Can FSAs Survive Healthcare Reform?

Flexible Spending Accounts (FSAs) or Health FSAs have for years enabled employers to offer employees the opportunity to spend non-taxable compensation on eligible medical expenses.  FSAs could not only be used to pay for routine deductibles and co-insurance, but they also could buffer against unexpected health care costs. Now, Health Care Reform under the Affordable Care Act (ACA) has changed the way in which FSAs can be offered to employees.

First, for plan years beginning in 2013, the amount an employee can contribute to an FSA through salary reductions is capped at $2,500. Next, for plan years beginning in 2014, Health FSAs can only be offered through Section 125 Cafeteria Plans. Otherwise, the FSA would not be exempt from the ACA requirement that group health plans may not establish any annual limit on the dollar amount of benefits for any individual. Finally, the FSA itself must be structured to qualify as something called an “excepted benefit.” If the employer provides a Health FSA that does not qualify as an excepted benefit, the Health FSA is subject to the ACA’s market reform rules, including the requirement that non-grandfathered group health plans provide certain preventive care services without imposing any cost-sharing requirements for these services. Health HSA’s are considered group health plans under the ACA.

Excepted benefits include, among other things, accident-only coverage, disability income, certain limited scope dental and vision benefits, and certain long-term care benefits.  In order to qualify an FSA as an excepted benefit, an employer must make available group health plan coverage that is not limited to excepted benefits.  In other words, if it offers its employees the opportunity to elect group health coverage, an employer will have satisfied this part of the test.

In addition to the availability of group health coverage, the FSA must be structured so that the maximum benefit payable to any participant cannot exceed two times the participant’s salary reduction election for the Health FSA for the year, or if greater, cannot exceed $500 plus the amount of the participant’s salary reduction election.  Thus, for example, if an employee elects a Health FSA salary reduction of $2,500, the employer can match the employee’s contribution dollar for dollar up to a maximum of $2,500. If this were to happen, the employee would have $5,000 available in her or his FSA account for the plan year.

Health Care Reform has not eliminated the Health FSA. If an employer modifies plan documents as necessary and follows the rules summarized above, Health FSAs can continue to provide tax-free compensation to employees to pay for medical care expenses that are not covered by group health insurance.

Flexible Spending Accounts Become More Flexible

Flexible Spending Accounts (FSAs) or Health FSAs for years have let employers provide pre-tax dollars through employee salary reductions or employer contributions to an FSA account that the employee can spend as he or she pleases for qualifying medical expenses.  The down side, especially if the FSA account were composed of salary reductions, was the “use-it-or-lose-it” rule.  This rule meant that unused money in an FSA account was forfeited at the end of the plan year.  Naturally, this led to end of year buying binges by employees who did not want to leave unused FSA money on the table.  Not only did this encourage potentially unnecessary spending but it also prevented employees from setting aside unused funds for a rainy day when a few extra dollars might go a long way to offsetting unexpected medical expenses during the next plan year.

Recognizing this problem, the IRS in 2005 allowed employers to include in their FSA plans a grace period of up to 2 ½ months after end of the previous plan year for employees to spend amounts left in their FSA account.  For the first time, Health FSAs, like Health Reimbursement Arrangements (HRAs) and Health Savings Accounts (HSAs), gave employers and employees the ability to moderate spending that was encouraged by the “use-it-or-lose-it” rule.

In late October of this year, the Treasury Department announced a new option that gives FSAs greater flexibility.  FSAs can now offer a $500 maximum rollover option that lets employees spend unused FSA account balances during the next plan year.  Not only does this defuse employee ill will caused by the forfeiture of unused balances, the new rule also lets the employee use the saved money after the expiration of the optional 2 ½ month grace period that was permitted under previous guidance.  Although the employer has to choose between the grace period option and the rollover option (a plan cannot have both options), it is clear that employees who are careful with their FSA money can look forward to managing those funds in a way that maximizes their usefulness, especially where medical expenses in a given plan year exceed the maximum amount (up to $2,500) that can be contributed to a Health FSA.

Overall, this small change is the kind of flexible thinking that makes a Flexible Spending Account a useful way to promote prudent use of healthcare resources.  For those employers who offer Health FSAs, it is a small but not insignificant way to make healthcare more affordable for everyone.

Authored By: Randall Weill, a partner in Preti Flaherty's Labor and Employment Group.