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The FSA/HSA Misalignment Conundrum

“An employee enrolled in both the HSA-qualified medical plan and traditional Health FSA is not HSA-eligible. She can enroll in the medical plan, but she can’t open an HSA or make any HSA contributions before the end of the Health FSA plan year at the earliest. (If she has an already existing HSA with funds in it, she is able to use those funds.)”

William G. (Bill) Stuart

Director of Strategy and Compliance

July 7, 2017

It happens all too often. A benefits adviser or employer calls me with a dilemma. The company’s FSA program runs on the calendar year. The medical plan anniversary date is mid-year, let’s say Sept. 1. The company wants to offer an HSA program for the first time this year.

Their inevitable question: “Does having the Health FSA run on a different plan year from the medical plan create a problem?”

My answer: “Yes.”

Their next question: “Is there something we can do about it?”

My answer: “I can give you several options, but you’re not going to love any of them.”

Let’s explore the issue.

A Health FSA Is a Group Health Plan

A Health FSA is a limited-benefit, self-insured, employer-sponsored medical plan. We think of it as a benefit, not a medical plan, but the IRS sees it differently. In the IRS view, participants choose a benefit level. They then pay premiums toward that plan. The employer underwrites the plan. The timing of participant payroll deductions is independent of benefits received during the plan year. Some participants pay more in premiums than they receive in benefits (forfeiting the balance to the employer at the end of the plan year), while others receive more in benefits than they pay in premium (leave employment after “overspending” their accounts).

To the IRS, that looks like a medical plan. After all, on a traditional medical plan, almost no one receives in benefits what she pays in premiums. Everyone receives either more or less in benefits than the premium that the employee and employer pay toward that coverage. That’s the nature of insurance.

Note: One benefit to having a Health FSA classified as a medical plan is that provisions of the Affordable care Act (ACA) apply to it. For example, a participating employee can cover the eligible expenses incurred by a child up to age 26, whether or not the child is the employee’s tax dependent. By contrast, HSA owners can’t reimburse tax-free an expense incurred by a child who’s no longer a tax dependent, even if the child remains enrolled on the parent’s HSA-qualified medical plan.

HSA Eligibility

The key requirements to becoming HSA-eligible are that an individual can’t qualify as someone else’s tax dependent, must be covered by an HSA-qualified medical plan and can’t have access to any disqualifying coverage. If the individual is enrolled in more than one medical plan, each plan must be HSA-eligible. Otherwise, the individual can enroll in an HSA-qualified medical plan but can’t open or contribute to an HSA until no longer covered by the disqualifying coverage.

In this case, an employee who enrolls in an HSA-qualified medical plan and also a Health FSA has coverage under two plans. Each plan must be HSA-qualified. A traditional Health FSA, which reimburses medical, dental, vision and certain OTC items without a deductible, doesn’t meet the definition of an HSA-qualified medical plan because it covers non-preventive medical services (and medical OTC items) prior to the participant’s meeting a deductible of at least $1,300 for self-only coverage or $2,600 for family coverage. (Note: These figures increase to $1,350 and $2,700 in 2018.)

An employee enrolled in both the HSA-qualified medical plan and traditional Health FSA is not HSA-eligible. (Important note: Enrollment in the Dependent Care portion of the FSA has no impact on HSA eligibility.) She can enroll in the medical plan, but she can’t open an HSA or make any HSA contributions before the end of the Health FSA plan year at the earliest. (If she has an already existing HSA with funds in it, she is able to use those funds.)

HSA-Qualified Health FSA Designs

The good news is that employers can design their Health FSA programs so that employees can participate and become or remain HSA-eligible. There are two limited Health FSA plan designs that meet HSA eligibility criteria:

Limited-Purpose Health FSA: This plan, by far the more common, reimburses dental and vision expenses only. Because dental and vision are excepted benefits (meaning that they aren’t considered when assessing HSA eligibility), employees enrolled on this plan don’t lose their HSA-eligibility. You can read more about Limited-Purpose Health FSAs, how they work, their advantages and when and how to use them here.

Post-Deductible Health FSA: The other option is to allow the Health FSA to reimburse the full range of medical, dental, vision and OTC expenses, but do so only after the participant has spent at least $1,300 (self-only coverage) or $2,600 (family coverage) that she pays with non-Health FSA funds (such as personal funds or from her HSA).

Post-Deductible Health FSAs aren’t common, though sometimes this feature is wrapped into a Limited-Purpose Health FSA. In that design, the limited Health FSA reimburses all eligible dental and vision expenses without a deductible; when the participant certifies to the Health FSA administrator that she’s met the minimum deductible for her coverage type, she can reimburse eligible medical and OTC expenses from the Health FSA as well.

Assessing Employer Options

When Health FSA and medical plan anniversary dates don’t coincide and the employer introduces an HSA program, this misalignment creates a problem. Health FSA participants can’t drop that plan in order to become HSA-eligible, either by renouncing their participation or spending their balances. They’re enrolled in the Health FSA through the end of the plan year, with no escape.

Given this situation, employers have four options:

Option 1: Prospectively terminate the Health FSA mid-year: The employer can announce in July that it’s terminating the Health FSA program effective Sept. 1 (in our example). Employees have fair warning and can spend their elections prior to that date. If they spend more than the eight months of payroll deductions that they’ll make, they come out ahead financially. If they were planning to spend their funds in November for an inpatient copay for a maternity stay, they’re out of luck unless they can find something else to buy with their money.

