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Take It to the Limit with an HSA and Limited Health FSA

“If you want to pay this year’s expenses this year and enjoy immediate tax benefits, a HSA/Limited-Purpose Health FSA combination allows you to pay your bills and gain a tax advantage this year, rather than carry financial obligations or delay tax benefits into the future.”

William G. (Bill) Stuart

Director of Strategy and Compliance

December 27, 2018

Employers who offer an HSA program have the option to sponsor a Limited-Purpose Health FSA plan as well. Does it make sense to offer what some people consider duplicate reimbursement plans?

I’m often asked that question. In most cases, I recommend both plans. In some situations, the Limited-Purpose Health FSA doesn’t seem appropriate.

Let’s take a step back and define a Limited-Purpose Health FSA. It’s a limited Health FSA that allows participants to reimburse dental and vision expenses only (plus a handful of preventive services that aren’t covered in full under federal law). Because dental and vision are excepted benefits, employees can participate in a Limited-Purpose Health FSA and still open and make or accept contributions to an HSA.

Of course, dental and vision expenses can be reimbursed tax-free from an HSA as well. Thus, a Limited-Purpose HSA represents duplicate coverage, with the use-it-or-lose-it risk associated with a general Health FSA.

So, why participate in an HSA program and make an election to a Limited-Purpose Health FSA as well? Here are five distinct reasons to consider making an election to a Limited-Purpose Health FSA if your employer offers this option:

Increase your tax savings. You can fund your HSA up to your maximum contribution and make an election to your Health FSA up to your employer’s limit. If you’re under age 55 and have family coverage, instead of reducing your taxable income by only $7,000 (2019 figure) with an HSA contribution, you can lower your taxable another $2,700 (2019 statutory limit, although employers can set a lower amount) by electing that amount into your Limited-Purpose Health FSA.

If you elect only $1,500 in your Limited-Purpose Health FSA because that’s the total amount of qualified dental and vision expenses that you anticipate incurring and you’re in a 20% marginal tax bracket (such as a New Hampshire resident with modest income and no state income tax), you save only $300 annually. If you live in Massachusetts and have a household income of $100,000 or more, the same $1,500 election may net you $525 in tax savings. Increase your election to $2,700 and the savings are $540 and $945, respectively.

Regardless of your marginal tax rate and elections, your total savings won’t substantially alter your lifestyle or allow you to retire years earlier. But having an extra $500 or so in the family budget makes life a little easier.

Manage high expenses. You may have a year in which you project that your qualified expenses exceed your statutory maximum annual contribution to an HSA, particularly if you have self-only coverage and are under age 55. In that case, your 2019 HSA contribution limit is $3,500. If you have a $3,000 deductible that you anticipate satisfying, expect to incur some prescription copays after the deductible, and are in the middle of a dental treatment (such as orthodontia or a root canal and crown), your qualified expenses could exceed your annual HSA contribution maximum.

Of course, a benefit of an HSA is that, once you establish your HSA and carry at least a small positive balance, you can reimburse any qualified expenses from future contributions. So, if your employer doesn’t offer a Limited-Purpose Health FSA, you can incur these expenses, pay them (including agreeing to a repayment plan), and then subsequently reimburse your providers or yourself tax-free from your HSA once you replenish your balance with contributions that you make next year or decades from now.

If you want to pay this year’s expenses this year and enjoy immediate tax benefits, an HSA/Limited-Purpose Health FSA combination allows you to pay your bills and gain a tax advantage this year, rather than carry financial obligations or delay tax benefits into the future.

Preserve your HSA balances. Your strategy may be to use your HSA in whole or in part to accumulate balances that you can spend tax-free on qualified medical expenses in retirement. If so, you can make an election to a Limited-Purpose Health FSA and enjoy tax benefits when you purchase qualified dental and vision services and build your HSA balances by not making withdrawals to reimburse those dental and vision expenses.

Imagine you fund a Limited-Purpose Health FSA for 10 years and pay $1,200 annually for dental and vision expenses from that account, then stop. This amount is hardly outlandish if you have a family. By using a Limited-Purpose Health FSA, you enjoy tax benefits and retain HSA balances. If you invest your HSA balances at 6%, this additional $12,000 balance grows to $30,000 after 20 years and to nearly $54,000 after 30 years. All in exchange for committing an additional $1,200 annually for 10 years to a second tax-advantaged account to maximize your tax savings and HSA balances.

