The Unlimited Possibilities of Limited-Purpose Health FSAs

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By William G. (Bill) Stuart

Director of Strategy and Compliance

Sept. 15, 2016

As most readers know, individuals covered by a traditional medical Health FSA, which reimburses medical, prescription drug, dental, vision and certain OTC products and services, are not eligible to open or contribute to an HSA. It doesn’t matter whether the individual’s or his or her spouse’s employer sponsors the traditional Health FSA. Under federal tax law, the employee, spouse and children to age 26 are automatically covered by a Health FSA unless an employer excludes some family members (which is very rare).

The tax code allows individuals to remain HSA-eligible while enrolling in a Limited-Purpose Health FSA. A Limited Purpose Health FSA (LP FSA) reimburses only eligible dental and vision expenses, plus select preventive services that aren’t covered in full under the Affordable Care Act. For readers who delight in the details, a Limited-Purpose Health FSA is born of Sections 223 (c) (1) (B) (ii) [vision and dental] and (c) (1) (C) [preventive care] of the Internal Revenue Code.

Many employers and employees overlook the power of the LP FSA. They reason that since employees can reimburse out-of-pocket dental, vision and preventive care services from their HSA without the use-it-or-lose-it restrictions of a Health FSA, a LP FSA isn’t necessary. Far from being rendered redundant or superfluous, though, the LP FSA serves an important purpose and increases the attractiveness of an HSA program.

 Benefits to employees

First, LP FSAs can help participants with cash flow. HSA balances grow as deposits are made into the account by employers and employees. Think of an HSA as a checking account with no overdraft protection. This key feature of an HSA may leave participants with cash-flow issues early in their first year in an HSA program, or at times when they have had to draw down much of their HSA balance. A LPFSA has the same universal coverage feature of a traditional Health FSA, allowing employees access to their full annual LP FSA election on the first day of the plan year. For employees undergoing expensive vision or dental expenses – vision-correction surgery, orthodontia or a dental crown, for example – a LP FSA is a cash-flow godsend. These participants often can take advantage of cash discounts for these services while building their HSA balances to cover medical services and prescription drugs.

Second, LP FSAs increase tax savings. Individuals with access to a LP FSA can make the maximum contributions to their HSAs and to a LP FSA as well. An individual under age 55 with family coverage can reduce taxable income not only by up to $6,750 (less contributions from any other source, including employer) through HSA contributions, but also exclude up to $2,550 (the LP FSA election limit for 2016) from taxable income. For individuals filing jointly with taxable incomes between about $75,000 and $150,000, the savings amount to about $830 in federal income and payroll taxes alone and approach $1,000 in states that impose state income taxes. For most families in that taxable income range, an extra $1,000 per year to pay medical bills, invest in college funds or pay for auto repairs or utilities is welcome additional income.

Third, employees can build HSA balances more quickly. A growing number of HSA owners are building account balances over time sufficient to begin investing their balances in mutual funds while retaining sufficient cash to pay their eligible expenses. A smaller but growing number of owners are taking a more aggressive stand, paying most or all of their eligible expenses with personal funds and building their HSA balances as quickly as possible to pay for eligible expenses later in life tax-free. In either case, the opportunity to pay eligible dental and vision expenses tax-free from an account other than their HSAs allows them to build their HSA balances, increase their net worth and potentially build their account balances through savvy investing rather than on minuscule market interest rates.

Fourth, some employees can take advantage of Health FSA rollovers. Some employers have adopted the provision allowing participants to roll up to $500 of their remaining Health FSA balance into a Health FSA during the following year. This option represents a potential gotcha to employees transitioning into an HSA program, since any rollover into a traditional Health FSA makes them ineligible to open or contribute to an HSA during the entire 12-month Health FSA plan year. Employees can always spend their remaining balances before the end of the Health FSA plan year, though sometimes that spending is on low-value items (such as a third pair of prescription sunglasses). Employers who offer a LP FSA can roll over balances from a traditional medical Health FSA into a LP FSA for employees who want to become HSA-eligible, while allowing other employees for whom HSA eligibility isn’t an issue to roll over balances into a traditional medical Health FSA.

 [Important note: Employer’s do not have this flexibility within a Health FSA plan year. When the medical plan anniversary falls during the Health FSA plan year or the Health FSA includes a grace period, employers can’t split the population by moving some participating employees to a LP FSA while allowing others to remain on a traditional medical Health FSA. The difference is that in the case of rollovers, a new Health FSA plan year is involved.]

Benefits to employers

First, they have happier employees. Employees have more benefits flexibility, enjoy an additional opportunity to avoid cash-flow crunches and can shelter more of their income from taxes.

Second, employers enjoy additional tax savings. Employers avoid FICA (Social Security and Medicare payroll) taxes on employee contributions to HSAs and LP FSAs through a Cafeteria (Section 125) Plan. While each employee who makes a $2,550 election into a LP FSA saves up to $1,000 in taxes, an employer saves nearly $200 in FICA taxes. That amount is far less than the typical $50 to $60 that an administrator charges annually to manage a LP FSA account.

Third, they’re helping employees with financial planning. Millennials are the largest single generation in the work force and will become an absolute majority of US workers within the next four to five years. Survey after survey shows that they are looking to their employers to help them with financial planning as they’re squeezed with educational debt and the cost of supporting not only their immediate families, but also, in many cases, helping parents or other older relatives financially. An additional tax-saving option, along with some guidance on how to take advantage of this tax-reduction opportunity, is a welcome benefit to these employees.

Conclusion

Most employers – and nearly all with 100 or more employees – offer Health FSAs to their employees. They realize the importance of these accounts in attracting and retaining talent, easing employee concerns about paying for rising out-of-pocket health-related expenses and offering tax-saving opportunities for both employees and employers. These same factors make LP FSAs an attractive option to employees and employers when the employer offers an HSA program. Far from being an either/or proposition, employers who offer both HSAs and LP FSAs bring additional benefits to themselves and their employees.

What we’re reading

Michael Cannon of the Cato Institute has spent the last six years educating Americans about the perverse effects of the ACA. In his latest piece, see how residents of one county in Arizona are caught in a “Catch 22” situation. The absence of medical plans in the county’s public marketplace means no subsidies in this crazy, convoluted, wacky scenario.

One percent of patients account for 21% of health care spending, while 50% account for only 3% of total spending. When looking at average costs per covered individual doesn’t provide meaningful information, Kaiser Family Foundation breaks down spending within subsets of the population here.

 

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