Health FSA & HSA in the same year?

puzzle

Q: We just hired a new employee on 7/1 who told us he elected the maximum amount under his previous employer’s health FSA that started in January. We offer a HDHP with an HSA. Is he eligible to participate in an HSA? Or does he need to wait until next year? 

A:  If his health FSA terminated (i.e. he did not elect COBRA), he is eligible to participate in an HSA as of the first of the month after his FSA termination, assuming he’s otherwise eligible for the HSA.

There are 4 basic rules to Qualify for an HSA:

  • Covered under a high deductible health plan (HDHP), on the first day of the month.
  • Have no other health coverage except what is permitted under the regulations
  • Not enrolled in Medicare.
  • Cannot be claimed as a dependent on someone else’s tax return.

So if he meets these 4 requirements, he is eligible to open an HSA on the first of the month following the health FSA termination.

When an employee leaves a job during the course of the year, they are still entitled to the earmarked FSA amount for that year (assuming the eligible expenses incurred prior to termination and claims submitted timely), even if they spend more than has been taken out of their paycheck so far. Furthermore, they could contribute to a new employer’s FSA (or HSA) and have additional pre-tax dollars to spend. (The “FSA loophole” doesn’t work for HSAs because the HSAs are portable and the employee’s account even if they leave.) Likewise, an employee may work for two or more entirely different (i.e. unrelated) entities and contribute the maximum amount to both employer’s FSAs at the same time. The health FSA limit is per employee per employer’s health FSA plan.

So if the health FSA and the HSA don’t overlap, (i.e. the health FSA terminated when the employee left the previous employer) he can contribute to an HSA for the remaining months assuming he’s otherwise eligible (mentioned above). The amount he is eligible to contribute, is calculated in two ways (see Limit On Contributions):

  1. “general monthly contribution rule” – which is one-twelfth of the applicable maximum contribution limit for the year for each month of they year they are HSA eligible. (There are tax implications for “over contributing” when not eligible.)
  2. “last month rule” – which basically states an individual is treated as HSA-eligible for the entire calendar year for purposes of HSA contributions, if they are eligible on the first day of the last month of their tax year (which is Dec. 1 for most). However, to rely on this special rule, the individual must then remain eligible for the HSA through the next 12 months after the last month of their tax year. (i.e. 13 months total).

If he did elect COBRA, assuming no carry-over provision (not common for COBRA participants to be eligible for) or grace period (this is something many COBRA participants are eligible for), or if there is a grace period (or carryover) & he has a zero balance on the last day of the FSA plan year, then he would be eligible for an HSA as of the first day of the month after the health FSA plan year ends (assuming he’s otherwise eligible for the HSA).

Cafeteria Plans Do Not Have to Permit Midyear Election Changes

Changes

Under an Internal Revenue Code Section 125 cafeteria plan, employee’s elections must generally be irrevocable until the beginning of the next plan year. In other words, employees are unable to make a change to their pretax elections made when newly hired or open enrollment unless they experience a permitted election change event (e.g. change in status) allowed under IRS rules (26 CFR § 1.125-4) and the event is recognized by the employers cafeteria plan.

Employers do not have to allow any exceptions to the irrevocable rule for pretax elections1.  However, the IRS does allow employers to design their cafeteria plans to permit employees to change their pretax elections prospectively2 when certain conditions are met.

NOTE: Section 125 permitted election changes are regarding pretax deductions to pay for benefits, not the actual enrollment (or disenrollment) in an insurance plan.

But I thought if an employee got married, or had a baby we had to let them enroll in our plan? 

It is true, the Health Insurance Portability and Accountability Act of 1996 (HIPAA) requires group medical plans to permit midyear enrollment due to certain events (marriage, birth, adoption, loss of other group coverage etc.). The HIPAA special enrollment requirement is only for medical, it’s not required for excepted benefits, i.e. stand-alone dental, vision or most FSAs. (29 CFR § 2590.701-6)

NOTE: HIPAA is not a directive regarding how benefits are paid, it only mandates that an employee must be allowed to enroll in the medical plan

HIPAA special enrollment events are a subset of the Section 125 permitted election change events that provide special rights. Therefore, for practical matters, and to avoid requiring the premium to be taken post-tax, at a minimum, employers generally include HIPAA special enrollment events as permissible events allowing for a change to the pretax election, when designing their cafeteria plan3.

Footnotes:

1The irrevocable pretax election rules do not apply to health savings accounts (HSAs). Employees may prospectively change (start/stop, increase/decrease) their HSA contribution election at any time during the plan year. An employer must allow for changes at least monthly.

2Under HIPAA special enrollment (birth, adoption or placement for adoption) a retroactive pretax election change may be made. Likewise, if the plan has no waiting period (e.g. employees are eligible for coverage as of the first day of employment), employers may allow new employees to make a retroactive pretax election within 30 days of employment. However, if an employer has a waiting period (e.g. first of the month following date of hire, 30 days etc.) the new employee may only make a prospective election. (i.e. the effective date must be a date after the enrollment form was signed and submitted.)

