Don’t Let New FSA Flexibility Disqualify New HSA Owners

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“But these temporary rules do not solve the grace-period problem. They’re prospective election changes only. . . The plan year is over, so a participant can’t make a prospective change. The only viable solution is to end the grace period by November 30.”

William G. (Bill) Stuart

Director of Strategy and Compliance

March 18, 2021

Three times during the last 12 months, the federal government has granted special relief to participants in Health FSAs, Dependent Care FSAs, and Health Reimbursement Arrangements. This flexibility is welcomed by employers and employees as the pandemic has left an unexpected chasm between participating employees’ projections of eligible FSA expenses and their reality as hospitals, doctors, and child-care centers limited the range of services that they offered due to state and local government regulations, revised work schedules, and other pandemic-related changes.

This flexibility allows employers to grant participants the opportunity to change their participation, alter their elections, or extend the period during which they can incur claims that are reimbursed by their FSAs. This relief is generally welcome. But general Health FSAs and Health Savings Accounts are a toxic mix, and the relief may extend the negative effects if employer and employees don’t manage it correctly.

Health FSAs and Health Savings Accounts

In recent years, the federal tax code has been amended to allow Health FSA participants additional time to spend their balances. This flexibility is important, as it reduces the likelihood that participating employees will forfeit unused balances. Reducing forfeitures increases participant satisfaction with the program and encourages more employees to enroll.

The additional time to spend balances comes in two forms:

  • A grace period, which allows an unlimited rollover of balances for a limited period. Participants forfeit balances that they don’t spend by the end of the extended period to incur claims.
  • A rollover, which allows a limited rollover for an unlimited period. The standard rollover amount is up to $550 (a figured indexed for inflation) into the following plan year. Since the following plan year can also have a rollover provision, in theory, these balances never expire.

Let’s look at how the new flexibility affects both plan-year extenders:

Grace Period

Health FSA rules allow employers to add an additional two and a half months to the end of the plan year. During this grace period, participants can continue to spend their balances on eligible expenses. Recent temporary provisions allow employers to extend the period to incur claims to up to 12 months (thus a full two years to spend balances) for 2020 and 2021 plans.

Issue: Participants transitioning into a Health Savings Account program can’t fund their new accounts if they carry a balance into the grace period. They’re disqualified until the first day of the first month following the end of the grace period.

Example: If the grace period on a calendar-year plan extends through March 15, participants who carry a balance into the grace period can’t open or fund a Health Savings Account before April 1. They can’t reimburse tax-free any eligible expenses that they incur before April 1, but they can spend Health FSA funds to reimburse eligible expenses that they receive prior to the end of the grace period.

Employers who adopt the new flexibility and extend the grace period to December 1 or later disqualify employees from funding a Health Savings Account that calendar year.

Example If an employer extends the grace period on the 2020 calendar-year plan (yes, employers can amend plans retroactively) to the end of 2021, employees who enroll in HSA-qualified coverage effective January 1, 2021, can’t make or receive contributions to their new Health Savings Account in 2021. Under the old rules, the grace period couldn’t exceed March 15, thus making them eligible to fund their accounts beginning April 1.

Employees can solve this problem by spending their balances during the 12-month plan year. If they do, the grace period doesn’t apply to them. But imagine an employee with a 2020 general Health FSA who carried funds into the grace period because they scheduled major dental work in January and February 2021. They enrolled in HSA-qualified coverage on January 1, 2021 and is expected to fund their Health Savings Account beginning in April. If the grace period is extended to the end of 2021, they’re enrolled on a high-deductible health plan with no safety net in the form of Health Savings Account funds.

Solution: Employers who offer a Health Savings Account program and a general Health FSA should determine whether extending the period to incur claims to 12 months will disqualify employees from funding a Health Savings Account. If so, the best option is to extend the period to incur claims to no later than November 30. Employees who want to fund an account can use the Last-Month Rule, a provision that allows anyone who’s HSA-eligible by December 1 to contribute up to the statutory maximum annual contribution for that calendar year to a Health Savings Account.

