LAST REVIEWED Apr 10 2019 14 MIN READ
By Damian Davila
At the top of the list of the most requested benefits by employees is the ability to cover health care costs. More and more employers are making available Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs) to their employees to help them budget for medical expenses.
This article is for employees who have the option to choose between an FSA and an HSA, and want to know how this impacts personal finances. However, we also offer some help for employers who are deciding between which one to offer and the differences from a company perspective.
FSA vs HSA – What’s the difference?
While FSAs and HSAs are both tax-incentivized plans in which you can set aside money for qualified medical expenses, the main differences are in eligibility, contribution limits, and rollver capabilities. You can find more details on each of these below.
Why should I care about an FSA or HSA at all?
The main reason is that FSA and HSA plans are “Cafeteria Plans” governed by IRS Section 125, which allows you to deduct a portion of every paycheck on a pre-tax basis and reduce your taxable income. By contributing with pre-tax dollars to a FSA or HSA to cover eligible medical, dental, and vision expenses, you can increase your take home pay.
Let’s assume that you make $60,000 per year, have a tax rate of 25%, and spend $2,500 out-of-pocket in expenses not covered by your medical plan.
|Your Annual Income||FSA/HSA Pre-Tax Contribution||Taxable Income||Taxes (25%)||After-Tax Medical Expenses||Take Home Pay|
|Without FSA or HSA||$60,000||$0||$60,000||-$15,000||– $2,500||$42,500|
|With FSA or HSA||$60,000||– $2,500||$57,500||-$14,375||$0||$43,125|
If you were not to opt for a medical cafeteria plan, then you would only be able to deduct qualified medical expenses that exceed 10% of your adjusted gross income (AGI). Assuming that your AGI were $50,000, you would only be able to deduct medical expenses in excess of $5,000 and have to wait as much as a whole year to take advantage of that tax break. With an FSA or HSA, you can reduce your tax liability and keep more of your paycheck right away.
So, which plan should I choose? HSA or FSA?
While a FSA doesn’t have eligibility requirements, an HSA is only available to individuals who:
Are enrolled in a High Deductible Health Plan (HDPH) with an annual deductible of at least $1,300 for personal coverage or at least $2,600 for family coverage
Are not listed as a dependent on another person’s tax return
Aren’t enrolled in Medicare
If you don’t meet all of these criteria, then you have no option than to choose a FSA. Which of course, given its tax advantage, it’s not a bad situation at all. However, what if you were to have both options available? Let’s run some key criteria to consider to determine the better fit.
1. What are your annual medical expenses?
The higher your eligible medical expenses, the more it makes sense to choose an HSA over a FSA. In 2017, you can only contribute up to $2,600 to an FSA for individual coverage. On the other hand, you can contribute up to $3,400 to an HSA for individual coverage.
2. Have you reached age 55?
Starting age 55, HSA plan holders can make a catch-up contribution on top of the regular limit. In 2017, that annual catch-up contribution can be of up to $1,000. Additionally, if you were to have a family HSA plan and your spouse were to be over age 55 as well, then each one of you could contribute an extra $1,000 per year to the plan.
3. Have you reached age 65?
The older you’re, the more it pays to hold an HSA. Starting age 65, you can use your HSA funds for non-qualifying medical expenses without the hefty 20% penalty from the IRS. Still, you’ll be liable for applicable income taxes.
4. Do you need flexibility in changing contribution amounts?
With a FSA, you can only adjust your contribution from each paycheck during open enrollment or during a qualifying life event, such as marriage or birth of a child. With an HSA, you can adjust your paycheck contribution throughout the year.
5. How predictable are your medical expenses?
Depending on your ability to budget for medical expenses, you may or may not find yourself at the end of the year with a balance on your plan.
Any unused balance on a FSA by December 31st of every year is subject to a “use it or lose it” rule. An employer may choose to let you carry over up to $500 to the next year, the entire balance until March 15th of the next year, or nothing at all. Under law, an employer is not forced to let you carry over an unused FSA balance. On the other hand, an HSA allows you to carry over any unused balance year after year.
6. Does your employer provide matching contributions?
While employers can provide matching contributions to both FSAs and HSAs, your employer may chose to only provide matching contributions to one type of plan. Inquire with your HR department for more details.
