A health flexible spending account (health FSA) is a pre-tax account used to pay for out-of-pocket medical care costs for a participant as well as a participant’s spouse and eligible dependents. Health FSAs are employer-established benefit plans and may be offered with other employer-provided benefits as part of a cafeteria plan. Self-employed individuals are not eligible for health FSAs.
Even though a health FSA may be extended to any employee, employers should design their health FSAs so that participation is offered only to employees who are eligible to participate in the employer’s major medical plan. Generally, health FSAs must qualify as excepted benefits (unless they are integrated with another group health plan), which means other nonexcepted group health plan coverage must be available to the health FSAs participants for the year through their employment. If a health FSA fails to qualify as an excepted benefit, then this could result in excise taxes of $100 per participant per day or other penalties.
Employee FSA Contributions
A health FSA is similar to a bank account and is established for the employee’s use to pay for eligible health care expenses throughout the year. Each year, employees must decide how much money will be deducted from their paycheck on a pre-tax basis and contributed to their account. The employee’s salary reduction and contribution election is irrevocable unless the employee experiences a change in employment or change in family status as specified in the plan documents governing the health FSA. The account is then used to pay for eligible medical care expenses during the plan year.
For 2021, an employee’s health FSA contributions may not exceed $2,750 (indexed annually). An employer may, however, impose a lower contribution limit.
Health FSAs have tax-favored status under the Internal Revenue Code (IRC) provisions that apply to insurance. Accordingly, health FSAs operate with an element of risk to the employer and employee. The amount of an employee’s election must be immediately available for reimbursement as soon as the employee completes the salary reduction agreement, known as the uniform coverage rule. For example, if an employee elected to contribute $2,000 to the health FSA for 2020, on January 28, 2020, the employee’s health FSA would have a balance of $167 ($2,000 ÷ 12). If the employee incurred an eligible medical expense in the amount of $2,000, the employer would be required to reimburse the entire expense. This represents a risk to the employer.
The employee’s risk is that the unused balance in the health FSA after the end of the year cannot be used to reimburse qualifying medical expenses. After the close of the year, some employers allow an additional two and one-half months grace period in which to have additional qualifying medical expenses reimbursed from the unused balance. Some employers allow up to $500 ($550 in 2020 and 2021) to be carried over to the next year for use by the employee. Employers can implement the grace period or the carryover, but not both. If the employee fails to use the FSA account balance for the year, the remaining balance is forfeited: use it or lose it.