For the employee the premiums paid are pre-tax as explained in Lesson 89. The deductible is paid with post tax dollars. Thus, the employee only receives a partial tax-free benefit. To offset this unfair advantage larger employers have with less expensive overall costs for health coverage, Congress allows businesses to set up health savings, reimbursement and flexible spending accounts. This lesson first explains the differences in these three accounts; next a section covers the accounting involved and finally; a section provides some insights with appropriate application of these tax-free benefits.
Legal Differences in Tax-Free Benefits Accounts
These three types of accounts have different characteristics and rules to follow. This of course impacts the accounting related to each type of account. The following explains in more detail the respective accounts, their characteristics and rules.
Health Savings Accounts (HSA)
The health savings account is established for a single purpose – payment of qualified medical expenses incurred by an employee. This type of account is strictly an employee account whereby the employee makes income tax-free contributions. Note that these contributions are not FICA tax-free. The contributions reduce the taxable income for both federal and state purposes. This allows the employee to offset the high deductible for the respective insurance plan. As an example, suppose the plan has an out-of-pocket expenses limit of $10,000 for family coverage. An employee elects to have $4,800 withheld each year at a rate of $400 per month. This contribution is deposited into an account at a third-party provider. As the employee’ s family incurs medical costs throughout the year the employee is reimbursed the amount, therefore the account balance will fluctuate. The balance cannot go negative as the employee must pay any costs in excess of the $4,800 out of his pocket up to the $10,000 limit.
The rules for a health savings account are as follows:
(1) The employee must be covered by a high-deductible health plan (HDHP);
(2) Cannot by covered by a health reimbursement or flexible spending account (covered below);
(3) May contribute up to $3,350 for self-only/single plan coverage or $6,750 for family coverage per year (limits for 2016); AND
(4) The HDHP must require at least an A) annual deductible of $1,300 in 2016 for self-only coverage or $2,600 in 2016 for family coverage, and B) annual out-of-pocket limit of $6,550 (single) or $12,900 (family) in 2016.
This type of account works extremely well with young families and older employees as medical care is commonly for births and geriatric issues.
Health Reimbursement Arrangement (HRA)
The health reimbursement arrangement is very similar to a HSA except it is funded by the employer and not the employees. An account is set up for each qualified employee and the employer contributes an annual amount. Any unused portion is carried forward to the next year. Any payments made from the HRA is excluded from the employee’s income for tax purposes (both FICA and income taxes).
This type of arrangement works well for companies that have a high retention rate with staff. The employee is not allowed to have a HSA as the two will conflict with each other. To alleviate this, Congress allows the employee to have a flexible spending account.
Flexible Spending Arrangement (FSA)
The employer establishes this benefit for the employee. Either the employer or the employee may contribute to this plan. This plan can cover health care (not health insurance premiums), dependent care (such as child care) or adoption expenses. It is a direct reimbursement plan for these expenses fronted by the employee.
Any contributions made by the employer are excluded by the employee with determining gross wages. Employee contributions are also excluded from gross income if this plan is a function of a cafeteria plan. If not, contributions are income tax-free only.
There is a maximum dollar limit for the health portion of contributions. For 2016 it is $2,550. The child care component is limited to $5,000 per year.
There is one significant drawback to this kind of account. It is referred to as the ‘use-it-or-lose-it’ rule. Basically, any unused portion for either benefit is forfeited if not used by year-end. Plans are allowed a 2 1/2 month grace period to March 15th of the following year. In general, the forfeited amounts are returned to the employer.
Accounting For HSA, HRA and FSA’s
As with most benefits, there are two contributors – the employer’s contribution and the employee’s share. The employee’s share may be either totally excluded from gross income or the contribution is income tax free. If totally excluded, there is no requirement to pay either FICA or income taxes. This payment is recorded as a cost of the benefit in either cost of sales/ labor – benefits or in the expense section under management expenses. There is no requirement to reconcile employer contribution amounts to payroll tax Forms 941, 940 or to the W-2’s. However as explained in Lesson 89, the accountant should reconcile all payments made by the employer to the benefits spreadsheet and any reports from the benefit providers.
As for the employee contributions, it is essential that the human resources officer obtain the signed directive(s) from each employee to take money from the employee’s wages to purchase benefits, i.e. contribute funds to any benefit plan. HSA contributions are with FICA taxed dollars and is calculated as the difference between Social Security wages and taxable wages which is similar to how retirement contributions affect taxable income.
Since HRA contributions are strictly employer only contributions, it has no effect on the employee calculations. It gets a bit tricky with the flexible spending arrangement though. The underlying reasons are two-fold.
