Understanding Health FSAs

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“There are three important ways employees benefit from participating in a Limited-Purpose Health FSA that employers should consider when reviewing whether to offer it:  Additional tax savings, preservation of HSA funds and cash-flow advantages.”

William G. (Bill) Stuart

Director of Strategy and Compliance

October 12, 2017

One of the more difficult concepts for benefits administrators to comprehend is that a Health FSA, which we traditionally think of as a reimbursement account, is actually a group health plan. Its inclusion in this category has important implications for design and compliance.

In this post, we’ll explore:

  1. Why a Health FSA is a group health plan and what it means for compliance.
  2. Health FSA options that keep employees HSA-eligible.
  3. The benefits of limited Health FSAs.
  4. What strategies employers are using around Health FSAs.

A Group Health Plan?

Sometimes, the reasoning behind IRS regulations is confounding. In the case of Health FSAs, the IRS employs sound logic in labeling Health FSAs as self-insured, limited-benefit group health plans.

Think about a Health FSA. It’s a limited benefit plan, as each participant chooses her benefit level, up to a maximum set by the IRS (and expected to increase from $2,600 in 2017 to $2,650 for plans starting in 2018). Unlike standard medical plans with no annual or lifetime limits on essential health benefits, a Health FSA has an annual limit chosen by the participant.

It’s also a self-insured plan, although this concept is a little more difficult to grasp. The key to understanding this aspect of Health FSAs is the concept of “uniform coverage,” or the availability of the entire annual election at any point during the plan year. Simply stated, when a participant makes an election, the employer is funding the plan up to that election. The participant makes uniform payroll deductions throughout the year, which represent a premium paid. The plan sponsor, the employer, makes benefits available at any point during the year, just as a commercial insurer does.

If the participant reimburses a large expense early in the plan year and then leaves employment, she no longer pays premiums deducted from her paycheck. She has “overspent” her account. The plan sponsor – again, her employer – is responsible for the difference between premiums paid and expenses insured, just as a commercial insurer is responsible for paying for a hospitalization early in the plan year for an employee who leaves employment so that employer and employee no longer pay a premium.

If a participant fails to spend the entire election during the plan year and the employer hasn’t attached a grace period or rollover to the plan, the employee has no legal claim to a refund of those unused balances. This is the dreaded “use it or lose it” feature of Health FSAs that paralyzes the risk-averse and leads many eligible participants to elect too little or not participate at all in fear of forfeiting balances. A Health FSA works just like a commercial health plan: When an employee and his covered dependents incur only a small amount of claims, the employer and employee can’t demand a refund from the insurer.

Now does it make sense why the IRS calls a Health FSA a group health plan?

Implications

Categorizing a Health FSA as a group health plan has some important compliance implications.

Health FSAs and adult children. Under the ACA, children can remain covered on a parent’s group health plan until the child reaches age 26. The same holds true for a Health FSA. A Health FSA participant can reimburse expenses incurred by an adult child under age 26, whether or not the child is a tax dependent and whether single or married.

This tax treatment is different from Health Savings Accounts. HSA owners can reimburse eligible expenses incurred by tax dependents only, regardless of whether the adult child (or any other family member) is covered on the HSA owner’s medical plan.

In my case, and perhaps yours, this distinction has important implications. My son, age 23, needs to have his wisdom teeth removed. This service isn’t covered on my medical or dental plans, which means that he and I will be responsible for perhaps $3,500 in expenses. I can’t reimburse this expense tax-free through my HSA because he’s no longer my tax dependent. I can, however, reimburse it from my Limited-Purpose (more on this concept below) Health FSA because he’s not yet age 26. And if he had a Health FSA at work, he too could make an election and contribute toward the cost of the service with tax-free dollars.

Health FSAs and HSA eligibility. HSA eligibility rules are clear: When an individual is covered by more than one medical plan, the individual is HSA-eligible only if all plans are HSA-qualified. (Please note that a Dependent Care FSA, which reimburses child and adult day care, preschool, after-school programs and certain summer camps do not compromise HSA eligibility, since they don’t reimburse any medical expenses.)

Are HSAs and Health FSAs mutually exclusive? Not entirely. It’s true that an individual who wants to be eligible to contribute to an HSA can’t be covered by his own or a spouse’s traditional or General-Purpose Health FSA. As we’ve shown already, the Health FSA is a group health plan, and a traditional Health FSA plan reimburses medical expenses on a first-dollar (no Health FSA deductible) basis. Anyone who can access benefits through her own or a spouse’s traditional Health FSA can’t contribute to an HSA for the months that she’s also covered on a traditional Health FSA.