7. Do you need to supplement your retirement savings?
There are three ways an HSA can help retirement savers.
Since you can carry over unused HSA balances year after year, then you could create a separate fund for medical expenses during retirement and boost your total retirement savings. For example, in 2018 you could contribute up to $18,500 to a 401(k) for non-medical expenses and up to $3,400 to an HSA with individual coverage for qualifying medical expenses.
While distributions from a 401(k) during retirement are subject to applicable income taxes, withdrawals from an HSA aren’t subject to taxes as long as they’re used for qualifying medical expenses.
Contributions to an HSA can gain interest. Depending on your provider, you could choose from a wide range of options, including savings accounts insured by the FDIC, mutual funds, and index funds.
8. How long do you plan to stay with your current employer?
The balance on your HSA is always portable from one employer to another. The one on your FSA is only portable for FSA continuation through COBRA.
Can I use both an FSA and an HSA?
The only way for you to be able to enroll in both a FSA and HSA is to select an HSA and a limited-purpose FSA. By limiting a FSA to eligible dental and vision expenses, the IRS allows you to contribute to a both types of plans. Choosing a limited-purpose FSA plan allows you to minimize withdrawals from an HSA, allow funds in the HSA to grow tax-free longer, and cover medical and vision expenses with pre-tax dollars from the limited-purpose FSA.
To learn more about other types of FSA plans, review Beyond an FSA: Dependent Care, HSA, Adoption, and More.
For employers: Offering FSAs and HSAs to your employees
By offering ways to help your employees use tax-free dollars to better manage their healthcare costs, you’ll have a powerful tool to recruit and retain talent. However, it’s important to understand the pros and cons of offering these plans from a company perspective.
Pro: Tax breaks for the company
When an employee enrolls in an HSA or FSA, the employer no longer has to pay his portion of the Social Security (6.2%) and Medicare (1.45%) taxes on the employee’s contributions to those accounts. This means that the employer reduces his payroll taxes by 7.65% of total employee contributions.
Let’s imagine that a company has 20 employees and a total payroll of $1 million. Without a FSA or HSA plan, the company would owe $76,500 in Social Security and Medicare taxes. However, if each of the 20 employees were to contribute $2,600 to a FSA, then the employer would save $3,978 in annual taxes.
Additionally, employers who match contributions to FSAs and HSAs don’t have to pay payroll taxes on those matched funds. The costs of running the program in-house or outsourcing it to a third party are tax deductible as business expenses.
Con: Potential cash crunch for the company
Under the Uniform Coverage Rule, an employee enrolled in a FSA is entitled to receive the full amount of her annual election since day one of the plan, regardless of how much the employee has contributed. This means that in the example of our 20-employee company, assuming that all 20 employees were to make an annual election of $2,600, the company has to be ready from the first day of the FSA to provide a reimbursement of up to $52,000. And the company can’t recover reimbursements once it lays off or fires an employee.
To avoid a cash crunch, a company must set aside enough cash to address FSA reimbursements that fall short of current employee contributions. The IRS allows employers offering a FSA to keep unused funds to cover the costs of administering the FSA program. Another way is to dovetail a cash crunch is to offer a HSA. All reimbursements from an HSA are limited to the current level of contributions.
Summary for employers
In summary, from an employer perspective there’s not a big financial difference between offering a FSA or HSA. At the end of the day it comes down to the preferences of employees to budget for their health care expenses. However, given HIPAA, employers can’t poke too much into the medical history of employees so it’s often best to work with a third-party provider to find out what employees would really want. Make sure to compare the cost of implementing and administering the plan in-house against the cost of outsourcing administration to a reputable provider. While the outsourcing costs may offset some of the tax breaks, those costs could help ensure that your company meets all legal requirements outlined by the IRS and other agencies.
The bottom line: Get ready for upcoming open enrollment
HR departments are gearing up for the upcoming open enrollment for FSA and HSA plans. Since the majority of companies start open enrollment in October, some will start releasing information about their plans in just a few months. Get ready by reviewing your total medical expenses for the previous year, determining whether or not a HDHP makes financial sense for your unique situation, and evaluating your current retirement strategy. While an HSA is often the better choice when you’re eligible for both plans, you can still obtain tax breaks with a FSA. No matter which option you choose, you’ll be able to increase your take home pay!
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.