How are Lifestyle Spending Accounts taxed?

Taxes play a significant role in the design and implementation of employee benefits, and Lifestyle Spending Accounts (LSAs) are no exception. These accounts provide employees with the flexibility to allocate funds toward personal well-being, from fitness memberships to mental health services. However, their tax treatment can often be a source of confusion for both employers and employees.

Unlike certain tax-advantaged accounts like Health Savings Accounts (HSAs), LSAs are typically considered taxable income. This means funds disbursed through LSAs may be subject to payroll taxes for employers and income taxes for employees. Navigating these regulations requires a clear understanding of compliance, reporting requirements, and how to communicate the tax implications effectively.

In this article, we’ll explain the tax treatment of LSAs, outline key considerations for employers, and offer guidance to help employees maximize this modern benefit.

Key takeaways

• LSA funds are generally taxable income for employees, subject to federal, state, and payroll taxes, while employers must account for payroll taxes on contributions.
• Unlike tax-advantaged accounts like HSAs or FSAs, LSAs generally lack tax exemptions because they cover non-medical, lifestyle expenses. We say ‘generally’ because while LSAs themselves are typically post-tax, certain expenses could qualify as tax-free if they fall within specific IRS guidelines and are set up accordingly.
• Employers can deduct LSA contributions as business expenses, but compliance requires clear guidelines separating taxable and tax-free eligible items.
• Tax implications should be understood by HR and Total Rewards leaders to ensure compliance during tax season.
• LSAs offer unparalleled flexibility and personalization, covering expenses like fitness, mental health, caregiving, or professional development, enhancing employee satisfaction despite taxable status.
• With Forma, employers can simplify LSA management, ensuring compliance, efficiency, and enhanced employee experience with personalized options.

What is a Lifestyle Spending Account?

A Lifestyle Spending Account (LSA) is an employer-provided benefit that gives employees a set amount of funds to spend on eligible personal expenses that enhance their well-being. Unlike traditional benefits tied to specific categories like health insurance or retirement, LSAs offer unparalleled flexibility, allowing employees to allocate funds based on their unique needs and preferences.

Common uses of LSA funds include gym memberships, fitness equipment, mental health services, professional development courses, caregiving support, and even financial planning. Employers can customize the program by setting contribution amounts, defining eligible expenses, and determining how funds are accessed, often through direct reimbursement or a prepaid benefits card.

Why is an LSA taxed?

LSAs are generally taxed because they do not fall under the specific tax-advantaged provisions defined by the Internal Revenue Code, unlike accounts such as Health Savings Accounts (HSAs). LSAs are designed to offer flexible, personalized benefits that cater to a broad range of employee needs, such as fitness memberships, professional development, and caregiving. These expenditures, while valuable, are not tied to medical or dependent care expenses, which are the primary criteria for tax exemption under federal guidelines.

However, LSAs can be structured as tax-free under certain circumstances, provided they meet specific IRS criteria. For example, expenses related to job-related education or training may qualify under tax-advantaged provisions like Section 127 (educational assistance programs) or Section 132 (working condition fringe benefits). Companies must carefully adhere to these rules to ensure compliance and avoid unintended tax liabilities. Proper documentation, like defining eligible expenses and ensuring they meet IRS guidelines, is critical for maintaining the account’s tax-advantaged status.

In contrast, HSAs are directly linked to healthcare costs and high-deductible health plans (HDHPs). Contributions to HSAs are pre-tax, and funds can grow tax-free as long as they are used for qualifying medical expenses. LSAs, however, cover a wide array of non-medical expenses, making them ineligible for the same tax treatment in most cases. Employers looking to create tax-advantaged accounts should consult a tax professional to ensure their program complies with all applicable regulations.

How are LSA funds taxed?

