Choosing the Right Health FSA Extender

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“This flexibility is a strong argument in favor of using this approach when employees transition from traditional to HSA-qualified coverage. Employers and participants must be vigilant to ensure that they don’t make a mistake that negates an employee’s HSA eligibility for an entire 12 months.”

William G. (Bill) Stuart

Director of Strategy and Compliance

October 26, 2017

Have you placed the right extender on your Health FSA?

Prior to 2007, Health FSAs were truly “use it or lose it” accounts. Participants forfeited back to their employer any remaining balances at the end of the plan-year claims run-out.  This provision paralyzed many potential participants into not enrolling in a plan, reflecting our general preference that we place a higher value on avoiding pain (losing money that we otherwise could accept as taxable income and spend on other things that we value) rather than achieving a gain (a less visible reduction in our taxable income).

Since then, two important modifications to the tax code allow employers to offer an extender that allows employees to spend their balances beyond the 12-month Health FSA plan year. These provisions help increase participation by reducing the financial risk of forfeiture.

The first modification, the grace period, allows for an unlimited balance carryover for a limited period of time. The second, a carryover, allows for a limited balance carryover for an unlimited period of time.

Let’s look at the general advantages and disadvantages of each option, then discuss their specific application to HSA eligibility.

Grace Period

In the waning days of the 109th Congress, lawmakers approved the Tax Relief and Health Care Act of 2006. The law included a handful of provisions that expanded the attractiveness of HSAs and provided the first statutory relief to the then rigid “use it or lose it” nature of Health FSAs.

The grace-period provision allows employers to elect an additional period of up to 2½ months (it can be shorter, but employers almost universally adopt the maximum extension period) during which participants can continue to incur expenses that can be reimbursed with funds from that prior plan year.

In simple terms, a calendar-year 2017 Health FSA with a grace period allows participants to continue to spend Health FSA funds through March 15, 2018. The grace period doesn’t impact the claims run-out period (the time during which all claims must be submitted to the Health FSA administrator for reimbursement), which for most companies run for 90 days following the end of the 12-month plan year (March 30th in our calendar-year example).

Advantages of the Grace Period

  1. Employee participation increases because of the reduced risk of forfeiting unused balances. Fear of forfeiture is probably the No. 2 reason that employees don’t participate in a Health FSA (trailing only the range of expenses that they’re already incurring that are FSA-eligible).
  1. Many participants increase their tax savings. Employees are notoriously conservative in their elections to reduce the risk of forfeiture. As a result, they often elect far less than what they need and end up spending their entire balances and then purchasing additional eligible goods and services with post-tax dollars. The grace period allows them to be less conservative in their election, knowing that they have an additional 75 days to incur expenses that they can reimburse.
  1. With the ACA’s imposition of an election limit ($2,650 in 2018), the grace period allows participant to have access to two years’ elections at once. This is important when a spouse wants to undergo vision-correction surgery (as mine does) or a child needs to have four wisdom teeth extracted (as one of mine does). The grace period allows a participant to make maximum elections in both 2017 and 2018 and then have access to more than $5,000 to cover either procedure in full. Without a grace period and the ability to double-up, a participant  either pays a portion of the expenses with post-tax dollars or tells his the spouse or child that she can have vision in only one eye corrected each year or must have two wisdom teeth pulled in each of two years.

Disadvantages of the Grace Period

  1. Participants still face a deadline to spend their balances. The grace period gives them some flexibility, but no absolution from an aggressive election. They can still forfeit balances.

Carryover

Effective with plan years beginning in 2014, the IRS modified Health FSAs further by allowing participants to carry over up to $500 of unused balances into the following Health FSA plan year. This provision applies only to plans that don’t include a grace period. As with the grace period, the employer has discretion on whether or not to offer this feature.

Advantages of the Carryover

  1. Employee participation increases because of the reduced risk of forfeiting unused balances.
  1. Many participants increase their tax savings because they can be more aggressive in their election if they know that they have additional time to spend any balance not used during the plan year.
  1. Employees don’t face a deadline for spending the carryover money. They can use it at any time during the new plan year and then carry over $500 again into the following year.

Disadvantages of the Carryover

  1. The amount that participants are allowed to carry over isn’t much money for participants who dramatically overestimate their expenses. These employees still could forfeit balances if their ending balances exceed the maximum $500 carryover allowance.

HSA Implications

Traditional Health FSAs, which reimburse eligible expenses without participants’ satisfying a Health FSA deductible, are problematic for employees who want to become eligible to open and contribute to an HSA. Traditional Health FSAs disqualify those employees from becoming HSA-eligible for varying periods, depending on the design of the Health FSA extender.

For our discussion, let’s assume that the Health FSA and medical plan both run on the calendar year.

Grace Period and HSA Eligibility

An employee with the grace period who spends her entire election and submits all claims by the end of the 12-month Health FSA plan year can become HSA-eligible as of Jan. 1 (assuming she meets all other HSA eligibility requirements). Participants always have the power to erase the negative consequences of the grace period on HSA eligibility by spending their balances before the beginning of the grace period.

