QUESTION:

One of our five employees (who's covered by our current health insurance plan) has asked that we establish a flexible spending account. We're wondering if it would be easier, cheaper and a better idea to establish a health savings account instead of an FSA. Our four remaining employees are covered by Medicare or their retired spouses' policies.
—Eileen Flynn, John J. Flynn Consulting Engineers, Norwalk, Conn.

ANSWER:

It depends on what your employees want — and what you, as the employer, are willing to provide.

If you establish an FSA, you'll give your employees a way to sock away pretax dollars for co-pays, deductibles and other expenses not reimbursed by medical insurance. Also, your employees covered by Medicare or other plans can utilize FSAs for noncovered expenses. There's no statutory limit, but most employers fix the maximum annual contribution at $5,000. You'll save 7.65% in payroll taxes on the wages set aside. Generally, that amount should cover the FSA plan's administrative costs, which typically range from $50 to $100 a month.

HSAs work a bit differently. Like FSAs, employee contributions are excluded from payroll taxes, and withdrawals are made tax free as long as they're used for medical expenses. Annual contributions are limited, however, to $2,900 for an individual and $5,800 for families. A big selling point is that HSAs — unlike "use it or lose it" FSAs — can roll over year to year and turn into hefty nest eggs. There is one catch, though: These accounts must be paired with a high-deductible health plan, which in 2008 are defined as plans with a $1,100 deductible for individuals or $2,200 for family coverage.

In your situation, setting up an FSA could be the best route, especially since your company already has a health-insurance plan in place, and your employees covered by others plans (including Medicare) wouldn't be eligible to participate in an HSA. Just be aware that there are a number of drawbacks to setting up FSAs, including strict rules that prevent too many highly-compensated employees (such as principals) from receiving the benefits. In addition, an employee has access to the full contribution at the start of the year — before it's technically been collected — which means the company is on the hook if the employee uses the entire amount right away, then quits. "If you have a lot of turnover, that can expose the business owner to cash-flow risk," says Jerry Ripperger, director of consumer health for Principal Financial Group, a provider of HSAs and FSAs in Des Moines, Iowa.

Another option is to switch to an HSA from your current health insurance plan, which might save your company money in the long run. In a recent survey conducted by Information Strategies, a Ridgefield, N.J., research firm that tracks HSAs, about one-third of the roughly 6,000 small-business owners who participated said they now provide HSAs and half of those offering HSAs said the plans were easier to administer than their old plans.

How to decide? "One of the best things that business owners can do is have a continuous dialogue with their employees about what their needs are," recommends Michelle N. Dimarob, manager of legislative affairs with the National Federation of Independent Business in Washington, D.C. Talk to your insurance agent or broker about your options, and check with your state's Department of Insurance for special programs, lists of approved carriers and other information, she says.

Got a question? Send us an email at Editors@smSmallBiz.com. Due to the volume of questions we receive, we are not able to answer all questions. Questions that are selected for publication may be edited for length and clarity.

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