Don’t Let New FSA Flexibility Prevent Your HSA Funding

Picture of a Scrabble board with the letters FSA in the front

“But this new flexibility can’t erase every potential disqualifying event. If you had a 2020 plan-year Health FSA with a newly extended grace period through the end of 2021, you can’t disenroll from the grace period. The 2020 plan year is over.”

William G. (Bill) Stuart

Director of Strategy and Compliance

January 21, 2021

A new law signed by now-former President Trump late last month provides additional flexibility to employees whose companies offer FSAs. Employers can offer special open-enrollment periods during which employees can prospectively enroll in, disenroll from, and change their future elections to a Health FSA (and a Dependent Care FSA).

This flexibility creates opportunities and challenges for employees who want to fund a Health Savings Account. Here’s a quick guide to some of the key changes, the potential effect on your eligibility to fund a Health Savings Account, and actions that you or your employer can take if your goal is to fund your account.

Health FSAs Defined

A Health FSA is an employer-sponsored plan that allows you to receive a portion of your income in the form of a tax-free election to a reimbursement account. You make a binding annual election that you generally can’t change without experiencing one of a handful of qualifying life events. The plan normally runs for 12 months, and you’re covered by the plan during that span, even during months after you’ve exhausted your balance.

A general Health FSA – which reimburses medical, dental, and vision services, as well as over-the-counter drugs, medicine, equipment, and supplies – disqualifies you from opening and funding a Health Savings Account. You can be covered by a Limited-Purpose Health FSA and still open and fund a Health Savings Account. A Limited-Purpose Health FSA restricts reimbursement to dental and vision services. Coverage for these services – whether through insurance, a discount program, or a Health FSA – isn’t disqualifying. Some Limited-Purpose Health FSAs open reimbursement to all eligible expenses once the participant attests that she has met her minimum deductible on her HSA-qualified medical plan.

Health FSA Coverage

It’s important to understand this key concept: It’s not just your general Health FSA that disqualifies you. Under federal tax law, a Health FSA covers not only the employee, but also a spouse, tax dependents, and children to age 26. Employers can narrow the range of eligible family members (for example, limiting reimbursement to the employee), but they almost universally do not.

It doesn’t matter whether you’re covered on your spouse’s medical plan. If your spouse participates in a Health FSA and that plan document doesn’t narrow the federal list of family members covered, you’re covered under that Health FSA. And that coverage disqualifies you from opening or funding a Health Savings Account. You can’t become eligible by not filing for reimbursement through her Health FSA or by spending the entire election early in the year. You’re enrolled on that plan for 12 months unless you can – via a qualifying event or under the new pandemic-related temporary flexibility – disenroll mid-year.

Children under the age of 26 face the same problem. Your 23-year-old may have enrolled in an HSA-qualified medical plan and now wants to open and fund a Health Savings Account. But if you or your spouse participates in a general Health FSA, your child is disqualified from making or receiving contributions to a Health Savings Account.

If You’re Not Covered by a Health FSA

The new flexibility doesn’t affect you.

You’re Covered by a Limited-Purpose Health FSA

The new flexibility doesn’t affect your eligibility to fund a Health Savings Account. Your (or your spouse’s or parent’s) employer may roll over your balances or extend the time that you can incur expenses and pay them with the prior year’s balance. The rollover carries funds into a new plan year’s Limited-Purpose Health FSA or extends the grace period of your existing Limited-Purpose Health FSA plan year. Either way, because your Health FSA is limited, you’re not disqualified from opening or funding a Health Savings Account.

You’re Covered by a General Health FSA: Grace-Period Issues

This coverage may be problematic, particularly if you were covered by a general Health FSA and didn’t renew your participation because you want to open and contribute to a Health Savings Account for the first time. The new rules allow employers to add or extend (for up to an additional 12 months) a grace period of any plan that ends in 2020 or 2021. Prior to this new rule, a grace period (additional time to incur eligible expenses) couldn’t exceed an additional two and a half months.

If you exhaust your account balance before the end of the 12-month plan year, the grace period – even an extended grace period – doesn’t disqualify you from opening and funding a Health Savings Account.

Example: Your calendar-year 2020 Health FSA plan has a grace period. You spent your balance by December 31 and thus could open and fund a Health Savings Account beginning January 1, 2021.

If you don’t spend your entire balance by December 31, 2020, the grace period disqualifies you from funding a Health Savings Account. You have additional time to use your 2020 funds, but you can’t open and fund a Health Savings Account until the first day of the first month after the end of the grace period (April 1, 2021, in our example).

If you carry a balance into your grace period and your employer extends the grace period (or adds a grace period retroactively to the 2020 plan and you had a forfeitable balance at the end of that plan year), your balance and the extension of the grace period disqualify you from opening and funding your account before the end of the grace period.

