Beware of HSA – FSA Overlap

At this time of year, it is open enrollment season for benefits at many companies—and your clients may be choosing their health coverage for the coming year. If your clients are typical, many of them will opt for a high deductible health plan (HDHP) coupled with a health savings account (HSA) to pay for out-of-pocket medical expenses. According to the latest survey from America’s Health Insurance Plans (AHIP) Center for Policy and Research, the number of individuals enrolled in HDHP/HSA coverage has steadily increased over the last several years, with 17.4 million enrollees with HDHP/HAS coverage in January 2014.

Caution: For clients who are new to HDHP/HAS coverage, a word of caution is in order. HSAs and health flexible spending accounts (FSAs) don’t mix. Clients who have contributed to a health FSA in prior years will have to discontinue those contributions once they switch to HDHP/HSA coverage. Moreover, clients should be careful to avoid an unintentional HSA-FSA overlap.

Symptoms of HSA-FSA Overlap. An HSA can offer double tax benefits: Contributions made with pre-tax dollars and distributions from the account are tax-free if used for qualifying medical expenses. However, an individual is eligible for contributions to an HSA only if he or she is covered by a high deductible health plan (HDHP) and does not have coverage under another plan (other than certain permitted coverage) [IRC Åò223(c)(1)(A)]. A general purpose health FSA constitutes other coverage that is incompatible with an HSA. Therefore, an employee cannot make or receive tax-favored HSA contributions in any year that he or she has coverage under a health FSA. However, HSA-FSA overlap can occur even if an individual does not make or receive any FSA contributions.

Under a new FSA option, plans can now allow up to $500 of unused FSA contributions to be carried over to the following plan year [Notice 2013-71, 2013-47 IRB 532]. However, IRS guidance indicates that the carryover option can have unintended side effects.

In a Chief Counsel Memorandum, the IRS says the prohibition on HSA contributions applies to an individual who has general purpose FSA coverage solely as a result of a carryover of unused amounts in a health FSA from the prior year [CCA 201413005 (Feb. 12, 2014)]. What’s more, the prohibition will apply for the entire plan year, even if the FSA is tapped out early in the year. The individual will be barred from HSA contributions for the entire plan year, including months in the plan year after the health FSA no longer has any amounts available to pay or reimburse medical expenses.

Overlap Antidote. Fortunately, there are some antidotes for HSA-FSA overlap.

If the employer’ plan permits, an employee who participates in a general purpose health FSA for one year and chooses HAS coverage for the following year can elect to have any unused FSA amounts carried over to an HSA-compatible FSA. The IRS says that there is no requirement in the new carryover rules that unused amounts in a general purpose health FSA be carried over to a general purpose health FSA. However, unused amounts may not be carried over to a non health FSA or to another type of cafeteria plan benefit.

HSA-compatible FSAs include limited purpose FSAs that restrict reimbursements to additional health coverage that is permitted under the HSA rules (such as vision, dental, or preventive care benefits) and post-deductible FSAs that provide reimbursements only after the minimum annual HDHP has been satisfied [Rev. Rul. 2004-45, 2004-22 IRB 971].

A plan can also offer an employee, who switches from a general purpose FSA to an HSA, the option of declining or waiving any carryover of unused FSA funds. An employee must make this election prior to the beginning of the plan year in which he or she wishes to participate in the HSA.