Dependent Care or Medical Care = Tax Breaks

A form of cafeteria plan under Section 125 of the Internal Revenue Code, a health care FSA allows employees to set aside pre-tax dollars from their paychecks to pay medical and dental expenses that are not reimbursed from an insurance plan. Eligible expenses are then reimbursed from the employee's account. You can also offer flexible spending accounts for dependent child or elder care expenses.

Flexible spending accounts offer several advantages to you company and your employees. However, there are also some disadvantages to be aware of. One of the best known is the "use it or lose it" feature. Any amounts contributed to an account and not spent by the end of the year are forfeited to the employer. However, a 2005 IRS ruling softened this deadline considerably. Employees now may have an additional 2 and 1/2 months after the end of the plan year to spend FSA funds, if the employer amends its plan by December 31st to allow for this extension. (See the right-hand box for more on this subject.)

Here are some more pros and cons of flexible spending accounts for your company and its employees:

From the Employer's Perspective

 Decreased employee taxable income, as a result of contributions to reimbursement accounts, results in decreased expenditures for FICA, unemployment insurance, workers' compensation and other wage-based benefits.

 The cost for administration is typically offset by the savings on payroll taxes.

 Interest is earned on account balances.

 The primary area of concern for employers is the "at risk" provision associated with health care reimbursement accounts. The "at risk" provision requires that you reimburse an employee for incurred eligible expenses up to the full amount that he or she has elected to set aside during the plan year — regardless of how much he or she has actually contributed up to that point.

For example, let's say an employee has elected to contribute $2,400 for the plan year and incurs $2,400 of eligible expenses at the end of the second month. At this point, the employee has only contributed $400 to his account, yet he is entitled to $2,400 in reimbursement. If the employee remains with your organization, he will contribute the remaining $2,000 by year's end. However, he has no repayment obligation if he leaves his job before the end of the year.

But there is a flip side. An employee who leaves in the course of the year without having expended any or all of what he has contributed to his account relinquishes the remaining account balance, unless he continues participating through COBRA. Employees also forfeit to their employers any unspent amounts left in their accounts at the end of the year.

Apart from the offsetting savings, you can cap your company's liability by limiting the amount that employees set aside. Some employers use a two-tiered capitation: Limiting first-year participants to $1,000, for example, while they become accustomed to the program, and then capping future participation at a higher amount, say $3,000.

From the Employee's Perspective

 Reduced taxable income means employees reduce their federal, FICA and, frequently, state taxes. Because an FSA reduces adjusted gross income, it may make an employee eligible for other valuable tax benefits.

 Employees can be reimbursed with pre-tax dollars for out-of-pocket deductibles, co-pays and procedures that are not covered by their health care insurance (if they have coverage). 

 For many taxpayers, FSAs are the only way to get a tax break for medical expenses. That's because medical expenses are only deductible to the extent they exceed 7.5 percent of adjusted gross income.

 Contributing pre-tax dollars to their FSAs provides employees with more spendable income.
 
 Employees are concerned about the "use or lose it" provision of health care accounts. If an employee elects to contribute $2,400 for the plan year, but incurs only $2,000 of eligible expenses, the remaining $400 reverts to the employer. However, planning and past experience can result in accurate contribution-estimates. And the savings on taxes may offset any loss.

While the "use it or lose it" provision applies to dependent care accounts as well, there is generally less risk. Employees find it easier to estimate what they will spend for child or elder care on an annual basis.

If you are interested in learning more about flexible spending or reimbursement accounts, call Ronald J.Cappuccio, J.D., LL.M.(Tax) at (856) 665-2121. Keep in mind that if you decide to implement an FSA plan, employee education is a critical component for maximum participation.