule.

A recent Congressional Research Report 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 Code, but not for health insurance or long-term care insurance premiums; and
  • Employers may impose additional restrictions.

The report goes on to remind us that there have been changes to the FSA rules as required by the Patient Protection and Affordable Care Act. Significantly, PPACA:

  • Modified the definition of “qualified medical expenses” to remove over-the-counter medicines (except those prescribed by a physician), effective 2011. Effective Jan. 1, 2011, expenses incurred for over-the-counter medicines, with the exception of insulin, will not be eligible for reimbursement under a health FSA, HRA or HSA without a prescription. The penalty for using HSA funds for ineligible expenses increased from 10 percent to 20 percent; 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).

Planning Implications for Individuals and Business Owners

So even though the contribution amount will be changing, we should not lose sight of the value of participating in a FSA account if it is available to us. In the 30% tax bracket one has to make a $1.42 before taxes to have $1 of after-tax dollar to spend on medical or other expenses. Wouldn’t you rather pay a $1 ‘cost’ (pre-tax contribution) for a medical expense rather than a ‘$1.42’? Of course, we wouldn’t want to ‘lose’ any overfunded FSA contribution amount so make your deferral election choices judiciously, but, nonetheless, make those choices and participate in this valuable employee benefit!

Employers who offer an HSA may want to consider adding a limited-purpose health care FSA (allowing employees to set aside pre-tax dollars for eligible dental and vision care expenses). Or, employers who aren’t offering HSA-eligible, high-deductible plans may want to consider them. Employers who offer FSAs can reduce their workers’ compensation obligations as well as the employer matching on Social Security and Medicare taxes.

Paired together, limited-purpose FSAs and HSAs allow employees to maximize their tax-advantaged savings for health care. They can use limited-purpose FSA funds to reimburse themselves for dental and vision care, and use HSA funds to pay or reimburse themselves for qualified medical expenses (deductibles and co-insurance, for example) and save for future expenses. HSA contribution limits for 2012 are $3,100 for individual coverage and $6,250 for family coverage. Don’t forget the limits for catch up contributions for persons over age 55 – $1,000 (unchanged from 2011).

Conclusion

In today’s world of spiraling medical costs it is imperative that we make every ‘benefit dollar’ we expend go as far as it can in covering our medical, and other, needs. I don’t know about you, but I would rather pocket that $.42 cents of taxes (referenced above), say into my 401k, than give it to the government. 

Effectively coordinating your family’s personal circumstances with benefit plans and options available to you is just one of the steps in the financial planning process but it is clearly an important one!

David Bergmann, CFP®, EA, CLU, ChFC
Managing Principal
The David Bergmann Group
Marina Del Ray, CA

Author: David Bergmann, CFP®

ACADEMIA David has been an instructor in UCLA’s CFP Board Accredited Personal Financial Planning Certificate Program since 1995 and he is a member of the Program’s Academic Review Committee. David has taught both the Financial Analysis and Employee Benefits/Retirement Plan courses and regularly teaches the Federal Income Taxation in PFP class. He is also the instructor for the Ethics course and oversees the internship program. PROFESSIONAL CONTRIBUTIONS David has served as an editorial reviewer for the Journal of Financial Planning since the magazines inception. He has been a reviewer for the FPA’s Financial Planning Perspectives publications and other various National publications. David served from 1988 through 1990 as President of the Los Angeles Society of the Institute of Certified Financial Planners (ICFP). He also served on the National Board of the ICFP from 1988 through 1993 having chaired The Education, The Communications, The Regional Directors and The Case Law Oversight Committees as well as serving a year on the Executive Committee. David has been a mentor and since 2006 has been a Dean in the nationally recognized FPA’s Residency Program. PROFESSIONAL ACTIVITIES The David R. Bergmann Group is a comprehensive services firm supporting the work the firm does in, and with the process of, comprehensive Life Financial Planning. In our life financial planning process we focus on the client’s life goals and individual passions in the context of what brings joy, purpose, fulfillment and sense of valued legacy and then we structure their financial affairs and personal resources to enable, inspire and empower them to live their impassioned and fulfilled life. David was twice named as one of the Top 100 Financial Advisors in the country by Mutual Fund Magazine. He has appeared on CBS Nightly News and in many National print publications, including the Wall Street Journal, Investor’s Business Daily, Business Week, and others.

3 thoughts on “Flexible Spending Account Changes Looming

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