Limited Health FSAs

Fortunately, there are several Health FSA designs that allow individuals to participate while remaining HSA-eligible. Here they are:

Limited-Purpose Health FSA. This plan limits reimbursement to dental and vision services (plus some preventive care that isn’t covered in full by the medical plan). Section 223 of the Internal Revenue Code (which created HSAs) specifically lists dental and vision coverage as not disqualifying individuals from becoming HSA-eligible and provides that select preventive care can be covered outside the deductible. Thus, individuals can participate in these limited Health FSAs and remain HSA-eligible.

Post-Deductible Health FSA. This plan can cover all Section 213(d) expenses, including medical, dental, vision and certain OTC items, but only after imposing a deductible. The Post-Deductible Health FSA can’t begin to reimburse eligible expenses until the participant certifies that he has incurred at least $1,350 (self-only coverage) or $2,700 (family coverage) of eligible expenses that he pays with personal or HSA funds.(These minimum figures apply to all plans that begin in 2018 and represent $50 and $100 increases from 2017 minimum deductibles.)

Hybrid. A third flavor combines the first two limited Health FSA features. Under this plan, typically labeled a Limited-Purpose Health FSA, reimburses dental and vision, then adds medical, prescription drug and certain eligible OTC items once the participant certifies that she has reached the minimum deductible for an HSA-qualified plan. This design provides additional flexibility for participants by expanding the range of expenses eligible for reimbursement.

Are Limited Health FSAs Redundant?

Expenses eligible for reimbursement through both HSAs and Health FSAs are governed by the same section of the Internal Revenue Code: Section 213(d). This section of the tax code doesn’t provide a convenient list of eligible expenses, but it broadly defines as eligible any expense that diagnoses, treats or mitigates an injury, illness or condition. IRS Publication 502, published annually, provides a comprehensive list of items eligible for the medical tax deduction, a list that is nearly identical to the list of services eligible for tax-free distribution from Health FSAs and HSAs.

Since the list of eligible expenses is the same, why would an employee contribute to an HSA and also elect to participate in a Health FSA? HSAs are much more flexible, allowing unlimited rollover, while participants in Health FSAs, whether traditional or limited, risk forfeiting unused balances back to their plan sponsors.

There are three important ways that employees can benefit from participating in a Limited-Purpose Health FSA that employers should consider when reviewing whether to offer it:

Additional tax savings. Employees with access to a limited Health FSA can contribute to the maximum in their HSAs ($3,450 for self-only coverage or $6,900 for family coverage, plus an additional $1,000 if age 55 or older in 2018) and also elect to contribute up to $2,650 in their Health FSAs. Every dollar that they contribute/elect to these plans reduces their taxable income dollar-for-dollar. As a bonus to employers, all Health FSA elections and employee pre-tax payroll contributions to an HSA aren’t subject to the employer’s share of payroll (FICA) taxes. Offering both the HSA and the limited Health FSA option benefits both employees and employers seeking to minimize their tax burdens.

Preservation of HSA funds. A growing number of HSA owners – and their financial advisors – now realize the benefits of HSAs as long-term savings and investment accounts to save for medical, dental and vision expenses and Medicare premiums in retirement. For these owners, a limited Health FSA allows them to reimburse certain expenses from those accounts rather than their HSAs, thus preserving HSA balances for growth and tax-free spending on eligible expenses in retirement.

Cash-flow advantages. HSA owners who don’t contribute to the maximum don’t gain additional tax advantages by making an election to a limited Health FSA and probably don’t have sufficient discretionary income to systematically save for retirement in their HSAs. A limited Health FSA, particularly a Limited-Purpose Health FSA, can help them with cash flow. An employee can make a $2,650 election to a Limited-Purpose Health FSA, incur an expense early in the year and pay the entire bill, perhaps receiving a prompt-pay discount (as your author did when settling an endodontic bill of $2,400 for a prompt-pay discount of $1,900 last January).

When HSA Eligibility Doesn’t Matter

 The discussion around limited Health FSAs is relevant only when employees want to become or remain eligible to open and contribute to an HSA. In some cases, an employer offers an HSA-qualified medical plan and then builds an HRA that reimburses a portion of the medical plan deductible. Most such plans disqualify employees from contributing to an HSA because an HRA, like a Health FSA, is a group health plan. Unless the HRA is a Limited-Purpose or Post-Deductible HRA, employees won’t be HSA-eligible. In this case, employees can participate in a traditional Health FSA, which reimburses all Section 213(d) expenses (less any restrictions the employer imposes).

What Are Other Employers Doing?

Among the two limited Health FSA designs, employers almost universally choose the Limited-Purpose Health FSA. It’s easy to understand and provides immediate (no deductible) benefits. We rarely see a Post-Deductible Health FSA, which employees perceive (correctly) as being riskier because they don’t receive any reimbursement until they’ve satisfied the Health FSA deductible. Few employees want to be so “unlucky” as to avoid high medical bills during the year and thus not be able to access their Health FSA balances.

