A Health FSA May Enhance Your HSA Strategy

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“You’d have to withdraw $24,000 from a taxable account or pay about two-thirds of the average Social Security payment during those 14 months that your Health Savings Account continues to fund all your medical expenses tax-free. When you’re in your 70s or 80s and living on a fixed income in a volatile financial market, an extra year-plus of covering qualified expenses without spending your Social Security check or dipping into other retirement savings can make a huge difference.”

William G. (Bill) Stuart

Director of Strategy and Compliance

April 30, 2020

It’s one of the more frequently asked questions during implementation, when we ask clients whether they want to offer a Limited-Purpose Health FSA to their employees who enroll in a Health Savings Account program:

“Why?”

That’s a valid question. Here’s the answer.

What Is a Limited-Purpose Health FSA?

A Limited-Purpose Health FSA (LPFSA) is a Health FSA that, as its name implies, limits the range of products and services that are eligible for reimbursement. A LPFSA usually takes one of two forms:

  • LPFSA: Dental and vision only, plus select preventive care that’s not covered in full. This design is straight-forward. It excludes all medical, prescription-drug, and OTC services and items from the list of qualified expenses.
  • Post-Deductible LPFSA: Same as Option 1, plus medical, prescription-drug and OTC services and items, once the participant attests that she’s met the statutory minimum annual deductible for her contract type. This design’s a little more complicated. Dental, vision, and select preventive services are always qualified expenses. Once the participant attests (the nature of this action varies by administrator) that’s she’s met $1,400 (self-only contract) or $2,800 (family contract, 2020 figures) of qualified expenses that she’s reimbursing from non-LPFSA funds (such as Health Savings Account balances or personal money), the list of qualified expenses opens up to include all services and items that diagnose, treat, mitigate, or cure and injury, illness, or condition. In the industry, these services and items are referred to as Section 213(d) expenses to reflect the section of the federal tax code that defines them.

Of course, you know that these same employees can reimburse all Section 213(d) expenses from their Health Savings Accounts, without participating in an LPFSA or signing an attestation. The LPFSA overlaps much of the coverage that a Health Savings Account offers.

And LPFSA participants forfeit unused balances that they don’t spend by the end of the plan year or grace period, or amounts in excess of $500 if their employer offers a carryover of unused balances. This use-it-or-lose-it feature of Health FSAs is what attracts many employees to Health Savings Accounts, which allow unlimited carryover of unused funds.

Why Offer a Limited-Purpose Health FSA?

There are at least four distinct reasons why an employee might benefit by participating in an LPFSA:

Further reduce taxable income. The most obvious reason is additional tax savings. Let’s say you’re someone who funds her Health Savings Account to the statutory limit ($3,550 for self-only and $7,100 for family coverage in 2020), perhaps diverting retirement savings from your company’s 401(k) plan to maximize your Health Savings Account contribution. And you want to enjoy additional tax savings. And you expect to incur qualified dental and vision expenses.

In this scenario, you can contribute $7,100 to your Health Savings Account and elect an additional $2,750 to your LPFSA, thus shielding nearly $10,000 from federal and state income taxes (except residents of California and New Jersey, the two states that don’t allow a deduction against state income tax liability for Health Savings Account contributions).

Access balances up-front. By law, Health FSA participants can access their full annual election at any time. That’s a great cash-flow benefit for participants, who can negotiate prompt-pay discounts when they pay in full with a Health FSA debit card for major restorative dental work, new prescription glasses, or vision-correction surgery early in the plan year.

In contrast, Health Savings Accounts work like a checking account with no overdraft protection. Owners can’t draw their full election because they don’t make a binding election. Instead, they can change their payroll deductions monthly. A growing number of Health Savings Account administrators now offer a service that works like a cash advance (though legally it’s not), which reduces the Health FSA advantage. But many employers – who must sponsor the cash-advance look-alike program – haven’t adopted it, leaving account owners with no access to future contributions.

Health Savings Account owners can always pay for services with personal funds and later reimburse those expenses, even with future contributions. That degree of flexibility isn’t available to Health FSA participants. But for Health Savings Account owners who don’t have available personal or HSA funds to cover a large purchase early in the plan year, the cash-advance advantage of an LPFSA can’t be overlooked.

Preserve Health Savings Account balances. Some Health Savings Account owners – not enough, but a growing number – understand that these accounts represent a tax-perfect opportunity to save for retirement medical expenses. Owners don’t need to be HSA-eligible to make tax-free distributions for qualified distributions – a list that expands at age 65 to include Medicare Part B, Part D, and Part C premiums.

How will account balances benefit you in retirement? Let’s say you defer $3,000 of salary annually for 25 years to save for retirement. You’d deposit $2,000 into a Health Savings Account or $1,847 into a traditional 401(k) plan ($2,000 less payroll taxes). After 25 years of 6% annual returns, you’d have about $9,000 more in your Health Savings Account.

