Flexibility in Flexible Spending

The Internal Revenue Service has provided guidance in Notice 2005-86 on the interaction of the 2.5-month grace period for a health flexible spending arrangement (health FSA) (established earlier by Notice 2005-42) and an individual's eligibility to contribute to Health Savings Accounts (HSAs).

Notice 2005-86 is available online at www.irs.gov/pub/irs-drop/n-05-86.pdf. Notice 2005-42 is available online at www.irs.gov/irb/200523_IRB/ar11.html.)

Generally, an individual who is participating in a health FSA is not eligible to contribute to an HSA until the first day of the first month following the end of the 2.5-month grace period, even if the individual's health FSA has no unused benefits at the end of the prior cafeteria plan year. However, Notice 2005-86 provides that an employer may amend the cafeteria plan document to enable a health FSA participant to become eligible to contribute to an HSA during the grace period.

For cafeteria plan years ending before June 5, 2006, an individual participating in a health FSA that provides coverage during a grace period will be eligible to contribute to an HSA during the grace period if:

• The person would be an “eligible individual” [as defined in Section 223(c)(1)(A)] during the grace period but for the coverage under a general purpose health FSA described in clause 2; and
• Either:

(a) The individual's (and his/her spouse's) general purpose health FSA has no unused contributions or benefits remaining at the end of the preceding cafeteria plan year; or
(b) In the case of someone who is not covered during the grace period under a general purpose health FSA maintained by his/her spouse's employer, the individual's employer amends its cafeteria plan document to provide that the grace period does not provide coverage to an individual who elects HDHP coverage.

Implications

By amending their cafeteria plan documents in accordance with IRS guidance, employers may ensure that certain individuals are not denied eligibility to contribute to an HSA during the 2.5-month grace period provided by a health FSA. As failure to amend the plan document would result in an individual's not being able to contribute the annual maximum amount to his HSA to cover eligible medical expenses that are incurred during the coverage period, amendment provides the opportunity for these individuals to take advantage of the annual maximum contribution amount eligible under HSAs. (As it is likely that not many employers are yet taking advantage of the new grace period for health FSAs, this IRS guidance may be more relevant next year.)

Background

Notice 2005-42 permitted a cafeteria plan to be amended at the employer's option to provide a grace period immediately following the end of each plan year, during which an individual who incurs expenses for a qualified benefit during the grace period may be paid or reimbursed for those expenses from the unused benefits or contributions relating to that benefit. If a plan provides a grace period, it must provide the grace period to all participants who are covered on the last day of the plan year, and the period must remain in effect for the entire period, even if the participant terminates employment on or before the last day of the grace period. However, the employer may restrict availability of the grace period to certain cafeteria plan benefits.

Under the provisions of Section 223(a), an eligible individual [as defined in Section 223(c)(1)(A)] may deduct contributions to an HSA for any month during the tax year. However, an individual who is covered by a health FSA that pays or reimburses all qualified medical expenses is not an eligible individual for purposes of making contributions to an HSA. Therefore, a participant in a health FSA is not eligible to contribute to an HSA until the first day of the first month following the end of the 2.5-month grace period, even if the individual's health FSA has no unused benefits at the end of the prior cafeteria plan year.

However, Rev. Rul. 2004-45 (available online at www.irs.gov/irb/2004-22_IRB/ar06.html) provides that an individual who is otherwise eligible for an HSA may be covered under specific types of health FSAs and remain eligible to contribute to an HSA. Examples of these health FSAs include:

• Limited-purpose health FSAs, paying or reimbursing expenses only for preventive care and permitted coverage, like vision and dental care; and
• Post-deductible health FSAs, paying or reimbursing preventive care and other qualified medical expense only if incurred after the HDHP's annual deductible is satisfied.

In other words, an otherwise HSA-eligible individual will remain eligible if covered under a limited-purpose health FSA, post-deductible FSA, or combination of the two.

Employer Options

Notice 2005-86 outlines two options that an employer may adopt that will affect participants' HSA eligibility during the cafeteria plan grace period.

General purpose health FSA during grace period. The employer may amend the cafeteria plan document to provide a grace period but take no other action with respect to the general-purpose health FSA. Under this option, an individual who participated in a health FSA (or a spouse whose medical expenses are eligible for reimbursement) for the preceding cafeteria plan year and who is covered by the grace period is not eligible to contribute to an HSA until the first day of the first month following the end of the grace period.

Mandatory conversion from health FSA to HSA-compatible health FSA for all participants. The employer may amend the cafeteria plan document to provide for both a grace period and a mandatory conversion of the general-purpose health FSA to a limited-purpose or post-deductible FSA (or a combination thereof) during the grace period. These amendments:

• Would not permit an individual participant to elect between an HSA-compatible FSA or an FSA that is not HSA-compatible;
• Must apply to the entire grace period and to all participants in the health FSA who are covered by the grace period; and
• Must satisfy all other requirements of Notice 2005-42.

Coverage of these participants by the HSA-compatible FSA during the grace period would not disqualify participants who are otherwise eligible individuals from contributing to an HSA during the grace period.

