FSAs, HRAs and HSAs: Which One Is Right for Your Employees?
Flexible spending accounts (FSAs), health reimbursement arrangements (HRAs) and health savings accounts (HSAs) can help lessen the financial burden of employees’ medical costs. All three allow employees to set aside pretax dollars so they (and their family members or dependents) can pay for qualified medical expenses (QMEs).
From a practical standpoint, QMEs include things like:
- Over-the-counter and prescription medications and supplies
While all of these plans are designed to provide some pretax relief to offset health care costs, they differ in many ways.
FSAs: Flexible spending accounts
An FSA is a way for an employee to be reimbursed for QMEs after setting aside pretax funds from their salary. FSAs can be an attractive way for employees to budget for QMEs because the money is automatically deducted from their gross income and isn’t subject to employment or federal income tax. The reimbursements are also tax-free for QMEs. And, even if an employee hasn’t yet put funds in an FSA, they can still use it to pay for QMEs. That’s because the employee’s entire contribution for the year becomes available the day they enroll.
There is no tax reporting requirement for an employee’s income tax return with an FSA. And you may offer an FSA along with other employer-provided benefits as part of a cafeteria plan. However, self-employed individuals cannot participate in FSAs and some limitations may apply for highly compensated employees.
To participate in an FSA, an employee must elect how much money they want withheld from their pay at the beginning of the plan year. This is generally done through a salary reduction agreement.
You can also contribute to your employees’ FSAs. While the money in an FSA is generally not counted as income, if you make contributions to cover long-term insurance, that benefit must be included as income.
The FSA contribution limit may vary from year to year (due to changes in IRS rules). For example, the contribution limit was $2,750 for 2021. Employees should know that any money contributed to an FSA that is not spent down by the end of the plan year is forfeited, unless an exception allowing the benefit to carry over applies.
To receive a reimbursement, an employee must provide a written statement from an independent third party, such as a medical provider. The document must state the QME and the amount, and certify that the expense hasn’t been paid or reimbursed under any other coverage plan.
HRAs: Health reimbursement arrangements
An HRA is an employer-funded account that, unlike an FSA, cannot be funded through a voluntary salary reduction. It provides a way for employees to be reimbursed tax-free for QMEs up to a maximum amount for the applicable coverage. An HRA may be offered with another health plan, such as an FSA.
The contributions, which are not subject to a limit on the dollar amount, are not counted toward an employee’s income. Therefore, employees don’t pay federal or employment taxes on the funds. Like an FSA, self-employed individuals are excluded from participation.
Employees are generally permitted to carry over unused funds from year to year, so long as you don’t refund any of the balance to them. However, the IRS notes that if a distribution is made to an employee, that amount must be included in their gross income. This rule applies whether the unused reimbursement is made payable to the employee upon termination, upon their death (in which case it may be payable to their beneficiary as cash) or at the end of a plan year. It is also possible for an employee to transfer an unused reimbursement amount to a retirement plan at the end of the year.
HSAs: Health savings accounts
An HSA is a tax-exempt trust that an employee can set up to pay for or reimburse themselves for QMEs associated with a high-deductible health plan. Any eligible individual, such as an employee or their family member, may contribute to an HSA. Unlike FSAs and HRAs, self-employed (or unemployed) individuals may contribute.
For 2022, minimum annual deductibles were set at:
- $1,400 for self-coverage
- $2,800 for family coverage (eligible individual plus at least one family member)
Maximum annual deductibles and out-of-pocket expenses were set at:
- $7,050 for self-coverage
- $14,100 for family coverage
The IRS notes the limit doesn’t apply to deductions or expenses for out-of-network services, and only the above figures should be used for calculating the applicable limits.
The maximum HSA contribution for 2022 was:
- $3,650 for self-coverage
- $7,300 for family coverage
The contributions made to an HSA can be excluded from an employee’s gross income, and they sit in the account until they’re used. If an employee under age 65 withdraws funds from an HSA for a nonqualified expense, income tax and a penalty apply.
The bottom line
There are many additional nuances that apply to FSAs, HRAs and HSAs. For instance, if an individual is eligible for Medicare, they may or may not be able to participate. As a best practice, consult with an experienced benefits broker or employee benefits or tax attorney who can walk you through what’s best for your workforce. You can also find an in-depth discussion about each of these plans in IRS Publication 969.
This content is for informational purposes only and not for the purpose of providing professional, financial, medical or legal advice. You should contact your licensed professional to obtain advice with respect to any particular issue or problem.