How a Flexible Spending Account Works for Employers

Flexible Spending Accounts (FSAs) allow employees to set aside pre-tax money for qualified healthcare or dependent care expenses. Employers offering these plans provide a mechanism for employees to reduce their taxable income. This employer-sponsored benefit involves specific responsibilities for employers, from initial setup and ongoing administration to tax considerations and compliance with federal regulations.

Understanding Employer Responsibilities in FSA Setup

Establishing a Flexible Spending Account requires employers to make foundational decisions about the plan’s structure. This includes determining the types of FSAs to offer, such as healthcare FSAs and dependent care FSAs. Employers must also align contribution limits with annual IRS guidelines, which are subject to change; for instance, the healthcare FSA maximum contribution for 2025 is $3,300, while the dependent care FSA limit is generally $5,000 per household.

Employers must decide on the “use-it-or-lose-it” rule, where unspent FSA funds are typically forfeited at year-end. To add flexibility, employers can offer a grace period of up to 2.5 months into the new plan year, or a carryover option for a portion of unused healthcare FSA funds (e.g., up to $660 for 2025). Employers can choose only one of these options, or neither.

Many employers partner with a Third-Party Administrator (TPA) to manage FSA plans. TPAs handle administrative tasks, from processing claims to ensuring regulatory compliance. When selecting a TPA, employers should evaluate their expertise, experience, compliance knowledge, and the range of services offered.

Formal plan documents are essential for FSA setup: a written FSA plan document and a Summary Plan Description (SPD). The plan document establishes the plan’s terms and conditions, while the SPD provides an understandable overview of employee rights and responsibilities. These documents are essential for compliance and must be maintained and sometimes distributed to employees.

Implementing and Administering the FSA

Employers are responsible for ongoing implementation and administration of the FSA. The employee enrollment process typically occurs during an annual open enrollment period. Employees also have opportunities to enroll or adjust their contributions due to qualifying life events, such as marriage, divorce, or the birth of a child.

Employers accurately deduct employee contributions from paychecks on a pre-tax basis, meaning they are taken from an employee’s gross income before federal, state, and FICA taxes are calculated. The employer then remits these collected funds to the TPA, who manages the individual employee accounts. For dependent care FSAs, funds become available as they are contributed, while for healthcare FSAs, the full elected annual amount is available on the first day of the plan year, regardless of how much has been contributed so far.

The employer’s role in claims processing involves facilitating the TPA’s operations rather than direct claims management. Employers provide necessary employee data and reconcile accounts to ensure accurate contributions and reimbursements. The TPA handles expense substantiation and direct reimbursement to employees, which streamlines the process for the employer.

Employers must maintain internal reporting and record-keeping related to FSA contributions and distributions. This documentation is important for financial audits, compliance checks, and addressing employee inquiries.

Employer Tax Considerations

Offering an FSA provides employers with tax advantages through reduced payroll tax liabilities. Employee contributions are deducted from wages before FICA (Federal Insurance Contributions Act) taxes are calculated. This pre-tax treatment lowers employee taxable income and reduces the employer’s FICA tax obligation.

FICA taxes include Social Security and Medicare taxes. By reducing the employee’s gross income subject to these taxes, the employer saves on the amount contributed to the FSA by each employee. These savings can often offset the administrative costs of offering the FSA, potentially making it a self-funding benefit for the employer.

Employers are not required to contribute to employee FSA accounts; FSAs are primarily funded through employee salary reductions. If an employer chooses to contribute, these amounts are typically tax-deductible for the employer and are not considered taxable income for the employee.

Employers have tax reporting responsibilities for FSA deductions. Employee contributions are pre-tax and reduce taxable wages, generally not reported in Box 1 of the employee’s W-2 form, representing a reduction in gross income. For dependent care FSAs, contributions are reported in Box 10 of the W-2 for informational purposes.

Maintaining FSA Compliance

Employers offering Flexible Spending Accounts must ensure ongoing compliance with federal regulations. Adherence to IRS nondiscrimination rules is important to prevent plans from disproportionately favoring highly compensated employees (HCEs) or key employees. These rules examine eligibility, benefits, and contributions to ensure equitable access and benefits distribution. Failure to pass these tests can result in the loss of the plan’s tax-favored status, making contributions taxable for HCEs.

Healthcare FSAs are subject to the Employee Retirement Income Security Act (ERISA). ERISA imposes various requirements, including reporting and disclosure obligations. For instance, plans with 100 or more participants may be required to file an annual Form 5500 with the Department of Labor. Employers must also ensure that plan documents and Summary Plan Descriptions meet ERISA’s specific content and distribution requirements.

The Consolidated Omnibus Budget Reconciliation Act (COBRA) also applies to healthcare FSAs. Employers must offer continuation coverage to qualified beneficiaries who lose coverage due to certain qualifying events, such as termination of employment or reduction in hours. While few employees may elect COBRA for an FSA, the legal obligation to offer it remains to avoid penalties.

Employers have responsibilities under the Health Insurance Portability and Accountability Act (HIPAA) regarding the privacy and security of employee health information. A healthcare FSA is considered a group health plan under HIPAA, requiring employers to implement safeguards for Protected Health Information (PHI). This includes entering into Business Associate Agreements with TPAs, establishing internal privacy policies, and limiting access to PHI to only those necessary for plan administration.