That’s a compelling reason to participate in a Limited-Purpose Health FSA.

Of course, as HSA balances compound, so do qualified expenses due to inflation. Let’s say today’s Medicare Part B monthly premium of $135.30 grows by 4% annually. In 30 years it will increase to $438. Even at this inflated figure, your additional HSA balance pays for more than nine years of Part B premiums. In other words, you can effectively buy an annuity with a premium of $1,200 annually for 10 years to pay nearly a decade of Part B premiums beginning 30 years later.

That’s a pretty solid investment. And it’s available only to the financially savvy – including readers of this column.

Enjoy an interest-free loan. All Health FSA elections are subject to uniform coverage rules, which means that you can spend your entire election at any point during the year. This is a feature of a Health HSA that employers must offer. If you overspend your account (reimbursement exceed payroll deductions that fund the Health FSA), you in effect receive an interest-free loan from your employer. You continue to repay that loan in equal installments through payroll deductions.

In contrast, you aren’t bound by an HSA election. You can change your contributions, including pre-tax payroll deductions, at any time during the year. Because you’re not making a binding HSA contribution commitment, you can’t borrow against a future commitment.

What is the practical effect? I’ve told this story in a previous column: My daughter needed a dental implant. The cost was $2,400. The dental practice offered a $500 prompt-pay discount. Even though I had made only three payroll deductions (about $300) at the time of her procedure, the dentist swiped my Limited-Purpose Health FSA debit care for the entire $1,900. I saved $500 instantly.

Of course, my savings were magnified by tax savings. I probably saved about $600 in taxes. So, I effectively paid about $1,300 for that procedure. The patient in the next chair over would have paid $2,400 or more (if she had to enter into a payment plan with interest) for the same procedure.

The dental practice was happy. It received payment at the time of the procedure. It willingly offered the $500 prompt-pay discount because it makes business sense (no risk of non-payment – a risk that it builds into the $2,400 price). It received the $1,900 balance.

And I was happy. I avoided what amounted to a $500 surcharge for a bad-debt allowance that didn’t apply to me. And I received about $600 in tax savings.

I could have achieved the same savings using my HSA. I had built an adequate balance after about eight years in an HSA program at that point. And my daughter, a college student, was my tax dependent at the time of the service.

But not all HSA owners have that luxury. Even though I could have paid the bill from my HSA, I value preserving my HSA balances to build medical equity to pay my qualified expenses in retirement more efficiently than I can pay the same expenses from my traditional 401(k) plan or IRA.

Reimburse non-dependent children’s qualified expenses tax-free. If your child is no longer your tax dependent, you can’t reimburse her qualified expenses tax-free from your HSA. A Health FSA, however, follows certain medical-plan rules, including the provision that you can cover an adult child to age 26, even if the child is no longer your tax dependent. So, you can reimburse your adult, non-tax-dependent child’s qualified dental and vision expenses from your Health FSA, even if the child isn’t covered on your medical plan or isn’t HSA-eligible.

So let’s say your adult child needs a dental implant or crown . . . or needs her wisdom teeth removed and your medical and dental insurance doesn’t cover the procedure. Your child isn’t your tax dependent any longer, but she lives with you, is just starting her working life, and doesn’t have a lot of discretionary income. So you want to help her financially.

If you want to help her and reduce your costs, your only option is a Limited-Purpose Health FSA. You can elect to put aside $2,700 (either procedure listed above is likely to approach this figure) and save between $540 (20% marginal tax rate) and $945 (35% marginal tax rate). Reducing a $2,700 bill by that amount constitutes real savings.

Advising Employers

I discuss the pros and cons of a Limited-Purpose Health FSA with clients. Here are some cases when it may not make sense to supplement an HSA program with a Limited-Purpose Health FSA:

Employees are transient. Employers bear a risk when they offer a Health FSA program. If a participant overspends her account and then leaves employment, the company can’t demand repayment. And if a departing employee has underspent his account, he can elect COBRA continuation to spend the remaining balance. An employer in a high-turnover company may prefer not to offer a general or Limited-Purpose Health FSA plan because of the risk associated with uniform coverage.

Employees don’t make much money. This characteristic of the workforce can tilt the decision one way or the other. In general, these employees are better off paying their dental and vision expenses from their HSAs, since they typically don’t fund their accounts to the statutory limit (and often can’t, even if they incur high expenses) and are better served with funds in an account without a use-it-or-lose-it feature. On the other hand, these employees often need the cash-flow advantage (uniform coverage) of a Health FSA.

