Flexible Spending Accounts (FSAs): Offer A Popular Tax-Free Benefit

A Flexible Spending Account (FSA) is a tax-advantaged benefit that allows employees to set aside pre-tax dollars for qualified medical and dependent care expenses. For employers, FSAs help reduce payroll taxes, enhance benefits offerings, and improve employee retention.

Employers offering FSAs under a Section 125 Cafeteria Plan must also maintain a written plan document to ensure IRS compliance and avoid tax penalties.

This guide covers everything employers need to know about implementing, managing, and maintaining compliance for an FSA program.

A Flexible Spending Account (FSA) is an employer-sponsored plan that allows employees to contribute pre-tax earnings to cover healthcare and dependent care expenses.

• Reduces Payroll Taxes – Pre-tax contributions lower the company’s FICA tax liability.
• Enhances Benefits Package – Helps attract and retain top talent.
• Flexible Plan Options – Employers can choose from Healthcare FSAs, Dependent Care FSAs, and Limited-Purpose FSAs.
• Employer Contributions (Optional) – Employers can contribute to FSAs, further increasing their appeal.

• Covers out-of-pocket medical, dental, and vision expenses
• Reduces taxable income for employees
• Funded entirely by the employee or with employer contributions

• Doctor visits & copays
• Prescription medications
• Dental & vision care (including orthodontics & LASIK)
• Over-the-counter medications & first aid supplies
• Mental health services & therapy

💡 Key Employer Benefit: Employees get tax-free savings on healthcare, making this a valuable low-cost benefit to offer.

• Covers childcare and elder care expenses
• Annual contribution limit: $5,000 per household ($2,500 if married filing separately)
• Employees must use funds for dependent care needed while working

• Daycare, preschool, and after-school care
• Babysitting or nanny services (work-related only)
• Elder care (for dependents unable to care for themselves)
• Summer day camps

💡 Key Employer Benefit: Helps working parents and caregivers stay productive at work by reducing their out-of-pocket childcare expenses.

• Can be used alongside an HSA
• Covers dental and vision expenses only
• Keeps employees HSA-eligible while offering additional pre-tax savings

Eligible Expenses: #

• Dental checkups, fillings, orthodontics
• Eye exams, glasses, contacts, LASIK

💡 Key Employer Benefit: If you offer HSA-compatible high-deductible health plans (HDHPs), a Limited-Purpose FSA allows employees to benefit from both an HSA and an FSA.

The IRS sets annual contribution limits for FSAs, which employers must enforce.

Employer Contributions: If an employer chooses to contribute to an FSA, the total cannot exceed the IRS limits.

FSAs are subject to a “use it or lose it” policy, meaning unused funds are forfeited at the end of the plan year unless the employer offers one of the following options:

• Carryover Option – Employees can roll over up to $640 of unused funds into the next plan year.
• Grace Period Option – Employees have 2.5 extra months after the plan year to use their remaining funds.

Employer Tip: Offering either the carryover or grace period increases employee participation by reducing risk of losing funds.

Employers offering an FSA under a Section 125 Cafeteria Plan are required by the IRS to have a written plan document. This document outlines the plan’s rules, eligibility, contribution limits, and administrative procedures.

• IRS Compliance – Mandated under IRC Section 125 & ERISA
• Legal Protection – Ensures plan rules are clearly defined and enforceable
• Avoids Tax Penalties – Without a written plan, the IRS may disqualify the FSA, making employee contributions taxable

Employer Tip: Even if your FSA is managed by a third-party provider, the employer is responsible for maintaining a compliant plan document. Consult with an ERISA attorney or your third-party FSA vendor to create a compliant plan document.

• Employer’s name, address, and EIN
• Plan name and effective date
• Eligibility requirements
• Contribution limits and funding rules
• Covered expenses & claims procedures
• Election changes and mid-year adjustments
• Grace period or carryover provisions (if applicable)
• Nondiscrimination testing procedures

Employers should work with an FSA provider to manage contributions, claims, and compliance. Popular providers include:

• HealthEquity
• WEX (formerly Discovery Benefits)
• Paychex
• ADP

Choosing a provider with automated payroll integration reduces administrative burden.

Employers must ensure pre-tax deductions are applied correctly for enrolled employees. Payroll integration simplifies administration and ensures IRS compliance.

Many employees are unfamiliar with FSAs and may not take full advantage of them. Employers should provide:

• Educational materials during open enrollment
• FSA enrollment workshops or webinars
• Reminders about deadlines & eligible expenses

Providing real-world examples of savings helps employees see the value of FSAs.

To maintain IRS compliance, Section 125 plans must pass nondiscrimination testing to ensure FSAs are not disproportionately benefiting highly compensated employees (HCEs).

A Flexible Spending Account (FSA) program is a cost-effective way to enhance your benefits package while reducing employer payroll taxes.

Key Takeaways for Employers: #

• FSAs lower payroll taxes while providing valuable benefits to employees.
• Offering a grace period or carryover increases participation.
• Pairing an HSA with a Limited-Purpose FSA optimizes tax savings.
• Dependent Care FSAs are a highly valued benefit for working parents.
• Working with a third-party administrator simplifies compliance and claims management.

By implementing an FSA program, businesses can offer valuable tax-saving benefits while keeping costs manageable.