A Flexible Savings Account (FSA) is offered through a cafeteria plan, which is a special type of medical savings plan under the Internal Revenue Code. In a typical plan, employees elect to have a certain amount withheld from their paycheck.
These reductions, known as deferrals, are withheld before any federal, state, FICA (Social Security and Medicare) or city taxes are applied. This results in lower taxable income for the employee. It also reduces the FICA tax owed by the employer.
Employees receive nontaxable reimbursements from these deferrals to cover medical costs not covered by insurance reimbursement or other forms of payment. Medical plan costs eligible for reimbursement include deductibles, co-pays, over-the-counter medications and other out-of-pocket expenses.
Health and other insurance benefit premiums can be paid pretax as well. These expenses include amounts paid by the employee, the employee∏s spouse and qualified dependents.
Partners in a partnership, sole proprietors, shareholders with more than 2 percent of an S-corporation and members of an LLC cannot participate. This exclusion also includes certain family members. There is no maximum annual contribution limit set by the IRS; rather, the contribution limit is a product of plan design.
Health Savings Accounts
Health Savings Accounts (HSAs) are tax-exempt accounts established to receive contributions on behalf of an individual taxpayer. The accumulated amounts in the HSA can be used to pay qualified medical expenses (similar to FSAs).
Any individual who is covered by a high-deductible health plan (HDHP) may establish an HSA. The individual cannot be receiving Medicare payments, cannot be claimed on someone else∏s tax return and cannot be covered under any health plan that is not an HDHP.
The 2005 HDHP requirements are a minimum deductible of $1,000 for single employees and $2,000 for family employees. These amounts will increase in future years for cost-of-living adjustments. There are contribution limits towards the maximum amount that can be contributed to these plans.
Individuals between the ages of 55 and 65 may make additional catch-up contributions of up to $600. A married couple can make two catch-up contributions as long as both spouses are at least 55 years old.
HSAs can be set up by individual employees and are fully owned by that employee, so if an employee under a HDHP leaves employment with the company sponsoring the health plan, the account is still under the ownership of the employee. The accounts must be set up with a bank, insurance company or any approved nonbank trustee. All amounts are 100 percent vested at all times.
Contributions are deductible on Form 1040. It's up to the employee to prove to the IRS that the withdrawals are for medical expenses. Individuals must keep records in case of an audit.
Contributions and earnings growth can be withdrawn at any time to pay for qualified medical expenses for the owner, spouse or dependents. These distributions are not subject to income tax withholding.
But any distributions made from the HSA that aren't for qualified medical expenses will be included in the gross income of the employee. Additionally, the expense will be subject to a 10 percent income tax penalty, except in the cases of death, disability or upon attaining age 65.
As employers continue to search for ways to alleviate medical costs, FSAs and HSAs stand out as two vital options for employers that offer tax savings and cost benefits.
Kimberly Flett, CPA, QKA, is a senior associate in the Retirement Plan Design and Administration Group at Saltz, Shamis & Goldfarb Inc., the tax and accounting division of SS&G Financial Services Inc. (www.SSandG.com). For questions related to employee benefits, reach Flett at KFlett@SSandG.com or (330) 668-9696.