Employees don’t understand their benefits. If employees have trouble understanding the benefits that they’re offered, introducing another benefit like a Limited-Purpose Health FSA is likely to magnify that confusion. Employees are better served with fewer benefits and more employee education, rather than another opportunity to reduce taxable income that may result in their not taking other actions (“paralysis by analysis” is a real phenomenon when people are given too many choices to comprehend) that are in their financial interest.

The company doesn’t offer a general Health FSA: In this situation, offering just a Limited-Purpose Health FSA may be costly. Many administrators offer a general and limited Health FSAs with one annual set-up or renewal fee. Paying that fee for only a Limited-Purpose Health FSA is expensive, particularly because participation is typically far lower than on a general Health FSA. And a Health FSA that limits reimbursement to dental and vision expenses isn’t as attractive as a general Health FSA to employees (like those who waive benefits or are enrolled on other coverage) who don’t need a limited Health FSA to remain HSA-eligible.

And here are several situations when it typically does make sense to offer a Limited-Purpose Health FSA:

Employees are financially savvy: Workers who grasp financial concepts are more likely to seek opportunities to reduce taxable income. Participation in a Limited-Purpose Health FSA program is highest when employees understand tax advantages and are offered tools to reduce their tax bills.

Employees are highly compensated: Highly compensated employees are looking for tax benefits. And they’re far more likely to spend on discretionary services like a restoration of less-visible teeth (bicuspids and molars) and vision-correction surgery. They face almost no risk of forfeiting Limited-Purpose Health FSA elections and can increase their tax savings and preserve HSA balances with a Limited-Purpose Health FSA election.

The company already offers a general Health FSA. In this case, the only additional costs to the employer are the monthly administration fee and additional employees who could overspend their Health FSAs and then leave employment. If the monthly account admin fee is $4.00, a participant election of as little as $628 allows the employer to cover the entire fee with FICA tax savings.

More Information – Benefit Strategies’ HSA Fact Sheets

For more information on the topic of Limited-Purpose Health FSAs, please click here to read our HSA Fact Sheet on The Interaction of HSAs and Health FSAs. Questions 7-10 discuss Limited-Purpose Health FSAs. You’ll notice that I need to update Question 8 to reflect the fifth reason to consider a Limited-Purpose Health FSA. I identified Manage high expenses only earlier this month. To view all 13 topic-specific HSA Fact Sheets, click here.

What We’re Reading

Several weeks ago, I attended the New England Employee Benefits Council (NEEBC – by the way, a great organization for human-resource professionals) annual Best Practices conference. I had the opportunity to sit next to and listen to a presentation by Lori Lucas, president and CEO of the Employee Benefit Research Institute (EBRI). I value EBRI’s regular deep dives into HSA data. The independent research firm does a lot more. It’s now conducting extensive research on employee financial well-being, a nascent movement that’s beginning to gain visibility and gather steam.

Employers typically overestimate their employees’ financial well-being. A quick look at salary and even moderate retirement-program contributions can mask some serious financial concerns and the emotions that accompany them. The result is often more stress, which manifests itself in higher medical claims, more absenteeism, and less effective work output. To learn more about the information that Lori shared, read EBRI’s research report here.

I’ve touted the benefits of an HSA as a retirement account (the subject of my new book, HSAs: The Tax-Perfect Retirement Account, available in early 2019). It can be an important component of a fulfilling retirement. But it will always take a back seat to a 401(k) plan, which has much higher limits, doesn’t extend tax benefits to distributions for certain current expenses, and is better understood by employees as a retirement savings vehicle. There’s good news on the 401(k) plan front: contributions are trending higher, which will allow more Americans to enjoy a retirement that’s less stressful financially. Here’s the good news.

You’ll be hearing a lot about Medicare for All as the 116th Congress convenes in early January. The concept, in which the federal government assumes control of the delivery and financing of medical care, polls well when it’s described as Medicare for All as opposed to single-payer health care or government-controlled health care and when surveyors don’t include a discussion of project costs and the taxes necessary to finance the program. Many Democrats ran for election or re-election with strong calls for a transition to a government-managed system. The concept represents a double-edged sword for elected officials, according to the Kaiser Family Foundation’s Drew Altman. Read his analysis here.

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