First is the connection to Section 125 of the Code. If it qualifies, any contribution made is excluded from gross income in calculating any form of tax, in effect it is an above the line deduction. Lesson 92 into more detail about this benefit. Secondly, is the issue with the ‘use-it-or-lose-it’ rule. Here the employer receives back any unused portion paid in to the plan. When this happens each year (if it happens) the employer simply credits benefits expense and debits cash.
The beauty of the FSA is that there is no need to reconcile to the 941 and the W-2 reports for payroll tax purposes. Remember, the value of the benefit is excluded from the employee’s gross wages.
One last note to the accounting function. When either a HRA or FSA plan is created the employer may either use a third-party administrator to manage the account for the monies or use in-house accounting staff to account for the respective in’s and out’s. Using in-house staff is only cost effective when exceeding 50 employees. Use an external trust company for full services with less than 50 employees.
All three of these plans have moved up with prestige since the health insurance mandate in 2014. Notice that the HSA and HRA are mutually exclusive, i.e. an employer cannot have both available at the same time. However, an employer may fund a HRA and the employee may fund the health portion of an FSA obtaining the best combination. Please note the funding level differences for the employee between a HSA and the health portion of a FSA.
Plan Health Care Contribution Maximum
Health Savings Acct $3,350 (single)/ $6,750 (family)
Flexible Spending $2,550 for any coverage
This difference is important. If the organization is family driven, the HSA is by far superior in allowing for greater contributions by employees. However, child care does come into play here. The FSA allows for the second benefit of contributing excludable wages for child care costs.
Don’t forget a very important rule here, health savings accounts are designed for high-deductible health plans which are very common in small business.
To provide some insight into this, look at these two different organizations and how they handled their health care benefits package.
Three Rivers Auto
Three Rivers Auto owns four Firestone franchises with 74 employees. 56 of the employees are mechanics, mostly young. Many experienced mechanics depart the organization for higher compensation at dealership repair facilities. The average compensation for an employee at Three Rivers is $61,000 per year. Three Rivers purchased a high-deductible health plan with out-of-pocket costs of $3,200 for single coverage and $6,800 for family plans. Three Rivers pays the first $108 of either monthly premium for every employee.
Because of the high turnover rate and overall younger average age, Three Rivers sets up a HSA benefit and allows employees to contribute to their respective accounts up to the maximum allowed. The idea behind this isn’t to retain employees but to extend their service duration. Management recognizes that it cannot compete with the compensation packages offered at dealerships.
Stetson, Ballcap & Fedora, P.C.
Stetson, Ballcap & Fedora, P.C. (Stetson) is a legal services company serving a geographical territory with four offices. There are 96 employees of which 37 are either full or junior partners. The managing board has a goal of orienting benefits to serve partners. The health plan purchased is a premium plan with a low deductible. On average, Stetson pays over 50% of the premium for health insurance. Only about 20 of the employees are either recent hires (< 3 Yrs on the job) or hired for a particular project. The balance of the staff have been with the company for long periods of time and are committed to the success of the firm.
To help the partners and staff, Stetson decided against a HRA and purchased a full (health and dependent care) type of flexible spending plan for the staff. Partners and employees may contribute to cover the low deductible cost along with any costs for child care.
Notice the difference between the two companies. In one, employee retention and security is not the primary purpose in providing benefits. The benefits provided at Three Rivers is designed to recruit and extend the employee’s tenure; management has accepted the fact that once a mechanic has the experience, they will move on to better jobs.
At Stetson it is about retention and security for the professional staff. Think about how many resources is expended to find a qualified staff member, train them and get them productive. Retention is critical for the firm’s long-term success. Therefore the benefits are designed to take care of the staff and maximize overall value of compensation to the staff.
Summary – Health Savings, Reimbursement and Flexible Spending Plans
Health savings accounts, reimbursement and flexible spending arrangements are additional tools used with the health insurance benefit to reduce the overall cost of health care to employees. HSA’s are strictly employee accounts set-up to allow the employee to contribute additional tax-free dollars to offset the out-of-pocket expenses high-deductible health plans require. HRA’s are employer accounts that reimburse employees for out-of-pocket costs. Notice that health savings accounts are employee paid and health reimbursement arrangements are employer paid. Both are income tax-free to the employee.
The HRA is also FICA tax-free to the employee. A company cannot have both. A flexible spending arrangement is a hybrid of both and is not allowed with an existing HSA. The FSA is considered the Cadillac for this group of benefits as it also allows the employee to include dependent care costs and adoption expenses. FSA’s work best for organizations that want to provide long-term security and retention of staff. ACT ON KNOWLEDGE.