New Rules for Flexible Spending Accounts Are Likely to Increase Usage

    Thanks to a September IRS ruling, Seguine’s flexible spending account just got a little better. Now he can use the funds to cover over-the-counter medications. "Anything that allows you to have reimbursement for your medical needs is a boon, and that makes this particular benefit that much more attractive," he says. He hopes that he’ll be able to use pretax dollars to buy breathing strips, which help reduce snoring, since it’s a regular purchase for him.

    Seguine is among the approximately 15 percent of University of Michigan employees who enroll in flexible spending accounts each year. Of nearly 30,000 employees at the university, only 3,506 opted to use FSAs to pay for doctor’s visits and prescription medications in 2003. And only 1,102 employees are currently enrolled in FSAs to pay for preschools, day care, summer day camps or elder care.

    Marty Eichstadt thinks that more employees could benefit from using flexible spending accounts. As the university’s benefits director, she began a campaign this year to interest employees in using pretax dollars for health-care and dependent-care expenses. "Our real concern is enabling our employees to use their resources in the best way possible," Eichstadt says. In September, her campaign got a boost from the IRS. The agency issued this ruling to address the fact that many former prescription drugs such as Claritin, an allergy medication, and Prilosec, a heartburn medication, are now available over the counter, so they’re not covered by prescription-drug plans. By using pretax dollars, employees can save up to one-third of the price of these medications, depending on their tax bracket.

    On September 12, Eichstadt’s office sent an e-mail message to faculty and staff at the University of Michigan about the new ruling: "The new IRS ruling allows reimbursement for over-the-counter medications, tax-free (federal) when the OTC product is used for medical purposes." Examples of medications that qualify under this definition include allergy and heartburn medications, smoking-cessation products, pain relievers, cold medicines, cough syrups, topical steroids and contraceptive products. Eichstadt’s message noted that certain items would not be covered under the new IRS guidelines, including over-the-counter products that are not medicines or drugs and merely benefit the general health of an FSA participant. These items include cosmetic products like face cream, toiletries such as shampoo, and dietary and herbal supplements.

    It’s too early to tell if Eichstadt’s campaign and the new IRS ruling have substantially increased enrollment in FSAs because the final numbers won’t be in for a few weeks. But looking at the preliminary numbers, she says that an increase is likely.

Low participation in FSAs overall
    The FSA enrollment level at the University of Michigan is typical for an employer. On average, employers that offer FSAs sign up only 15 percent of their eligible employees. "It’s a tragedy it’s so low; it can save you an enormous amount of money," says Tom Billet, senior consultant at Watson Wyatt. "Many people are afraid of the use-it-or-lose-it rule, but with a reasonable amount of forethought, that wouldn’t happen." The new rule is a money-saver for both employers and employees. Since funds placed into an FSA are all pretax dollars, contributions lower an employee’s taxable income. This also lowers the income tax dollars both employers and employees pay to the IRS.

    For large companies such as CenturyTel, the savings can be dramatic. Last year, the 6,000-employee company, which is located in 22 states, paid over $100 million in federal income taxes. Currently, only 10 percent of the company’s employees are enrolled in FSAs. But if the company could increase the level of participation, the organization might be able to reduce its federal income taxes significantly. While CenturyTel wouldn’t give any estimates on its tax savings, companies often save about 10 cents on each dollar invested in a flexible spending account. Of the savings, about 7 cents comes from FICA tax and 3 cents from workers’ compensation. So, assuming that each employee invests $1,000--the average amount that employees contribute to FSAs--CenturyTel would save about $60,000 in taxes per year. However, if CenturyTel could convince 20 percent of its employees to enroll in FSAs, the company would save $120,000 in taxes. "We obviously see it as a benefit for the employee and the company," says Marina Pearson, vice president of compensation and benefits.

    Eichstadt says that the University of Michigan uses any tax savings to offset the administrative fees it pays to SHPS, the third-party administrator that handles the flexible spending accounts for its employees. "It’s a wash," she says.

