Employees Now Enjoy Even Greater Flexibility with FSAs

Employees who choose to participate in employer-provided flexible spending accounts (FSAs) can realize several tax benefits. Recent legislation — the Consolidated Appropriations Act (CAA) — provides participants with an even greater incentive to contribute to these accounts. IRS Notice 2021-15 outlines guidance relating to CAA changes for FSAs offered through cafeteria plans.

Plan Review

With an FSA, participating employees generally fund their accounts with pre-tax dollars through a salary reduction plan. Employees save both income tax and payroll tax when they contribute to their FSAs. In addition, they pay no tax when they withdraw money to pay for qualified expenses. Similarly, employers save on their share of payroll taxes.

Dollar sign on a spring

There are two main types of FSAs:

1. Health care. Account funds can be used throughout the year to pay for qualified health care expenses as they occur. The annual contribution limit for 2021 is $2,750 (the same as 2020). Tax-free withdrawals may be made for expenses incurred by an employee, the employee's spouse and the employee's dependents age 26 or younger.

The list of qualified expenses is extensive and generally mirrors what would be normally be deductible as medical expenses on a federal tax return. For example, a health care FSA can be used to pay for insurance co-payments, co-insurance and deductibles, dental and vision care, and prescription drugs. However, a health care FSA can't be used to cover health insurance premiums.

2. Dependent care. Dependent care FSAs operate much like health care FSAs. The difference is that distributions from these plans must be used for qualified dependent care expenses. Funds may cover costs of caring for a child under age 13 or a dependent who's physically or mentally incapable of self-care — for instance, an elderly parent with Alzheimer's disease.

The annual limit for dependent care FSA contributions is $5,000. (Note that this figure isn't indexed for inflation.) Qualified dependent care expenses generally include those that allow employees (and their spouses, if married) to work, such as costs for a day care center, nursery school, babysitter and summer day camp. Employees can't use a dependent care FSA to pay for food, clothing and entertainment; child support; educational supplies; overnight camp; or cooking and cleaning services not provided by a caregiver.

Grace Period vs. Carryover Rule

Historically, employees were required to use the funds in their health care or dependent care FSA by the end of the plan year. Any remaining amount was forfeited. This "use-it-or-lose-it rule" has long been considered a major drawback to FSAs.

That rule gradually has been relaxed over the years. First, employers were permitted to allow employees a 2½ month grace period in health FSAs. In other words, employees had until March 15 of the year following a calendar plan year to use any remaining funds in an FSA before they were forfeited. Then, employers could allow employees to carry over up to $500 of their health care FSAs (indexed to $550 for 2020 and 2021).

There was a catch to these newer rules: Employees with health care FSAs had to choose between the grace period and the carryover. It was one or the other — but not both.

CAA Changes

The CAA makes FSAs more flexible for employees and employers. Specifically, participants may carry over their entire unused health or dependent care FSA balance from 2020 and 2021 to the next plan year. The CAA also enables a grace period of 12 months for carryovers following plan years ending in 2020 and 2021.

Here are several other CAA changes:

All of these changes are optional for employers. An organization has until until December 31, 2022, to formally adopt an amendment implementing alterations to its health and dependent care FSAs effective on January 1, 2021.

Note: In another change under the CARES Act, a health care FSA can be amended to reimburse expenses for menstrual care products and over-the-counter drugs beginning on January 1, 2020.

Enhance Your Benefit Package

As health and dependent care costs rise and consumers seek greater flexibility, FSAs are likely to remain popular. If your organization doesn't already offer them, consider adding FSAs to your employee benefits package. These plans typically are cost-effective and can help your organization attract and retain valuable workers.

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