If the employer offers the incumbent (non-HSA-qualified) plan and introduces an HSA-qualified plan effective Sept. 1, the employer can’t split (the fancy term is “bifurcate”) the Health FSA population, terminating the plan for employees who want to become HSA-eligible Sept. 1 and retaining it for other employees. It’s all or nothing.

Option 2: Prospectively alter the Health FSA mid-year to make it HSA-eligible: A second option is not to terminate the Health FSA, but to prospectively change it to a Limited-Purpose Health FSA effective Sept. 1. In this scenario, employees can spend their balances on all FSA-eligible items purchased by Aug. 31, then on dental and vision only beginning Sept. 1. This helps employees who can’t spend all their balances by the Aug. 31 plan termination date in Option 1. On the other hand, the employee who planned to use his Health FSA funds for his wife’s maternity copay in November is worse off because he still can’t use his election for that expense (it’s not dental or vision) yet the employer continues to take payroll deductions from his paycheck.

Again, any change impacts every Health FSA participant, not just the ones enrolling an in HSA-qualified plan. Employers can’t split the population mid-year.

Option 3: Delay introducing the HSA program for one year: This option is least disruptive. The employer waits until the following Sept. 1 to introduce the HSA-qualified plan. Meantime, at the end of the Health FSA plan year (Dec. 31), the employer runs a short plan year for eight months (January through August). Then, the medical and Health FSA plan years line up Sept. 1.

This option doesn’t take anything away from any employee or create winners and losers, as the first two options do. On the other hand, it delays the introduction of a program that may benefit both employer and employees by offering lower premiums and tax savings.

Option 4: Launch the HSA program now: This option is really the opposite of Option 3. In this scenario, the employer chooses to introduce the HSA program this year. Any employees can enroll in the HSA-qualified medical plan, though those who do and also participate in the Health FSA can’t open or contribute to an HSA before Jan. 1 of the following year at the earliest, nor can they reimburse any eligible expenses, even HSA-qualified expenses, tax-free that they incur before Jan. 1 at the earliest.

The problem with this option is that the employees most likely to enroll in the HSA-qualified plan, those who understand and value the financial advantages of a plan that reduces taxable income, are enrolled in the Health FSA, which provides the same tax benefits (without the long-term savings features of an HSA). These Health FSA participants can reimburse the HSA-eligible expenses that they incur between September and December from their Health FSAs to realize tax benefits, but they can’t change their Health FSA elections to accommodate this larger out-of-pocket financial responsibility.

Additional consideration: Health FSA grace periods and limited rollover provisions impact the initial date of HSA eligibility as well under any of these options. Please review our HSA Fact Sheet on the Interaction of HSAs and Health FSAs to complete this aspect of the discussion.

The Right Approach: Prevention

The best way to avoid choosing the least bad option when launching an HSA program is to practice prevention. Though employers think of FSAs as a tax benefit that should coincide with the tax (calendar) year and the Dependent Care election ceiling of $5,000 is expressed as a calendar-year limit, Health FSAs can have any anniversary date. Here’s why it makes sense to run the medical and Health FSA plan years concurrently:

First, as we’ve seen below, different anniversary dates can impact the effectiveness of the launch of an HSA program. And if the employer doesn’t correct the problem during the year that it launches the HSA program, the defect impacts HSA enrollment in every subsequent open enrollment.

Second, even without an HSA program on the horizon, it’s not uncommon for employers to introduce medical plans that shift cost-sharing to employees. The impact varies from employee to employee, depending on projected utilization. In most cases, employees can’t review their Health FSA election mid-year to make adjustments reflecting medical plan-design changes that may impact their financial responsibility. By lining up Health FSA and medical plan anniversaries, employees will always be able to make annual Health FSA elections based on knowledge of their medical plan benefits and cost-sharing during the full 12 month plan year.

Health FSA election and medical plan decisions are not so daunting that employees can’t make both during a single point in the year. In fact, they’re complementary decisions that employees should make at one point during the year. In this case, what’s good for the launch of an HSA program makes sense in non-HSA situations as well.

What We’re Reading

Are you confused about how the Republican House and Senate versions of health-care reform compare with current law? You’re not alone. The Kaiser Family Foundation clears up the confusion with this comparison chart.

How does enrollment in a consumer-driven health plan impact employee engagement? Benefitfocus provides some answers in this survey. Spoiler: The data is encouraging!

It’s not often that “health care innovation” and “Walmart” appear in the same sentence. The retail giant is using the power of its employee base to negotiate innovative financial arrangements with providers to help manage medical costs and employees’ health. This program, described in this article, has the potential to reduce unnecessary services, save both employer and employee money when intervention is necessary and increase employee peace of mind. What’s not to love?

One thought on “The FSA/HSA Misalignment Conundrum”

  1. Jen says:

    I have 5 kids and have medical coverage for all of them. I’m divorced and my ex-husband does not help financially in any way so it’s up to me to have insurance for my kids. I had the FSA last year because my oldest son needed braces. I want to take the insurance that was a little less expensive from last year because when I added my medical, FSA, Dental, & Vision, I was paying over $750.00 a month. I am trying to cut costs and need to figure out what one to go with. Is it correct that I can’t use both of them?

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