Employers who offered Health FSAs when they introduced HSAs typically offer employees a Limited-Purpose Health FSA. This is especially true when the employer also offers a non-HSA option so that the company maintains a traditional Health FSA for enrollees in the other plan and benefit-eligible employees who waive coverage.

A growing number of employers are offering and promoting Limited-Purpose Health FSAs and educating employees about the benefits of participation. They tailor their messages, greater tax savings, faster HSA balance growth, and cash-flow advantages based on their employees.

What Should Employers Do?

Employers not offering a Health FSA should reconsider, and employees not participating should rethink their position as well.  Health FSAs generate tax savings for employees, effectively allowing them to grant themselves a raise by shielding a portion of their income from federal income and payroll taxes and, if applicable, state income taxes as well. And employer FICA tax savings offset a good portion, if not all, of the administrative cost.

Employers who offer an HSA program should review the benefits of offering employees a Limited-Purpose Health FSA to deliver the three benefits that we’ve listed several times.

Employers who run their Health FSAs and medical plans on separate plan years should take steps now to align the anniversary dates. We’ve discussed this issue before.  Employees who want to become HSA-eligible and begin to contribute to their HSAs can’t do so before the end of their Health FSA plan year.

What We’re Reading

The federal government currently finances about half of all medical spending through Medicare, Medicaid, the VA system, TRICARE (coverage for active and retired military and their families) and the federal employees’ benefits program. Are you inclined to hand over the other half of the market to the same federal government? The Sanders Institute tells you why it would be a good idea. In my personal blog, I raise serious questions about this approach to reform.

Is your benefit offering keeping up with changing employee needs? MetLife’s annual survey of employees indicates that they’re concerned about their financial security, want access to a wide range of employer-sponsored benefits (even if the employer doesn’t contribute to all), struggle to blend work and life and want to be valued for what they bring to the company. Learn more here.

In another of my recent personal blog posts, I wondered how medical delivery and financing might change if Amazon entered the market and brought its existing model to this segment of our economy. The online giant continues to access the medical market.

 

2 thoughts on “Understanding Health FSAs”

  1. Valerie Buffington says:

    I read your HSA GPS Fact Sheet Series from April and am interested in learning more about question #4, as this is the exact scenario that we are now facing. My husband will have Medicare starting November 1 and I am covered, as his spouse, on his high deductible health plan through his work. We have been contributing as a family to our HSA for several years. I would like to continue to contribute if possible. I can’t locate where on the IRS publication 969 that addresses this. Can you direct me to the paragraph that would pertain to this. Thanks.

    1. Bill Stuart says:

      Under “Qualifying for an HSA” (page 3 of Publication 969), The IRS lists four bullet-point eligibility rules that you must follow. If you meet these criteria, you’re eligible to open and contribute to an HSA. It sounds like you qualify. If your husband remains covered on his group plan in addition to Medicare, then you retain family coverage and can continue to make the full family contribution for 2017. The only caveat is that any contribution greater than 10/12 of the maximum contribution must be made into an HSA that you own. Total contribution to your husband’s HSA can’t exceed 10/12 of $6,750 (plus 10/12 of the $1,000 catch-up contribution). Assuming that you’ve been HSA-eligible all year (even if you haven’t opened your own HSA), the two of you can contribute up to up to $6,750, less non-catch-up contributions to his HSA, into your HSA. In other words, if he contributed only $3,833 to his HSA ($3,000 regular contribution plus $833 catch-up contribution), the two of you can contribute an additional $3,750 ($6,750 limit less his $3,000) to your HSA.

      If he drops the group coverage and you have self-only coverage beginning Nov. 1, then your adjusted family contribution limit for 2017 is 10/12 of $6,750 and 2/12 of $3,350. No more than 10/12 of $6,750 (plus 10/12 of his $1,000 catch-up contribution) can be deposited into his HSA. The two of you can deposit up to your adjusted family contribution limit (less his contributions to his HSA) into your HSA.

      Let’s simplify. The two of you can contribute up to $5,625 into his HSA for 10 months’ coverage on a family contract, plus $833.33 for his catch-up contribution. Any portion of that money can also go into an HSA that you own. In addition, you can contribute either an additional $1,125 (if your coverage tier remains “family”) or $558.3 (if you have self-only coverage beginning Nov. 1) into your HSA. Also, if you’re age 55 or older in 2017, you can contribute the full $1,000 catch-up contribution into your HSA, even if you’re just getting around to opening your own HSA now that your husband is enrolling in Medicare and further contributions to his HSA cease.

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