The Internal Revenue Service has provided guidance in Notice 2005-86 on the interaction of the 2.5-month grace period for a health flexible spending arrangement (health FSA) (established earlier by Notice 2005-42) and an individual's eligibility to contribute to Health Savings Accounts (HSAs).

Notice 2005-86 is available online at www.irs.gov/pub/irs-drop/n-05-86.pdf. Notice 2005-42 is available online at www.irs.gov/irb/200523_IRB/ar11.html.)

Generally, an individual who is participating in a health FSA is not eligible to contribute to an HSA until the first day of the first month following the end of the 2.5-month grace period, even if the individual's health FSA has no unused benefits at the end of the prior cafeteria plan year. However, Notice 2005-86 provides that an employer may amend the cafeteria plan document to enable a health FSA participant to become eligible to contribute to an HSA during the grace period.

For cafeteria plan years ending before June 5, 2006, an individual participating in a health FSA that provides coverage during a grace period will be eligible to contribute to an HSA during the grace period if:

• The person would be an “eligible individual” [as defined in Section 223(c)(1)(A)] during the grace period but for the coverage under a general purpose health FSA described in clause 2; and
• Either:

(a) The individual's (and his/her spouse's) general purpose health FSA has no unused contributions or benefits remaining at the end of the preceding cafeteria plan year; or
(b) In the case of someone who is not covered during the grace period under a general purpose health FSA maintained by his/her spouse's employer, the individual's employer amends its cafeteria plan document to provide that the grace period does not provide coverage to an individual who elects HDHP coverage.

Implications

By amending their cafeteria plan documents in accordance with IRS guidance, employers may ensure that certain individuals are not denied eligibility to contribute to an HSA during the 2.5-month grace period provided by a health FSA. As failure to amend the plan document would result in an individual's not being able to contribute the annual maximum amount to his HSA to cover eligible medical expenses that are incurred during the coverage period, amendment provides the opportunity for these individuals to take advantage of the annual maximum contribution amount eligible under HSAs. (As it is likely that not many employers are yet taking advantage of the new grace period for health FSAs, this IRS guidance may be more relevant next year.)

Background

Notice 2005-42 permitted a cafeteria plan to be amended at the employer's option to provide a grace period immediately following the end of each plan year, during which an individual who incurs expenses for a qualified benefit during the grace period may be paid or reimbursed for those expenses from the unused benefits or contributions relating to that benefit. If a plan provides a grace period, it must provide the grace period to all participants who are covered on the last day of the plan year, and the period must remain in effect for the entire period, even if the participant terminates employment on or before the last day of the grace period. However, the employer may restrict availability of the grace period to certain cafeteria plan benefits.

Under the provisions of Section 223(a), an eligible individual [as defined in Section 223(c)(1)(A)] may deduct contributions to an HSA for any month during the tax year. However, an individual who is covered by a health FSA that pays or reimburses all qualified medical expenses is not an eligible individual for purposes of making contributions to an HSA. Therefore, a participant in a health FSA is not eligible to contribute to an HSA until the first day of the first month following the end of the 2.5-month grace period, even if the individual's health FSA has no unused benefits at the end of the prior cafeteria plan year.

However, Rev. Rul. 2004-45 (available online at www.irs.gov/irb/2004-22_IRB/ar06.html) provides that an individual who is otherwise eligible for an HSA may be covered under specific types of health FSAs and remain eligible to contribute to an HSA. Examples of these health FSAs include:

• Limited-purpose health FSAs, paying or reimbursing expenses only for preventive care and permitted coverage, like vision and dental care; and
• Post-deductible health FSAs, paying or reimbursing preventive care and other qualified medical expense only if incurred after the HDHP's annual deductible is satisfied.

In other words, an otherwise HSA-eligible individual will remain eligible if covered under a limited-purpose health FSA, post-deductible FSA, or combination of the two.

Employer Options

Notice 2005-86 outlines two options that an employer may adopt that will affect participants' HSA eligibility during the cafeteria plan grace period.

General purpose health FSA during grace period. The employer may amend the cafeteria plan document to provide a grace period but take no other action with respect to the general-purpose health FSA. Under this option, an individual who participated in a health FSA (or a spouse whose medical expenses are eligible for reimbursement) for the preceding cafeteria plan year and who is covered by the grace period is not eligible to contribute to an HSA until the first day of the first month following the end of the grace period.

Mandatory conversion from health FSA to HSA-compatible health FSA for all participants. The employer may amend the cafeteria plan document to provide for both a grace period and a mandatory conversion of the general-purpose health FSA to a limited-purpose or post-deductible FSA (or a combination thereof) during the grace period. These amendments:

• Would not permit an individual participant to elect between an HSA-compatible FSA or an FSA that is not HSA-compatible;
• Must apply to the entire grace period and to all participants in the health FSA who are covered by the grace period; and
• Must satisfy all other requirements of Notice 2005-42.

Coverage of these participants by the HSA-compatible FSA during the grace period would not disqualify participants who are otherwise eligible individuals from contributing to an HSA during the grace period.