Avoid discrimination with your FSAs

Employers often provide an array of benefits to employees. One such benefit is a health flexible spending account (FSA), which allows employees to contribute pretax dollars to be used for unreimbursed medical expenses incurred during the year. FSAs are considered self-funded health plans and must not discriminate in favor of highly compensated employees.

Highly compensated employees and FSAs

Employers often think having a nondiscriminatory eligibility policy allowing all full-time employees to participate if they choose is sufficient to comply with nondiscrimination requirements, but it’s much more complicated. Even though any employee is eligible to participate, your FSA can violate nondiscrimination requirements if highly compensated employees participate in greater numbers than non-highly compensated employees.

Because highly compensated employees typically have more discretionary income and are more likely to be looking for ways to reduce their taxable income, they are more likely to participate in FSAs than employees in lower income brackets. When a higher proportion of highly compensated employees participate in an FSA than non-highly compensated employees, it can violate nondiscrimination rules even though you offered the benefit on a nondiscriminatory basis.

To ensure an FSA isn’t discriminating in favor of highly compensated employees, you should have your insurance vendor provide or arrange for nondiscrimination testing. The vendor will run eligibility and benefits tests prescribed by the IRS to determine whether the FSA has a discrimination issue.