What is it?

1. What is it? A type of cafeteria plan that is funded though salary reductions elected by employees each year Employees choose between cash and specified benefits

2. When is it indicated? • Employer wants to expand employee benefit choices while limiting additional cost to company • Employee benefit costs have increased and employer must impose additional employee cost sharing • FSA provides tax benefit for employees not available elsewhere • Employer has sufficient number of employees, usually 25 or more • FSA benefits cannot be provided to self-employed persons

3. Advantages • Gives employees choice between cash or benefits • Funded through employee salary reduction, employer has no additional costs except administrative costs • Employer-paid payroll tax may drop since taxable payroll is reduced • Salary reductions to fund nontaxable benefits under plan are not subject to federal income taxes • Large list of potential nontaxable benefits under plan; including benefits not otherwise available to employee (e.g. dependent care)

4. Disadvantages • FSA must meet complex nondiscrimination require-ments imposed on cafeteria plan—administrative costs increase • FSAs require employees to evaluate own benefit situation and file timely election form every year • can be confusing and difficult • unused funds are forfeited at year end

5. Disadvantages • Administrative costs higher than in fixed benefit plan • IRS proposed regulations require an employer to be ‘at risk’ regarding total annual amount employee elects to allocate to health benefits under his or her FSA

6. Design Features • Generally, complex nondiscrimination rules are met if • all employees are allowed to participate • benefits as a percentage of compensation are roughly equal across employees • cost of noncompliance is loss of tax advantage for highly compensated employees • Allowable benefits same as for cafeteria plans can include • medical reimbursement for items not covered in health insurance plan • dependent care reimbursement

7. How it Works: Basic Features of FSA Plan • Employer decides what benefits to provide in FSA and adopts written plan to provide these benefits • Employer advises employees to review their benefit needs near end of year and estimate next year’s expense items • Before year end, employees file written election to reduce salary and allocate amount among plan benefits

8. Design Features • Allowable benefits same as for cafeteria plans (cont’d) Cannot include • health insurance premiums • Archer medical savings account contributions • scholarships and fellowships (Sec 117) • educational assistance under Sec. 127 plan • employee discounts and fringe benefits (Sec. 132) • deferred compensation other than Sec. 401(k) • long term care insurance

9. Tax Implications • Employee salary reductions applied to nontaxable benefits are not subject to income tax • highly compensated lose tax advantage if plan discriminatory • must declare salary reduction in year before compensation earned • Employer gets tax deduction for amounts paid to reimburse employees for covered expenditures

10. Tax Implications • Employer’s payroll subject to payroll tax is reduced by amount of any employee salary reductions under FSA - payroll tax includes • FICA (social security) • FUTA ( federal unemployment tax) • state unemployment tax • worker’s compensation

11. ERISA Requirements • Written plan • Summary plan description • Formal claims procedure Also ERISA requirements applicable to the various individual plans in the FSA still apply

12. How to Install a Plan Before FSA plan can be in effect, employer must • design plan and salary reduction forms • formally adopt FSA plan and plans within FSA • communicate plan to employees • provide salary reduction forms to employees before end of year

13. Application Questions Robin Hays earns $38,000 per year and is covered under an FSA plan. On December 31 of last year, Robin filed an FSA election with her employer to reduce her salary by $2,500. Robin’s benefit expenses for this year are: • $200 per month for health insurance premiums • $2,400 for dependent care under her employer’s dependent care plan • $150 for deductible under company health care plan • $100 dental work

14. Application Questions • Considering these expenses in total, what is the dollar amount that the FSA will cover? • What is the tax consequence to Robin for covering benefit expenses under her FSA? • Given knowledge of this year’s expenses, what amount of salary should Robin elect to defer under her FSA next year?

15. Application Questions • Suppose Robin’s mother comes for an extended visit and Robin’s dependent care expenses fall to $1400 instead of the expected $2400. Explain how that change in Robin’s expenses will affect • the amount her FSA covers • the amount Robin has in her FSA at year end • the tax consequences for Robin for covering benefit expenses under her FSA • the amount of salary she should elect to defer next year, assuming her dependent care expenses remain at $1400.