LSA funds are mostly considered taxable income for employees, meaning they are subject to standard income and payroll taxes, apart from exceptions mentioned above. Employers provide funds to employees for use on approved personal expenses, but since these funds do not fall under tax-advantaged categories like healthcare or retirement savings, they are treated as part of the employee’s earnings.

From the employer's perspective, LSA contributions are subject to payroll taxes, including Social Security, Medicare, and unemployment taxes. While LSAs provide a significant boost to employee satisfaction and well-being, the lack of tax exemption means businesses must account for these costs in their budget.

Benefits of Lifestyle Spending Accounts

Despite the tax implications, LSAs offer several advantages for both employees and employers.

Flexibility for employees

One of the key benefits of LSAs is their flexibility. These accounts can cover a wide range of expenses, from fitness memberships and mental health apps to professional development courses and home office equipment. This allows employees to choose the benefits that best fit their individual needs and preferences.

For example, a new parent might use their LSA funds for child care expenses, while a fitness enthusiast could opt for a gym membership or workout gear. By giving employees more control over their benefits spending, LSAs can lead to higher satisfaction and engagement.

Attraction and retention tool for employers

In today's competitive job market, offering unique and valuable benefits can help companies stand out and attract top talent. LSAs demonstrate an employer's commitment to supporting employee well-being beyond traditional health insurance and retirement plans.

This can be especially appealing to younger generations of workers who prioritize flexibility and work-life balance. By showing that you care about your employees' overall happiness and success, you may be more likely to retain them for the long term.

Additionally, LSAs can help you build a more inclusive benefits package. Because these accounts can be used for such a variety of expenses, they can meet the needs of a diverse workforce with different lifestyles and priorities.

Enhanced productivity and well-being

LSAs contribute directly to improved productivity and overall employee well-being by allowing employees to address their specific needs and priorities. When employees can allocate funds to services or resources that reduce stress, improve physical health, or foster personal growth, they are better equipped to bring their best selves to work.

For example, employees who use LSA funds for mental health services or fitness programs may experience increased focus and energy, resulting in better job performance. Similarly, those investing in professional development through their LSA can build skills that directly benefit the organization. By supporting employees' unique goals and challenges, LSAs create a healthier, more engaged workforce, ultimately benefiting both the individual and the company.

Are LSAs a good fit for your company?

Deciding whether to include an LSA in your benefits package requires a thoughtful evaluation of your company’s goals, budget, and employee needs. LSAs can provide significant advantages, but they may not be suitable for every organization. Here are the key factors to consider.

Evaluate your budget and resources

Start by assessing your budget and the level of customization you’re prepared to offer. LSAs can be tailored to align with your company’s values and priorities, but increased customization often requires additional resources for setup and administration. 

Determine how much you can allocate to an LSA program and ensure it fits within your broader benefits strategy. If resources are limited, partnering with a third-party administrator can ease the administrative burden.

It’s important to remember that while LSAs themselves require a budget allocation, they can be cost-effective in the long run by reducing the costs of underutilized budgets.

Understand your employees’ needs

A successful LSA program reflects the preferences and lifestyles of your workforce. Use surveys, focus groups, or feedback channels to identify what employees value most. For example, remote workers may prioritize home office stipends, while parents might prefer childcare support. Understanding these needs allows you to create a program that resonates with your team and maximizes engagement.

Compare LSAs to existing benefits

Review how LSAs complement or overlap with your current benefits offerings. For instance, if you already provide a robust wellness program, an LSA focusing on fitness expenses might offer limited additional value. In such cases, you should consider shifting from a point-based fitness program to featuring it as part of your LSAs to make them more valuable for your employees. 

Weigh administrative costs and benefits

While LSAs offer flexibility and personalization, they also require clear guidelines, effective communication, and reimbursement processes. Evaluate whether your HR team has the capacity to manage these responsibilities or if outsourcing to a third-party provider is necessary. By balancing these considerations, you can determine if LSAs are a practical and impactful addition to your benefits strategy.

