In a recent Revenue Ruling, the IRS clarified that over-the-counter (OTC) medicines are eligible for reimbursement by pre-tax flexible spending accounts (FSA).   This ruling paves the way for many employees to purchase such items as aspirin, cough syrup, and allergy medicine with pre-tax dollars.

Although the ruling liberalizes the definition of medications for FSA purposes, it does not change the definition of qualified medical expenses for purposes of itemized deductions on individual tax returns.   For those taxpayers who itemize deductions, OTC medicines remain nondeductible.

In addition, the IRS ruling stated that the cost of vitamins and diet foods are not considered OTC medications that can be paid via an FSA.

It should be noted that the recent ruling does not constitute a change in an FSA plan that will allow employees to revise the amounts being withheld from their current paychecks for pre-tax treatment.   The ruling is considered a clarification of the definition of a medical expense entitled to pre-tax treatment, not an addition to deductible medical expenses.

However, as the end of an FSA plan year approaches, many employees will find that they may be able to apply a previously unused account balance to purchase OTC medicines for future use.   In addition, employees may be able to obtain receipts from pharmacies or supermarkets for prior purchases of OTC medicines that can now be reimbursed from their FSAs.

If you or your employer is currently offering an FSA plan, amendments may be necessary to the plan documents to allow for the reimbursement of OTC medications.   Employers with FSA plans should consult with their plan administrators to determine whether these amendments are necessary for their plans.

For those employers who do not offer an FSA plan and want to learn more, please read on:

What is an FSA plan?

An FSA plan, which is often called a cafeteria plan or Sec. 125(k) plan, allows an employee to allocate a portion of his or her gross salary to cover the projected costs of certain expenses for the plan year.   This allocated amount escapes federal and state income taxes, as well as Social Security and Medicare taxes.

The term "cafeteria" stems from the "menu" of items offered by the plan from which the employee can choose for this pre-tax treatment.   Typical menu items include the cost of health and dental insurance premiums, child-care costs, and out-of-pocket medical expenses such as co-pays, deductibles and prescriptions.

What are the costs of an FSA plan?

In almost all circumstances, the employee does not incur any costs associated with an FSA plan.   Rather, these plans are designed to offer significant tax savings for employees by using pre-tax dollars to pay for significant medical and child-care costs.

For employers, the costs of an FSA plan include the one-time plan adoption costs and the annual maintenance costs.   Many small employers choose to maintain the plan with their own staff; others choose to use an outside administrator.   Maintaining the plan typically involves the processing of claims made by employees for reimbursement from their FSAs.

The key item to note is that the employer's costs to adopt and administrate the FSA plan are partially offset by the reduction of the employer's portion of Social Security and Medicare taxes resulting from the amounts run through the plan by the employees.

In addition, the offering of an FSA plan by a company is a significant employee benefit for attracting and retaining quality employees.   Many employers also use an FSA plan to manage ever-escalating health insurance costs.

What is the next step in adopting an FSA plan for my business?

Please contact our office and we will recommend a plan administrator who will work with you in adopting the FSA plan and completing the necessary documents.   We will also explain to you the mechanics of making employee elections and processing employee claims.  

Please note that there are some limitations in the availability of FSA plans to business owners and S corporation shareholder/employees.   We'll help you understand these rules and determine their applicability to your business.

Please contact us at (865) 523-7400 for more information.