In a flexible spending account (FSA) arrangement, employees can sign up to have funds withheld from their pre-tax gross pay, which is stored in a fund for their subsequent use. The FSA is essentially a means by which the federal government makes it less expensive for employees to meet their medical and dependent care expenses.
If an FSA deduction is targeted at medical expenses, employees can apply actual expenditures for medical care against that fund. If an FSA deduction is targeted at dependent care expenses, employees can apply actual expenditures for dependent care against that fund. Employees are not allowed to mix the two funds for reimbursement purposes.
For both types of funds, the FSA is usually administered by a third party, which holds the withheld funds and disburses them to those employees who have documented valid expenditures.
The net effect of an FSA is to reduce the amount of taxable income for an employee, which means that he or she pays fewer taxes. However, this benefit has an offsetting risk, in that employees must use all of the FSA funds withheld within a calendar year, or lose any remaining funds that were withheld from their pay but never used. Further, there is a risk that the amount withheld for an FSA may be lower than the amount of actual expenses incurred, since the withholding amount for an FSA is set up and then frozen at the start of each calendar year. If so, the employee loses the tax exemption on the excess amount of expense for which there are no offsetting FSA funds. The restriction on subsequent changes to an FSA does not apply if there is a change in an employee’s marital status, number of dependents, or employment status that alters the underlying expenditures associated with an FSA.
It is permissible to accelerate expenditures that are allowable under an FSA, in order to use up all remaining funds.
The effect of an FSA can be quite substantial to the net pay of an employee, since that person will not pay any of the following taxes on the amount of funds shifted into the FSA:
The exact percentage of a person’s full-year net pay that will be increased by using an FSA is specific to the individual, since there is a cap on the amount of wages that are subject to social security taxes, and the amount of income taxes owed will depend upon a person’s wage bracket and number of exemptions taken. Nonetheless, the savings are certainly worthwhile, which will make an FSA attractive to any employee.
The effect of an FSA on the sponsoring company is generally beneficial, though there are some costs. The two cost issues are:
- Funding risk. A medical FSA allows employees to make claims against their FSA funds in excess of what they have thus far contributed during the year; if they leave the company before their contributions to the FSA match their claims against it, the company cannot obtain reimbursement from them for the difference. This scenario does not arise for a dependent care FSA, where employees can only withdraw funds to the extent that they have already contributed funds.
- Administration fee. If the company is using a third party administrator, it will pay a small fee to the administrator for each employee enrolled in either type of FSA plan.
The main point of an FSA is to reduce the amount of taxes that employees pay. Since the sponsoring company matches some taxes, it reduces its compensation costs by encouraging employees to maximize their participation in FSAs. This is the primary benefit of an FSA from the corporate perspective.