Health savings accounts (HSAs) and flexible spending accounts (FSAs) let employees or dependents set aside money, before taxes, for qualified healthcare expenses. Employers can use them to incentivize employees to participate in health improvement programs, and they have tax advantages for both the employer and employee. But they have a few key differences—which account should you use and when?
An HSA is a savings account available only to people who are enrolled in a qualified high-deductible health plan and who have no other health insurance. As the name implies, high-deductible health plans require higher deductibles and out-of-pocket expenses than other types of health insurance policies, but the premiums generally cost less per month.
The employer, employee or both can contribute to an HSA. Employer contributions do not count as taxable income to the employee; employees can take an above-the-line deduction for any contributions they make. If you offer employees a flexible spending account or cafeteria plan, they can make contributions to their HSA with pre-tax dollars through their FSA. A major advantage to using a health savings account is the money carries over from year to year, so employees don’t have to “use it or lose it.”
HSAs linked to high-deductible health plans can help control your group medical expenses by giving employees a greater stake in their health expenses. HSA account holders can use money in their HSA for any qualified medical expense, including medical expenses in retirement. Employees control the money in their accounts, not the employer. Balances accrue year to year and are fully portable, giving employees incentives to build their accounts rather than spend them down.
Employers set up FSAs for employees; FSAs can cover either medical/dental expenses, dependent care expenses or both. A medical flexible spending account will cover any medical expense considered deductible by the IRS. You can find a list on IRS Publication 502.
Employees elect how much of their pre-tax salary to deposit into their account, reducing their income tax liability. Employees pay no monthly or yearly maintenance fees on their account. However, they need to figure out how much they’re going to need for healthcare or dependent care expenses over the year, because they lose whatever is left in the account at the end of the year. This “use it or lose it” feature could encourage employees to make unnecessary expenditures.
Pros and cons for employers
Employers have much to love about FSAs and HSAs. Because funds are pre-tax withdrawals, they decrease employee taxable income, resulting in lower costs for FICA, unemployment insurance, workers’ compensation and other wage-based benefits. Payroll tax savings generally offset the cost of administration, and the employer can earn interest on account balances.
On the flip side, the FSA “at risk” provision requires that you reimburse an employee for incurred eligible expenses up to the full amount that he or she has elected to set aside during the plan year — regardless of how much he or she has actually contributed at that point. For example, let’s say an employee elects to contribute $2,400 for the plan year and incurs $2,400 of eligible expenses at the end of the second month. At this point, the employee has only contributed $400 to his account, yet is entitled to $2,400 in reimbursement. If the employee remains with your organization, he will contribute the remaining $2,000 by year’s end. However, he has no repayment obligation if he leaves his job before the end of the year. The employer may still break even, because an employee who leaves in the course of the year without spending all he has contributed to his account relinquishes the remaining funds, unless he continues participating through COBRA. Employees also forfeit to their employers any unspent amounts left in their accounts at the end of the year.
You can cap your company’s liability by limiting the amount that employees set aside. Some employers use a two-tiered limit, limiting first-year participants to $1,000, for example, and then capping future participation at a higher amount. Remember, however, that the Affordable Care Act will limit contributions to medical FSAs to $2,500 for tax years beginning after 2012.
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