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8:00pm EDT October 26, 2007

Aflexible spending account (FSA) is an employer-sponsored benefit plan that gives covered employees an opportunity to set aside payroll dollars on a pretax basis to help pay for health care and dependent care expenses. These expenses can be incurred by both the employee and his or her eligible dependents.

Smart Business talked to Nancy Busch of Priority Health about how FSAs can save employees as well as employers money over the long haul.

What is reimbursed?

Health care FSAs pay for medical, dental, vision and prescription drug services. This means that employees can use FSA money to pay for medical co-payments, deductibles and co-insurance, dental services like orthodontia and dental implants, and vision expenses like glasses or even Lasik surgery. Over-the-counter drugs, such as aspirin and cold medicine, can also be reimbursed as long as they are used to treat an injury or illness and are not for general well-being, such as daily vitamins.

A dependent care FSA, which is a separate account, can also be of great value to employees. Dependent care FSAs allow covered employees to put pretax dollars aside to pay for the care of dependent children up to age 13 and dependent adults. Some examples of reimbursable expenses include day care, after-school care or child care in the summer that allows parents to work. Contributions to dependent care FSAs are currently limited to $5,000 or $2,500 if married but filing taxes separately.

FSA plans almost always run for a 12-month period, unless the employer puts in place a grace period that extends the plan year by two months. That’s a recent IRS addition. Employees become participants in these programs by signing up at open enrollment and selecting their annual payroll deductions or plan contributions. By law, any unspent FSA funds cannot be refunded to the employee at the end of the plan year. The funds must revert to the employer.

What don’t they reimburse?

The IRS is pretty clear on this point.

Health care FSAs do not allow for reimbursement of services that are cosmetic, such as teeth whitening or tattoo removal. They also do not cover any expenses that have already been covered by health insurance — meaning no double-dipping and being reimbursed for something your insurer has already paid. With regard to dependent care accounts, you cannot run through dependent care services if you do not need those services in order to work — for example, you have a stay-at-home, non-working spouse.

Why do they make sense for employees?

By using an FSA, employees can enjoy a tax savings of up to 40 percent for every dollar they spend on health care or dependent care. FSA contributions bypass the employee’s gross income. They are not subject to federal income tax, social security tax, or, in most parts of the country, state and local income taxes.

Why do they make sense for employers?

It’s a great way to help employees save money, so it is definitely a valuable benefit that they can offer to retain and attract employees. From a financial standpoint, it’s a win-win situation. Employers are not liable for payroll taxes on any of the monies contributed to the accounts. That means that they don’t have to pay Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax (FUTA) on those dollars. Plus, administration fees are deductible expenses.

The only drawback with health care FSAs is that employees can be reimbursed for health care expenses that have not yet been funded through payroll contributions. [This is only for health care FSAs and not dependent care accounts.] For example, the employee incurs a $1,200 expense in January but has only contributed $100 through payroll when he submits for reimbursement. The employee will receive the full $1,200. That’s the law. Hopefully, assuming the employee doesn’t quit midyear, the employer will get the remaining $1,100 back over the remainder of the year’s payrolls. Employers set an annual plan maximum, which is the maximum amount that the employee can contribute to these accounts over the plan year. So, that is a way that employers can limit their exposure.

Where do I start?

You will need to determine who you want to administer your FSA. Most third-party administrators offer this kind of service at a reasonable per employee, per month fee. You’ll also need to purchase a plan document that sets forth all the terms of the plan. It is a legal requirement. Often, the plan document is provided as part of the set-up fee. Otherwise, you can get a plan document from an employee benefits attorney.

NANCY BUSCH is director of Small Business and Medicare Sales at Priority Health. Reach her at (616) 464-8739 or nancy.busch@priorityhealth.com.