    Smaller companies might not see as dramatic a savings, but still can benefit by encouraging employees to sign up for FSAs. New Edge Networks, for instance, has 286 employees, with 15 percent enrolled in FSAs. The company won’t say exactly how much money its employees contribute to FSAs, but assuming that each employee invests the average amount--$1,000--the company would have roughly $43,000 invested in FSAs each year. "For every dollar invested in FSAs, we see a 7.5 percent tax savings," says Scott Noren, benefits administrator at New Edge. That works out roughly to a tax savings of $3,225 per year.

    For employees, the tax savings will vary according to the individual. "If you live in New York, it could be worth a 45 percent savings," Watson Wyatt’s Billet says, factoring into his calculations a 30 percent federal tax, a 7 percent state tax and a 7 percent Social Security tax. New Edge Networks is in the process of moving from an August-July benefits year to a calendar year and so is currently in a shortened benefits season, from August to December. The company was able to offer its employees currently enrolled in FSAs the over-the-counter medication benefit. Scott Noren says that he dug through his old receipts for over-the-counter medications that he’d bought since August 1 and it saved him about 30 percent.

Dual-purpose meds
    The IRS has clearly outlined rules for eligible child-care and health-care expenses for FSAs, but the rules regarding over-the-counter medications are much broader. "While the guidelines provided by the IRS are generally helpful, they’re not as definitive as a list would be," Billet says. And it’s up to each company or third-party administrator to determine which medications will be covered.

    "There’s confusion caused by the IRS’s lack of clarity with regard to eligible and ineligible expenses and documenting those expenses," says George K. Reese III, president of FlexAmerica, a third-party administrator. The issue becomes fuzzy around items that serve a dual purpose. For instance, vitamins would not be covered unless they were prescribed for a pregnant woman. Sunscreen could go either way. Some third-party administrators refuse to cover it unless employees get a doctor’s note saying that it’s necessary because of a history of skin cancer. Others argue that sunscreen’s only purpose is to protect against skin cancer, so they automatically cover it.

    "It’s ridiculous what the IRS wants someone to go through to get a reimbursement documented for Advil," Reese says. For instance, while certain quantities of Advil might be covered automatically, larger amounts, such as a 350-count bottle, might require a note from a physician. "A 350-count bottle of Advil is $14," Reese says. "As an administrator, how much am I going to spend to see if that’s legitimate?"

Increased use of FSAs
    The new IRS rule is not mandatory. It’s up to each company to decide whether it wants to offer the option to its employees. However, third-party administrators say that most of their clients are interested in using FSAs for over-the-counter medications. Employers anticipate that this will encourage employees to use FSAs. "We expect an increase of 15 to 20 percent," says Colleen Nelson, a senior benefits consultant at Conexis, a third-party administrator. Currently, employee enrollment among its clients hovers around 14 to 18 percent. "We expect that to increase substantially," she says.

    Already, this ruling has increased the claims volume that Conexis typically sees. In just the first few weeks that it offered use of FSAs for over-the-counter meds, the company saw claims volume increase by 33 percent. "One out of every three claims is including over-the-counter drugs, and we haven’t actively marketed this yet," Nelson says. Conexis hasn’t started to charge for an increase in claims, but it’s possible that some third-party administrators will raise rates to cover the administrative costs of processing claims. "We don’t anticipate raising prices at this time," Nelson says.

    Other third-party administrators have already decided to raise rates. Wausau Benefits in Wisconsin is going to charge an extra 8 percent for companies that plan to include over-the-counter medications. "We think it will be virtually everybody," says Jay Coldwell, the company’s product director. So far, he says, about 10 percent of its claim volume is for over-the-counter medications, and "it’s growing all the time." Companies such as CenturyTel that pay their third-party administrators by the claim could be in for a big surprise if volume does increase 10 to 30 percent. It’s too early to guess how many employees will sign up to use FSAs to save money on over-the-counter medications. Once open enrollment is complete, many companies will have a better idea of how many employees will take advantage of the option. "Nobody is really sure how this is going to play out in January," Coldwell says. "We are going to track the usage so we can do the research."