By carefully aligning LSAs with your goals and employee needs, you can decide whether this innovative benefit fits your organization’s objectives.

What are the tax implications for employers offering LSAs?

Employers offering Lifestyle Spending Accounts (LSAs) must navigate specific tax and compliance considerations to ensure smooth implementation and reporting. While LSAs provide flexibility and support for employees, understanding the tax implications for your business is essential to maximizing their benefits.

Tax-deductible contributions

In most cases, employer contributions to LSAs are considered tax-deductible business expenses. This allows you to reduce your company’s taxable income by the amount allocated to employee LSAs, potentially lowering your overall tax liability. Properly tracking these contributions and maintaining clear documentation is key to ensuring compliance and maximizing deductions.

Separate taxable and non-taxable expenses

One critical compliance consideration is avoiding the combination of taxable and tax-free eligible expenses within a single LSA. For example, if your LSA covers both taxable items (like fitness memberships or streaming services) and tax-free items (such as educational expenses), it can complicate tax reporting and create confusion. To avoid this, separate these types of expenses into distinct accounts or programs, ensuring clarity for both employees and payroll processing.

Ensure accurate withholding and reporting

Because LSA funds are considered taxable income for employees, you must ensure appropriate tax withholding and reporting. This includes adding LSA benefits to employees’ gross income and following relevant federal, state, and local tax regulations. Employers with distributed workforces may face additional complexities due to differing tax laws across states or countries.

Consult tax and payroll professionals

Working with experienced tax and payroll advisors can simplify compliance and minimize risks. These professionals can assist with setting up LSAs to address issues such as constructive receipt, payroll reporting, and accurate withholding. Their expertise ensures your program complies with regulations, reduces administrative errors, and provides a smooth experience for employees.

By addressing these tax considerations proactively, LSAs can serve as a powerful tool to enhance employee well-being and engagement while aligning with your company’s financial and operational goals.

How do employers set up an LSA?

Setting up a Lifestyle Spending Account involves several key steps to ensure the program meets your company's goals and complies with relevant tax laws.

Determine eligible expenses

First, you'll need to decide which lifestyle and wellness categories to include in your LSA. Some common options are fitness memberships, mental health apps, financial planning services, and professional development courses. Consider surveying your employees to understand their preferences and needs.

You have the flexibility to choose expenses that align with your company culture and values. For example, if sustainability is a core part of your mission, you might include eco-friendly products or donations to environmental causes as eligible expenses.

Set contribution amounts and frequency

Next, determine how much you want to allocate to each employee's LSA and how often you'll fund the account. You might choose to provide a set amount per month, quarter, or year.

When setting contribution amounts, consider factors like your budget, industry benchmarks, and the types of expenses you're covering. You want to offer a meaningful benefit without overstretching your resources. 

Keep in mind that LSA funds are typically "use it or lose it," meaning that employees forfeit any unused money at the end of the designated period. This encourages active participation in the program and helps you manage costs.

Establish reimbursement process

Finally, outline the steps employees need to follow to submit expenses and receive reimbursement. You might require them to provide receipts or other documentation to verify that the expense is eligible under your LSA guidelines.

Decide whether you'll reimburse employees directly or use a third-party administrator to manage the process. Clearly communicate the submission deadlines and expected turnaround time for reimbursements.

You may also want to provide resources like FAQs or tutorials to help employees understand how to make the most of their LSA. The easier you make it for them to participate, the higher your engagement rates are likely to be.

How lifestyle spending accounts are taxed can seem complex, but with careful planning and communication, you can offer a valuable benefit that supports your employees' well-being and helps you attract and retain top talent.

Simplify administration with a benefits management platform

Managing employee benefits can be a complex and time-consuming task, but partnering with the right benefits management platform can transform this challenge into a seamless process. Forma specializes in taking the administrative burden off your shoulders, empowering you to focus on strategic goals while providing an exceptional benefits experience for your employees.