Employees who enter the grace period with any balance, even as little as a penny, don’t become HSA-eligible before the end of the grace period (March 15).  Since HSA eligibility is determined as of the first day of the month, they aren’t eligible to establish an HSA in most cases until April 1. Under federal tax law, they can’t reimburse tax-free any eligible expenses from their HSA prior to April 1, even if applicable state trust law that governs their HSAs allows them to establish their HSAs sooner.

Employers can help these employees by amending their Health FSAs prospectively before the end of the 12-month plan year. They can either eliminate the grace period or turn the grace period into an HSA-compliant Limited-Purpose Health FSA grace period (reimbursing only dental, vision and certain preventive services).

The catch: Any changes to the grace period impact all participants, not just those who want to become HSA-eligible. Employers can’t create a Limited-Purpose grace period for employees enrolling in the HSA program and maintain the full grace period for employees enrolled in non-HSA-qualified coverage who may want to spend their balances on medical, prescription-drug and over-the-counter items that aren’t eligible for reimbursement under a Limited-Purpose grace period. They can’t split these populations because the grace period merely extends the current Health FSA year, and employees can’t change their Health FSA coverage unless they have a qualifying life event (wanting to become HSA-eligible doesn’t qualify) or the employer changes the terms of the plan prospectively.

Carryover and HSA Eligibility

The carryover extender offers more flexibility but increases the potential for additional delays in HSA eligibility.

As with the grace period, an employee can avoid any issues with becoming HSA-eligible Jan. 1 in our example (assuming that she meets all other HSA eligibility requirements) by simply spending her entire balance and applying for reimbursement before the close of the Health FSA plan year.

If she fails to do so and her employer carries over her Health FSA balance into a traditional Health FSA, she can’t become HSA-eligible before the end of that following year’s Health FSA. In other words, in our example, if she carries over, say, $25 from her 2017 to her 2018 Health FSA, she can’t become HSA-eligible before Jan. 1, 2019. She can use the $25 that she carries over to reimburse HSA-eligible expenses, including medical plan cost-sharing that she incurs during 2018, but she can’t reimburse her 2018 eligible expenses tax-free, ever, from an HSA.

That’s a worst-case scenario, and it’s obviously bad for the employee.

On the other hand, because remaining balances carry over into a new Health FSA plan year, employers can place the funds into different types of plans participant-by-participant. Remaining balances for employees who want to participate in the employer’s HSA program can carry over into a Limited-Purpose Health FSA that reimburses dental, vision and preventive services only. That way, the employees can become HSA-eligible Jan. 1, 2018 (assuming they meet all other HSA eligibility requirements).

Employers can carry over balances accrued by employees enrolled on other coverage, including a spouse’s plan, who don’t seek HSA eligibility, into the 2019 traditional Health FSA that reimburses not only dental and vision, but also medical, prescription drug and certain over-the-counter services and items.

This flexibility, employers’ being able to choose employee-by-employee how to handle carryover amounts, is a strong argument in favor of using this approach when employees transition from traditional to HSA-qualified coverage. Employers and participants must be vigilant to ensure that they don’t make a mistake that negates an employee’s HSA eligibility for the entire 12-month Health FSA plan year.

Which Extender Is Better?

Ah, the eternal question. The chicken or the beef entrée? Cake or ice cream? A cabin in the mountains or a cabana on the beach? Different people have different preferences. In fact, some employers have never adopted an extender or tried one and then reverted back to the traditional 12-month plan year with no grace period or carryover.

There is no right or wrong answer. Both the grace period and the carryover decrease the likelihood that a participant actually forfeits unused balances back to the plan administrator (the employer) at the end of the plan year. This key benefit in either approach allows more employees to enroll with confidence and enrolled employees to elect to receive more of their pay in the form of a tax-free Health FSA election with less rick of forfeiture. And as most employers would agree, the more employees give themselves an increase in take-home pay through prudent Health FSA elections, the happier they are financially and emotionally.

What We’re Reading

Confused about what President Trump actually did with his executive orders earlier this month? Forbes columnist Avik Roy gives one perspective. Long-time ACA skeptic Sally Pipes weighs in with her thoughts here.  And in my personal blog, I provide some additional perspective.

For those of you holding your breath waiting for the report from the Massachusetts Senate working group on health care, you can exhale. Here it is. The proposal calls for more transparency in medical and prescription drug pricing, efforts to compress cost variations among Bay State hospitals, increased scope of practice for professional “extenders” – including nurse practitioners and dental therapists – an reforms to MassHealth, the state’s Medicaid program.

This study follows the state attorney general’s report in early 2010 on provider price disparities, a report that has gained no traction in nearly eight years. Expect a political stalemate if Monday’s hearing in the State House is any indication, with community hospitals’ arguing for higher reimbursement rates from private insurers to maintain and create critical programs and hospital receiving the highest reimbursement levels’ arguing that they are, in fact, underpaid relative to national peers and thus shouldn’t be the source to increase reimbursement rates to community hospitals.

The politics of this proposal will be fascinating to watch in the winter and spring of 2018.

 

 

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