Juice Up Your Company’s FSA Plan

Due to COVID-19 pandemic, many employees have incurred unexpected health and dependent care costs that go far beyond the usual run-of-the-mill expenses.

Give your employees more flexibility. Amend your company’s flexible spending account (FSA) plan to take advantage of liberalized rules.

The IRS has just issued new guidelines for FSAs in 2020. (IRS Notice 2020-29, 5/12/20).

Like a 401(k) plan, an FSA is funded with pre-tax dollars, so there are significant tax savings for employees. Employees direct employers to allocate part of their wages to their accounts, within certain limits, to be used to pay for qualified expenses.

Furthermore, the employer does not have to pay Social Security and Medicare (FICA) taxes or federal unemployment (FUTA) tax on amounts contributed to FSAs. Those benefits may offset some or all the cost of administering the plan. Plus, FSAs are good for employee morale. Result: It’s a win-win for employees and employers.

An FSA can be funded to provide for either healthcare or dependent care expenses. Some companies offer both types of FSAs. Although the rules vary slightly between the two, the basic premise is the same. Distributions paid for qualified expenses – for example, to have LASIK eye surgery or to pay a daycare center – are tax free. But withdrawals made for nonqualified expenses are fully taxable.

The annual contribution limit for a dependent care FSA is $5,000. Note: This figure is not indexed for inflation. Be aware, however, of the “use-it-or-lose-it rule.” If a participant does not empty out his or her account by the end of the plan year, the unused balance is generally forfeited. However, an employer can choose to allow a grace period of as long as 2½ months following the end of the plan year. In other words, the grace period for the 2020 plan year can extend through March 15, 2021, if the plan allows that.

Alternatively, an employer can allow FSA participants to carry over up to $500 of unused funds to the following year. Any excess is forfeited. For example, if an employee carried over $500 from 2019 and used an extra $400 in 2020, he or she loses $100.

An employer can allow the grace period or the carryover, but not both. The employer is not required to allow either.

Generally, an election relating to an FSA must be made before the first day of the plan year and is irrevocable. However, regulations allow for extenuating circumstances. Due to the COVID-19 health crisis, the new IRS notice allows employees participating in an FSA to revoke an election, make a new election or decrease or increase an existing election.

Election changes are usually prospective, but the IRS is allowing employees to benefit from these changes retroactive to January 1, 2020.

In addition, the new notice provides an option for employees to use leftover balances from the 2019 plan year to pay for expenses incurred after March 15, 2020. Finally, the IRS will now index the allowable carryover amount for inflation. The inflation adjusted carryover limit for 2020 is $550. If an employer decides to go along with these changes, it will require significant amendments to the plan.

Small Business Tax Strategies
August 2020