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The IRS & FSAs When Terminating Employment

A flexible spending account, or FSA, is often a valuable perk of employment. Through it, an employee can pay for medical expenses on a pre-tax basis out of every pay check. In the event of a lay off or voluntary departure, employees have a few options to ensure they don't lose coverage.

  1. What is an FSA?

    • A flexible spending account is an option offered by many employers under a cafeteria-style health benefits plan. An employee contributes a portion of each pay check directly into the FSA up to $5,000 per year. The funds deduct from the pay check prior to income tax and other payroll tax deductions. The total annual contribution amount is available to the employee to pay for health care costs on the first day of the year, even though the contributions have not been made.

    What Happens to an FSA on Employment Termination?

    • When an employee leaves a job, voluntarily or otherwise, the FSA terminates along with other health care coverage unless the employee elects the Consolidated Omnibus Budget Reconciliation Act, or COBRA, continuation coverage. Under some plans, the employee may continue to use the FSA until the end of the termination month as long as there is a balance, but the employee can no longer contribute to it. The amount the employee can use depends on the annual contributions pro-rated for the first day of the year to the date of termination. Any contributions used already in the year deduct from that amount to calculate the funds left available.

    COBRA and FSAs

    • COBRA continuation coverage is a federal program that allows employees to elect to continue their group health plans after their employment terminates for up to 18 months. The employee pays both employer and employee portions of the premiums along with a monthly administration fee, often calculated as a percentage of the premium. An employee can also elect to extend FSA coverage if he is not able to use up the available balance before it terminates. The employee will pay the regular contribution plus the administration fee. He does not need to continue other group health benefits to continue the FSA. Once he uses up the FSA balance, the plan terminates as the contributions are after-tax during the extension period, providing less of a benefit.

    Alternatives to an FSA for the Unemployed

    • If an employee does not elect to continue health coverage when employment terminates, he may instead select an individual health insurance plan. If the plan is only for catastrophic coverage and has high deductibles, he may be eligible to sign up for a Health Savings Plan, which is similar to an FSA except that the plan funds are available forever.

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