With Forma, you gain access to a cutting-edge platform that automates tedious tasks like claims processing, tax compliance, and employee reimbursements. Our intuitive tools allow you to customize benefits to match your organization’s needs, all while ensuring compliance with local and global regulations. Employees love the flexibility of choosing benefits that matter to them, and HR teams appreciate the reduced workload and streamlined processes.

Forma isn’t just about efficiency—it’s about elevating your benefits strategy. Our comprehensive analytics and benchmarking tools help you stay competitive, while world-class support ensures your program runs smoothly from day one.

Partner with Forma to create a benefits program that drives satisfaction, reduces complexity, and boosts retention. Schedule a demo today.

How do LSAs compare to other employee benefits?

When evaluating whether a Lifestyle Spending Account is the right fit for your company, it's helpful to understand how LSAs differ from other common employee benefits like Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs).

While all three types of accounts are designed to support employee well-being, they each have unique tax implications and restrictions on eligible expenses.

LSAs vs. Health Savings Accounts (HSAs)

HSAs are tax-advantaged accounts that allow employees to save and pay for qualified medical expenses. Contributions to HSAs are made on a pre-tax basis, which means they reduce an employee's taxable income. Withdrawals from HSAs are also tax-free as long as they're used for eligible medical costs.

In contrast, LSA funds are considered taxable income for employees. While this means that LSA benefits don't offer the same tax advantages as HSAs, they provide more flexibility in terms of eligible expenses.

LSAs can cover a wide range of lifestyle and wellness expenses beyond just medical costs, such as fitness memberships, mental health apps, financial planning services, and professional development courses. This makes them a valuable complement to traditional health benefits like HSAs.

LSAs vs. Flexible Spending Accounts (FSAs)

Like HSAs, FSAs are also tax-advantaged accounts that allow employees to save and pay for eligible expenses. However, FSAs typically have a narrower scope than LSAs in terms of what qualifies as an eligible expense.

FSAs are most commonly used for out-of-pocket healthcare costs and dependent care expenses. They're subject to annual contribution limits set by the IRS, and they often have a "use-it-or-lose-it" rule that requires employees to spend their FSA funds within a certain timeframe or forfeit the remaining balance.

LSAs, on the other hand, do not have the same contribution limits or use-it-or-lose-it rules as FSAs. Employers have more flexibility to design their LSA program in a way that meets their unique needs and budget, including setting their own contribution amounts and rollover policies.

Another key difference is that FSAs are funded through employee contributions (usually via payroll deductions), while LSAs are typically funded solely by the employer. This means that offering an LSA can be a powerful way to show your investment in employee well-being and differentiate your benefits package.

Are LSAs worth it for employers?

Lifestyle Spending Accounts (LSAs) offer a modern, flexible way for employers to enhance their benefits strategy and invest in their employees' overall well-being. While LSAs are usually subject to taxes, their ability to cover a wide range of lifestyle expenses—such as fitness, mental health, professional development, and caregiving—makes them a valuable tool for improving employee satisfaction, engagement, and retention. By empowering employees to choose benefits that align with their unique needs, LSAs create a more inclusive and personalized benefits experience.

For employers, LSAs can also drive cost efficiency by replacing underutilized, traditional point solutions with a single, streamlined program. When thoughtfully designed and managed, LSAs not only meet the diverse needs of a modern workforce but also demonstrate an organization’s commitment to supporting its employees beyond table-stakes benefits.

To make the most of LSAs without the administrative burden, partnering with a flexible benefits platform like Forma is the smart choice. Forma simplifies program management, ensures compliance, and delivers an intuitive experience for both employers and employees. Trusted by leading companies like Honda, lululemon, and Tripadvisor, Forma helps organizations build benefits programs that truly stand out.

Ready to see how LSAs can transform your benefits strategy? Schedule a demo with Forma today and create a benefits program that works for everyone.

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