Reducing the grace period so that it ends by November 30 allows these employees to contribute up to $3,600 (self-only coverage) or $7,200 (family coverage), plus $1,000 if they’re age 55 or older) to their Health Savings Accounts in 2021. They can never reimburse expenses incurred before they’re eligible to establish their accounts (December 1 in this example), but at least they can fund their Health Savings Accounts to reduce taxable income and build a balance to reimburse future eligible expenses.

Alternatively, the employer can convert the grace period to a Limited-Purpose Health FSA, which limits reimbursement to eligible medical and dental expenses. But this change limits the eligible expenses of all participating employees, not just those who want to open and fund a Health Savings Account. Employers can’t designate a grace period as general or limited-purpose depending on each employee’s medical coverage.

The new flexibility allows employers to offer a special enrollment period during which employees can enroll, disenroll, or change their election in a Health FSA. These changes are prospective (apply to the future, rather than being retroactive).

Example: An employee enrolled in a general Health FSA who wants to become eligible to fund a Health Savings Account can disenroll from the Health FSA effective the day before she is otherwise eligible to open and fund a Health Savings Account (usually the first day that she’s covered by an HSA-qualified plan).

But these temporary rules do not solve the grace-period problem. They’re prospective election changes only. A grace period is an extension of the period to incur claims after the end of the plan year. The plan year is over, so a participant can’t make a prospective change. The only viable solution is to end the grace period by November 30.

Rollover of Unused Funds

This provision allows employers to rollover their participating employees’ unused Health FSA balances from the 2020 or 2021 plan years into the following year. These funds don’t have an expiration date, as participants can then roll over up to $550 (or more, if the inflation-adjusted number increases) into the 2022 and subsequent plan years.

Issue: Employees who enroll in a Health Savings Account program and are otherwise eligible to fund an account are disqualified if they participate in a general Health FSA. If the employer allows the rollover of unused balances, they’re disqualified from funding a Health Savings Account during the entire following 12 months that they’re covered by the general Health FSA.

Solution: The solution to this problem is straightforward. Employers can carry over these employees’ unspent general Health FSA balances into a Limited-Purpose Health FSA on an employee-by-employee basis. This is different from the grace period because these funds roll over into a new Health FSA plan year. In contrast, the grace period extends an existing plan year.

Employers can still allow employees to enroll or disenroll, or to change their elections. But that flexibility isn’t necessary to solve the Health Savings Account eligibility issue.


What about former employees?

Certain Health FSA participants can continue their coverage on a Health FSA if their payroll deductions exceed their balances spent.

Example: An employee who elected $2,600 into her Health FSA is laid off in March 2021. Her total biweekly payroll deductions ($100 per pay period) were $500. If she spent $700 at the time of her separation from the company, she’s not entitled to COBRA (nor can her employer dock her final paycheck for the $200 difference between what she contributed and spent). But if she didn’t spend any of her balance, she can continue her participation via COBRA, pay a $100 premium biweekly to her employer, and spend the full $2,600 election.

If the participant has a 2020 Health FSA plan year extended into 2021, she doesn’t need to elect COBRA or pay premiums for that continued coverage. She already paid the full $2,600 election.

She can decline COBRA on her 2021 Health FSA (if she qualifies) or lose her access to additional 2021 Health FSA balances if she “overspent” her account before leaving employment without affecting her opportunity to continue to spend her 2020 grace-period balances.

The Bottom Line

Employers who offer a Health Savings Account program must be careful how they apply the temporary Health FSA flexibility. They need to understand the rules, lest an attempt to offer all employees more opportunity to spend their Health FSA balances inadvertently disqualifies some employees from opening or funding a Health Savings Account and barring them from reimbursing some eligible expenses from tax-free reimbursement forever.

What We’re Reading

The American Rescue Plan Act gives a major boost to government-run marketplaces by increasing premium subsidies for nongroup medical coverage. Learn more here.

Most employee benefits are forgotten soon after workers leave their company. But former employees can benefit from a Health Savings Accounts long after they leave the job.

One of the real challenges in vaccinating Americans for COVID-19 is what economists call the “last-mile” issue. Learn more about this distribution challenge here.

Did you know that Benefit Strategies maintains a library of Health Savings Account materials? Here’s a piece to help employers understand compliance around their contributions to employees’ accounts. Peruse the full library by clicking here and choosing “Health Savings Accounts.”

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