FSA Taxes: Implications, Advantages and More

Small business owners and managers should be aware of FSA tax advantages for not only their employees but themselves. An FSA plan – short for flexible spending arrangement or flexible spending account – is a type of healthcare savings account. It's an employer-sponsored plan that allows employees to put aside money to spend for qualifying medical expenses that they expect to encounter during the year. Employees don't have to pay employment or federal income taxes on the amounts they set aside.

The IRS limits how much employees can contribute to their FSA accounts. It increased the amount for 2024 to $3,200, up 4.9% from the $3,050 limit for 2023. Employers can also opt to contribute certain amounts to their employees’ health care FSA plans.

The plans provide tax advantages to both employees and employers. However, they have one disadvantage for employees. Employees forfeit any money that remains unspent at the end of the plan year, or after accounting for any grace periods or carryovers that may apply. A study found that 40% of employees with FSA accounts forfeited at least part of the money they had put in. The employees’ loss could be the employers’ gain, however, as employers have the option to keep the forfeited FSA money.

This article will discuss how flexible spending accounts are taxed and the advantages the plans provide to employers and employees.

FSAs and taxes

Contributions to FSA plans are made with pre-tax dollars. Employees save the amount of tax money they would have paid on that income. However, because these plans are funded pre-tax, employees cannot also take a tax deduction on medical expenses paid with FSA money.

Employers, on the other hand, save on payroll taxes. Payroll taxes, commonly known as FICA taxes, are the Social Security and Medicare taxes taken out of each paycheck. Both employees and employers pay them, with each party paying 7.65%.

When an employer provides FSA plans, it saves its portion of the payroll tax on the amounts that employees contribute to their plans. If the tax savings are greater than the cost of administering the plan, then the employer comes out ahead by providing the plans.

These plans must be provided by an employer through a Code Section 125 cafeteria plan, which is the way that employers can provide tax-free benefits. “Section 125” refers to the IRS section governing cafeteria plans. People who are self-employed are not eligible to have a flexible spending account.

As we noted earlier, the employer has the option to keep employees’ FSA money that was not used in a timely manner or carried over. The employer may apply it to FSA plan administrative costs, return it to employees, or use it as they see fit. Employers are not taxed on the forfeited benefits.

Rules for employer participation

Employers must comply with certain IRS requirements to maintain their plan’s tax advantages. These include following restrictions on plans for highly compensated employees and other IRS rules that apply to employer-sponsored health plans.

FSA tax adantages for employees

FSA plans offer several advantages to employees:

• They don’t pay employment and federal income taxes on the money they contribute to their plan.
• They can exclude from their gross income any contributions that employers make.
• Their reimbursements for qualified medical expenses may be tax free.
• They can use their FSA plans to pay for qualified medical expenses even if they haven’t yet funded the accounts. If you incur a big medical expense in January, for example, you can get reimbursed with FSA funds even though you have only contributed a smaller amount to your fund.

Examples of the many qualified expenses include doctor visits, copays, deductibles, prescription drugs, surgery (but not cosmetic surgery), physical therapy, treatment from psychologists, treatment from chiropractors, flu shots, fertility treatments, wheelchairs, eyeglasses, diabetes test kits, breast pumps, vasectomies and vaccines.

Although FSA funds can be used for many qualifying expenses, they cannot be used to pay for insurance premiums. Those must be paid with taxable dollars.

Employees cannot take money directly out of their FSA accounts. Instead, they must submit a claim to their employer accompanied by proof of the expenses. If the claim is approved, the employee gets reimbursed from the FSA account.

The advantages could be undercut, however, if employees don’t use all the money they put into their funds. During the enrollment period, when the employee has to decide how much to put into the FSA account from each paycheck, employees need to estimate how much they’ll spend in the coming year. They can review eligible medical expenses from the past year and consider procedures or treatments that they expect to incur.

It pays to know about FSA tax advantages

Health care FSAs are attractive benefits for employees because they allow workers to save money on their taxes. As part of a comprehensive benefit package, these plans can help employers attract and retain top employees.

TriNet would be glad to tell you more about these plans and help you decide if you should offer them to your employees. If you choose to work with us, we’ll also help you with compliance issues, so that you don’t have to worry about whether all the IRS requirements are being followed and whether you are administering the plans correctly. Contact us today to discuss FSA plans and all your employee benefits needs.