When unused flexible spending account (FSA) balances are forfeited back to employers under the "use-it-or-lose-it" rule, employers have several options for what they can do with the money. Here is what employers need to know after first covering some necessary background information.
Under an employer-sponsored flexible spending account (FSA) plan, employees can elect to contribute a designated amount of their annual salary to their personal health care FSA or dependent-care FSA or both.
For a health care FSA, the maximum amount that an employee can contribute for the 2022 tax year is $2,850 (up from $2,750 in 2021).
For a dependent-care FSA, the maximum amount that can be contributed is $5,000 (latest figure available). For a married employee, the $5,000 cap represents the maximum amount that both spouses can together contribute.
Employee annual FSA contribution amounts are withheld in installments from their paychecks. Employees can then use their FSA money to cover qualifying out-of-pocket medical expenses (such as amounts paid to satisfy health insurance deductibles and co-pays and amounts paid for prescription drugs, dental care and vision care) and qualifying out-of-pocket dependent-care expenses. The amounts withheld from employee paychecks are treated as a salary reduction for federal income tax, Social Security tax and Medicare tax purposes (and usually for state income tax purposes too). Reimbursements from FSAs to cover qualified out-of-pocket expenses are tax-free to employees.
To put it another way, the FSA arrangement allows participating employees to pay for all or a portion of their out-of-pocket medical expenses and dependent care expenses with pretax dollars. That is the same as getting an income tax deduction combined with a reduction in Social Security and Medicare tax withholding. The employee's tax savings are permanent -- not just a timing difference.
For employees, the main downside to an FSA is the use-it-or-lose-it rule. If the employee fails to incur enough qualified expenses to drain his or her FSA each year, any leftover balance generally reverts back to the employer. However, there are two exceptions to the use-it-or-lose-it rule.
The IRS gives employers the following options for unused employee FSA balances that are forfeited under the use-it-or-lose-it rule. The source for this is Treasury Proposed Regulation 1.125-5(o).
1. The employer can simply keep the money.
2. If the employer doesn't keep the money, forfeited amounts must be used for the following purposes:
Example: Alpha Corporation maintains a cafeteria benefit plan for its 1,200 employees. The plan includes a health care FSA under which participating employees can make salary reduction contributions in $100 increments, from a minimum contribution of $500 to a maximum contribution of $2,850 (up from $2,750 in 2021). For the 2022 plan year, 1,000 employees elected various contribution levels under the health care FSA plan. For the 2022 plan year, Alpha collected $5,000 of health care FSA balances that are forfeited under the use-it-or-lose-it rule. Alpha can choose to simply keep the $5,000.
Alternatively, Alpha could take one of the following steps or a combination of them. Here are some additional details under the alternative option.
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