Then you start spending the funds on retirement medical expenses of $15,000 in the first year and increasing 4% annually to reflect medical inflation. You’d withdraw $15,000 tax-free from your Health Savings Account or $18,072 (assuming a 17% federal and state income tax rate) from the 401(k) plan.

You’d exhaust your balance in your 401(k) plan about two-thirds of the way through Year 8 and in your Health Savings Account late in Year 9. That may not seem like much of a difference. But the extra 14 months of expenses that you can cover with your remaining Health Savings Account balance is nearly $20,000. You’d have to withdraw $24,000 from a taxable account or pay about two-thirds of the average Social Security payment during those 14 months that your Health Savings Account continues to fund all your medical expenses tax-free. When you’re in your 70s or 80s and living on a fixed income in a volatile financial market, an extra year-plus of covering qualified expenses without spending your Social Security check or dipping into other retirement savings can make a huge difference.

Every dollar that you elect and spend through your LPFSA for qualified dental and vision expenses is a dollar that you don’t withdraw from your Health Savings Account. You’ll thank yourself years from now if you adopt this approach.

Pay certain family member’s qualified expenses. You can’t reimburse your adult children’s expenses tax-free from your Health Savings Account if they no longer qualify as your tax dependents – even if they remain covered on your medical plan. One of my sons is a television news reporter at a network affiliate in Texas. This is an entry-level job that pays like minor-league baseball – you pay your dues for low wages, then advance to the big leagues, where salaries are much higher.

If he needs restorative dental work or wanted vision-correction surgery, he’ll need help paying the bills. I can’t reimburse his qualified expenses from my Health Savings Account. But because he’s my child and not yet age 26, I can reimburse those expenses tax-free from my LPFSA – even though he lives a 38-hour drive away (believe me – we did it last September) and a time zone away. He doesn’t have to be covered on my medical plan (although he is) for me to reimburse his qualified expenses tax-free from my LPFSA.

Caveats to This Strategy

The strategy of funding an LPFSA isn’t risk-free. As with any Health FSA, you forfeit unused balances. If you aren’t funding your Health Savings Account to the statutory maximum and don’t expect high dental or vision expenses, you’re better off simply increasing your Health Savings Account contribution. You can use those funds to reimburse your dental and vision expenses or other qualified services, or preserve your balances for future tax-free withdrawals for qualified expenses.

The level of forfeiture risk that you face with LPFSA funds depends on your employer’s design decisions, specifically:

Grace period or carryover of unused funds. Most employers have adopted one of two Health FSA plan year extenders. One option is to allow participants to incur qualified expenses for an additional two and a half months after the 12-month plan year. This option is, in effect, offers an unlimited carryover amount for a limited time period.

A second option is a carryover of up to $500 of unused funds into the following plan year. Think of this design as offering a limited carryover amount for an unlimited time period.

Employers can choose either extender, but not both. The presence of either extender reduces the likelihood that a participant forfeits a balance.

LPFSA design. If the employer chooses the design that opens the LPFSA to reimburse qualified medical, prescription drug, and over-the-counter items once the participant has met the statutory minimum annual deductible, participants further minimize their forfeiture risk. Reimbursing all covered medical expenses above $1,400 (self-only coverage) or $2,800 (family coverage) from an LPFSA offers dollar-for-dollar preservation of Health Savings Account funds.

Employer Considerations

Cost. Employers pay fees to a business partner to administer a LPFSA. Those fees often include an annual up-front fee (typically between $300 and $500) to draft compliance documents and set up the group in the administrator’s information system, plus a monthly fee (usually between $3 and $5 per participant account). A company that doesn’t have a Health FSA in place might find these costs prohibitive for the small population of employees who participate. On the other hand, some vendor partners (like Benefit Strategies) who already administer a group’s Health or Dependent FSA (or both) don’t charge additional set-up fees to add a LPFSA. The incremental cost is just the monthly account fee.

Cost-saving. An incentive for companies to offer the LPFSA is that the employer (and participating employees) don’t pay the 7.65% (each) federal payroll tax on elections. That’s a savings $153 to the company (and the employee) on a $2,000 election. That level of payroll savings more than pays the monthly administrative fee to maintain the account.

But the employer doesn’t realize net payroll-tax savings if employees would have contributed another $2,000 to their Health Savings Accounts in the absence of an LPFSA.

Risk. The employer faces the risk, as it does with other Health FSA designs, that some participants may leave employment having received more in reimbursement than they’ve contributed in payroll deductions. That potential financial exposure is offset, at least in part, by the payroll-tax savings and forfeitures of unused balances. This is a risk that companies always have to manage when they sponsor a Health FSA program.

What We’re Reading

You have more time to contribute to your Health Savings Account for 2019 and to correct mistaken contributions and distributions. Learn more in my weekly HSA Mythbuster Monday column published on LinkedIn.

Are you looking for five good reasons to open and fund a Health Savings Account as a retirement vehicle? Here they are.

Primary-care practices are being hit particularly hard financially by the pandemic. Three-quarters diagnose their problems as “severe” or “close to severe,” and up to one-fifth fear they may have to close. Learn more here and here.

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