How Does FSA Payroll Deduction Work?
Understand the operational details of FSA payroll deductions, including their effect on taxable wages and how they are systematically managed and reported.
A Flexible Spending Account (FSA) is an employer-sponsored benefit allowing an individual to set aside earnings for healthcare or dependent care costs. Participation is established during an open enrollment period, where an employee elects an annual contribution amount. These contributions are collected through pre-tax payroll deductions, a feature that impacts an employee’s paycheck and year-end taxes.
Understanding FSA Payroll Deductions
The defining characteristic of an FSA contribution is its pre-tax status, meaning the money is subtracted from an employee’s gross pay before most taxes are calculated. FSA deductions reduce the income subject to federal income tax, state income tax, and FICA taxes (Social Security and Medicare). The FICA tax rate is a combined 7.65%, composed of a 6.2% Social Security tax on wages up to an annual limit and a 1.45% Medicare tax with no wage limit.
To illustrate, consider an employee with a gross bi-weekly pay of $2,500 who contributes $100 per paycheck to a healthcare FSA. With the FSA, their taxable wage for federal, state, and FICA purposes is reduced to $2,400. This $100 difference directly lowers the amount of tax withheld from that paycheck.
By lowering the taxable income base, the employee’s overall tax liability for the year is reduced. While take-home pay will decrease because of the contribution, the tax savings mean the reduction is less than the full amount contributed.
Employer Payroll Processing for FSAs
For an employer, administering FSA deductions requires a precise payroll setup. The process begins by establishing a unique deduction code within the payroll system for FSA contributions. This code must be configured as a pre-tax deduction under Section 125 of the Internal Revenue Code, which ensures the system subtracts the amount from gross wages before calculating taxes.
The employer is responsible for tracking each employee’s annual contribution, which is divided by the number of pay periods to determine the per-paycheck deduction. The payroll department must ensure this specific amount is deducted each pay cycle.
Beyond the deduction, the employer aggregates the withheld funds and remits them to the third-party administrator (TPA) that manages the plan. This transfer must be done according to the service agreement with the TPA. The employer also maintains records to reconcile the amounts deducted with the funds sent to the administrator.
FSA Reporting on Form W-2
The tax-advantaged nature of FSA contributions is reflected on an employee’s year-end Form W-2. The total amount contributed to a healthcare FSA is excluded from the taxable wages reported in Box 1 (Wages, tips, other compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages and tips).
For informational purposes, many employers report the total health FSA contribution in Box 14, labeled “Other.” While there is no standard code, employers often use descriptions like “FSA” or “SEC125” to denote the amount. This entry provides a clear record of pre-tax contributions.
Dependent Care FSA benefits are handled differently. The total amount of dependent care benefits paid out or incurred is reported in Box 10 of the W-2, which includes amounts the employee contributed via payroll deduction.