Manufacturers & Distributors ARTICLE - Serving up a Better Health Care Plan-FSAs offer employers and employees plenty to chew on

Target Audience: Manufacturing Industry Professionals, Business Owners, Payroll Administrators, Human Resources

Today’s high health care costs have left workers and companies alike hungry for a better way to cover the former’s medical needs without hurting the latter’s profitability. One increasingly popular option that gives both parties plenty to chew on is the Flexible Spending Account (FSA), which can also provide dependent care benefits.

Appetizing Choices

FSAs are usually offered through cafeteria plans, which allow employees to choose between cash and a menu of tax-free benefits. At the beginning of each plan year, workers estimate their expenses for the year and decide how much to contribute.

Contributions are funded with pretax dollars through salary reductions over the year. Employees pay qualifying out-of-pocket expenses as they’re incurred and then submit reimbursement claims to the FSA plan administrator.

Workers may use FSA funds to pay a variety of out-of-pocket expenses not covered by insurance. Examples include annual deductibles, copays, orthodontia, prescriptions and over-the-counter medications. FSAs for dependent care expenses work similarly.

For employers, FSAs not only provide a valuable benefit that current and prospective employees appreciate, but also reduce payroll by the amount of FSA contributions, avoiding FICA taxes and other payroll expenses on those amounts.

Generous Portions

By leveraging pretax contributions, an FSA allows employees to enjoy significant savings on their out-of-pocket medical and dependent care expenses. For example, an employee in the 25% tax bracket who contributes $4,000 annually can save $1,000 per year.

Employees may contribute only up to $5,000 per year to a dependent care FSA, but there’s no legal limit on contributions to health care FSAs. Nevertheless, most employers set a cap on them to limit their financial risk.

That’s because the plan must reimburse employees for qualifying medical expenses even if they’re incurred before sufficient funds have been withheld from their salaries (provided the expenses don’t exceed an employee’s annual contribution amount). If an employee leaves the company before his or her FSA contributions “catch up” to previous reimbursements, the employer may be left holding the bag.

For instance, Jeff, an employee of ABC Inc., elects to contribute $4,800 in 2006 to ABC’s FSA. ABC deducts $400 per month from Jeff’s salary and contributes it to the account. On April 1, Jeff incurs $4,000 in qualifying medical expenses and submits a claim. The plan reimburses Jeff for the full $4,000, even though he’s contributed only $1,200 so far.

On July 1, Jeff’s employment with ABC terminates. When he leaves the company, his FSA contributions for the year total $2,400. ABC may not be able to collect the $1,600 shortfall.

Eyes vs. Stomach

FSAs hold dangers for employees as well. The accounts are subject to a strict “use it or lose it” rule stipulating that those who overestimate their expenses must forfeit any account balance remaining at year end. And once employees choose their contributions for the year, they can’t change their elections except in the case of certain life-changing events, such as marriage, divorce, death or the birth of a child.

Fortunately, in 2005, the IRS offered some relief from the “use it or lose it” rule. Employers may now provide participants with a grace period of up to 21/2 months after the end of the plan year. Workers can use remaining FSA funds to reimburse themselves for eligible expenses incurred during the grace period.

Bear in mind, though, that the grace period is available only if the employer amends its plan to allow it. And, unless the plan is further amended, extended coverage will be considered “other coverage” that would disqualify employees from contributing to a Health Savings Account (HSA). For a brief summary of these arrangements, see the sidebar “HSAs: Similar, but not the same.”

Check, Please

Companies considering an FSA should compare the benefits and costs to those associated with other options. The tab for setting one up includes legal, administrative and ongoing compliance costs. In addition, employers must pass nondiscrimination tests that prevent them from favoring key employees.

That said, these accounts are growing in popularity. After incurring the initial costs, many businesses are saving money by passing on rising health care costs to their workers. And those employees don’t mind as much because FSAs grant them a cost-effective way to cover, track and ultimately lower their medical expenses.

HSAs: Similar, But Not The Same

Like Flexible Spending Accounts (FSAs), Health Savings Accounts (HSAs) allow participants to pay qualifying medical expenses with pretax dollars. But unlike FSAs, HSAs have no “use it or lose it” feature — amounts remaining at year end roll over tax free.

For employees with modest health care expenses, an HSA can also serve as a supplemental retirement plan, as unused funds continue to grow tax free and can be withdrawn for any purpose without penalty, though subject to income tax, after age 65. (Early withdrawals are subject to a 10% penalty.)

What’s the catch? Employers must offer an HSA in conjunction with a high-deductible health plan (HDHP). For 2006, that means a plan with an annual deductible of at least $1,050 for individual coverage and $2,100 for family coverage, plus an annual out-of-pocket limit of no more than $5,250 for individual coverage and $10,500 for family coverage.

To qualify, an employee must be covered by an HDHP and generally must not be covered by any non-HDHP health insurance. The maximum contribution for 2006 is the lesser of the HDHP’s annual deductible or $2,700 for individuals and $5,450 for families. Additional “catch-up” contributions are allowed for those 55 and older.

HSAs can reduce the employer’s costs in two ways. First, switching to an HDHP usually reduces employer premiums. Second, the ability to tap unused contributions for other purposes provides employees with a powerful incentive to manage their health care costs, which, in turn, may lessen future health insurance expenses for the company.

FEELEY & DRISCOLL, P.C., an accounting and business consulting firm, has offices in Boston, Massachusetts and Nashua, New Hampshire. For more than thirty years, Feeley & Driscoll has provided businesses with auditing, accounting, forensic accounting, income tax planning, estate tax planning and management consulting services. Serving a variety of industries, including construction, manufacturing, healthcare, architects and engineers, and professional services, biotechnology, and information technology. Feeley & Driscoll is committed to helping clients grow their businesses profitably.

Find out how our accountants and consultants can add value to your business. Email us or call us at 1 (888) 875-9770.

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