Many businesses now offer, as part of their health care benefits, various types of accounts that reimburse employees for medical expenses on a tax-advantaged basis. These include health Flexible Spending Accounts (FSAs), Health Reimbursement Arrangement (HRAs), and Health Savings Accounts (HSAs, which are usually offered in conjunction with a high-deductible health plan).
For employees to get the full value out of such accounts, they need to educate themselves on what expenses are eligible for reimbursement by a health FSA or HRA or for a tax-free distribution from an HSA. Although an employer should not provide tax advice to employees, you can give them a heads-up that the rules for reimbursements or distributions vary depending on the type of account.
IRS Publication 502
Unfortunately, no single publication provides an exhaustive list of official, government-approved expenses eligible for reimbursement by a health FSA or HRA or for a tax-free distribution from an HSA. IRS Publication 502 — ‘Medical and Dental Expenses’ (Pub. 502) comes the closest, but it should be used with caution.
Pub. 502 is written largely to help taxpayers determine what medical expenses can be deducted on their income tax returns; it is not meant to address the tax-favored health care accounts in question. Although the rules for deductibility overlap in many respects with the rules governing health FSAs, HRAs, and HSAs, there are some important differences. Thus, employees should not use Pub. 502 as the sole determinant for whether an expense is reimbursable by a health FSA or HRA or eligible for tax-free distribution from an HSA.
You might warn health care account participants that various factors affect whether and when a medical expense is reimbursable or a distribution allowable. These include:
Timing rules: Pub. 502 notes that expenses may be deducted only for the year in which they were paid, but it does not explain the different timing rules for the tax-favored accounts. For example, a health FSA can reimburse an expense only for the year in which it was incurred, regardless of when it was paid.
Insurance restrictions: Taxpayers may deduct health insurance premiums on their tax returns if certain requirements are met. However, reimbursement of such premiums by health FSAs, HRAs, and HSAs is subject to restrictions that vary according to the type of tax-favored account.
Over-the-counter (OTC) drug documentation: OTC drugs other than insulin are not tax-deductible, but they may be reimbursed by health FSAs, HRAs, and HSAs if substantiation and other requirements are met.
The pandemic has put a renewed emphasis on the importance of employer-provided health care benefits. The federal government has even passed COVID-19-related relief measures for some tax-favored accounts.
As mentioned, the more that employees understand these benefits, the more they will be able to effectively use them — and the greater appreciation they will have of your business for providing them. Our firm can help you fully understand the tax implications, for both you and employees, of any type of health care benefit.