Example: You carry a $600 balance into the grace period. You had planned to spend those funds on a scheduled dental procedure in February 2021, then open your Health Savings Account on April 1, 2021. Your employer then extends the grace period through the end of 2021. You can’t open and fund a Health Savings Account in 2021, nor can you reimburse any expenses that you incur in 2021 with future (2022 and beyond) Health Savings Account contributions.

This example illustrates why employers need to assess their employees’ situation before applying the new flexibility to their Health FSA plan. The extra time to incur expenses may be welcomed by employees whose non-urgent medical services were delayed as providers focused on treating COVID-19 patients and minimizing the spread of the virus. But some employees who thought the balance that they carried into the grace period would affect their eligibility to open and fund a Health Savings Account for only three months may discover that they’re disqualified for the length of the extended grace period.

Employers can turn the grace period into a Limited-Purpose Health FSA, which reimburses dental and vision expenses only. But that change would affect all employees, not only those who want to fund a Health Savings Account. It would limit the reimbursement options of employees who made an election to pay their out-of-pocket cost for medical services or prescription drugs.

You’re Covered by a General Health FSA: Rollover Issues

The alternative to a grace period is a rollover (also called a carryover) of unused funds. In normal times, the rollover is limited to 20% of the maximum election (or $550 of the remaining balance in your 2020 or 2021 plan year). The new rule allows employers to roll over all unused balances without limit from the 2020 to 2021 plan year, 2021 to 2022 plan year, and 2022 to 2023 plan year.

If you have a general Health FSA, a rollover into a new plan year disqualifies you from funding a Health Savings account during the entire new plan year. That’s the bad news. The corresponding good news is that these balances are rolled into a new plan year. Your employer can roll the balance into a Limited-Purpose Health FSA for employees who want to fund a Health Savings Account and into a general Health FSA for those who don’t.

Example: You participated in your company’s general Health FSA in 2020 (calendar-year plan), then enrolled in HSA-qualified medical coverage effective January 1, 2021. Your employer adds a rollover feature retroactive to January 1, 2021, allowing you to roll your full remaining 2020 balance into your 2021 plan. If your company offers a Limited-Purpose Health FSA in 2021, you can request that your 2020 balances roll into that account, which you can use to reimburse eligible dental and vision expenses.

If your employer doesn’t offer a Limited-Purpose Health FSA in 2021, you can forfeit the rollover. You lose your remaining 2020 plan-year balance – but not your opportunity to fund a Health Savings Account.

An Opportunity – or an Eraser

The new rules provide an eraser that may help some employees. Employers are permitted to offer an open-enrollment period in which employees can prospectively (effective in the future) enroll in, disenroll from, or change their elections to a Health FSA. Here’s how this flexibility might help you if your employer offers it and you want to fund a Health Savings Account:

  • Disenroll from a general Health FSA. You can disenroll prospectively from a disqualifying general Health FSA. If you enrolled without realizing that your participation would prevent you from funding a Health Savings Account, you can disenroll as of, say, the last day of the current month. You can then begin to fund your Health Savings Account as of the following day.
  • Switch from a general Health FSA to a Limited-Purpose Health FSA. If you enrolled in a general Health FSA for 2021 without realizing that it would disqualify you from funding a health savings account, you can disenroll effective at the end of the current month and then simultaneously enroll in a Limited-Purpose Health FSA effective the first day of the following month. You’d forfeit your remaining general Health FSA balance (there is no mid-year rollover from that plan to the Limited-Purpose Health FSA, so spend accordingly.
  • Enroll in a Limited-Purpose Health FSA. If you missed the opportunity to multiply your tax savings and increase your cash flow by participating in a Limited-Purpose Health FSA to reimburse eligible dental and vision expenses, you have a do-over if your employer adopts the new flexibility.

But this new flexibility can’t erase every potential disqualifying event. If you had a 2020 plan-year Health FSA with a newly extended grace period through the end of 2021, you can’t disenroll from the grace period. The 2020 plan year is over. The flexibility to disenroll applies to the 12-month plan year only – not the grace period.

The Bottom Line

Congress and the Trump Administration approved changes to federal tax law that increased employer and participant flexibility during the pandemic. These new provisions are designed to help you manage your balances during extraordinary circumstances that no one could have predicted. Just be sure that the flexibility designed to help you doesn’t backfire by limiting your eligibility to fund a Health Savings Account.

What We’re Reading

How much money are today’s retirees spending annually on medical coverage and care? The figures are sobering – and provide more evidence of the importance of saving through a Health Savings Account.

If you’re a working senior who didn’t enroll in Medicare at age 65, your Medicare coverage may be retroactive when you finally enroll. That will affect your Health Savings Account contributions. Learn more here.

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