3HIPAA requires group health plans, to give special enrollment opportunities for HIPAA specific events. Carriers are not required to incorporate all the election changes an employer may allow as permitted, by Treasury Regulations in Section 1.125. Therefore, employers with fully insured coverage, who recognize changes outside of what is required by HIPAA should confirm with their insurance carrier the group insurance contract and permissible cafeteria plan midyear change events are consistent.

 

Dependent Care FSA & Leave of Absence

daycare

When an employee takes a leave of absence (LOA), protected (e.g. FMLA) or unprotected, they may no longer be eligible for reimbursements from their dependent care FSA (which IRS regulations call a “DCAP” = dependent care assistance program) during their leave. However, they may still be able to participate in the DCAP depending on their employer’s LOA policy. 

REIMBURSEMENT

There are 2 conditions required for dependent care expenses to be eligible for reimbursement:

  1. employee must incur the expense to enable the employee and the employee’s spouse to be gainfully employed” – a facts and circumstances test
  2. the expense must be for the “care” of one or more “qualifying individuals”

In general, condition #1 is determined on a daily basis, however there are exceptions to the “daily basis” rule for certain, short, temporary absences (e.g. vacation, minor illnesses) and part-time employment.

This “exception” is based on the IRS regulations establishing a “safe harbor” under which an absence of up to two consecutive calendar weeks is treated as a short, temporary absence. However, whether an absence for longer than 2 weeks qualifies as short and temporary is determined on the basis of facts and circumstances.

Likewise, when it comes to FMLA, the IRS does not agree that one’s entire absence under FMLA (which guarantees eligible employees up to 12 weeks of unpaid leave for certain purposes) is appropriate as a temporary absence safe harbor, noting that an absence of 12 weeks “is not a short, temporary absence” within the meaning of the regulations See Preamble to Treas. Reg. §§1.21-1 through 1.21-4, 72 Fed. Reg. 45338 (Aug. 14, 2007).

PARTICIPATION

Although the employee may not be eligible to reimburse dependent care expenses while on leave, an employee on LOA may be able to continue to participate in (and make contributions to) a DCAP but any reimbursements from the DCAP will still be subject to the gainfully employed rule and would have to fall within the exception for short, temporary absences.

A DCAP (a non-health benefit) is not subject to FMLA continuation requirements, therefore it would be based on the employer’s policies regarding a leave of absence as to whether they are allowed to continue or revoke their election of “non-health benefits” under the cafeteria plan and how contributions are handled during an unpaid leave.

Employers need to understand the rules regarding DCAPs when an employee is on a leave, and make sure it was “reasonable to believe” that a expense is reimbursable or there may be adverse consequences (e.g. taxes, interest, penalties).  Likewise, if using a third-party administrator, ensure that appropriate measures are being taken too, because in general the employer will ultimately be responsible for such procedures, both under the services agreement with the TPA and under governing law.

 

Not All Cafeteria Plans Are The Same

different

cafeteria plan is a mechanism that offers employees a choice between cash (i.e. their full salary as taxable income) or non-taxable qualified benefits (i.e. allows employees to pay with pre-tax dollars.)  All cafeteria plans are salary reduction plans based on Internal Revenue Code §125, however, there are many plan design variations and not all cafeteria plans are the same.

A Premium Only Plan (POP, also sometimes called a Premium Conversion Plan, PCP) is the simplest form of a cafeteria plan under IRS Code §125. It’s a “premium payment plan” and allows for employers to take certain employee paid premiums for insurance benefits pretax. (e.g. group health, dental, vision)

When you have a health and/or dependent care flexible spending account (FSA), that goes beyond the premium payment plan format because you are permitting employees to reduce their salaries before taxes to reimburse medical/childcare expenses.

In addition to the “rules” under IRS Code §125 found in a POP plan, FSAs are subject to special requirements contained in other IRS regulations.

Health FSAs are subject to requirements under Code §105 (self-insured medical reimbursement plans) Code §106 (the requirements for accident and health plans) and Code §125.

Dependent Care FSAs are subject to requirements under Code §129 (“Dependent care assistance programs”) and various special FSA requirements in Code §125 and IRS regulations. 

Therefore you need a more complex cafeteria plan document (often called a flexible spending plan) than a POP document to be in compliance when offering an FSA.  

The most complex form of a cafeteria plan, sometimes referred to as a “full flex” plan is where an employer provides employees “flex credits” to “spend” on qualified benefits. Depending on the plan design, the employee may be eligible to receive in cash, taxable compensation if the employee doesn’t “spend” all of his flex credits on benefits.

cafeteria

One requirement that every cafeteria plan must meet, is having a written plan document that includes all content specified in the IRS code. e.g. participation rules, election and election change procedures, manner of contributions, etc. 

While it is permissible to have separate cafeteria plan documents. i.e. a POP plan document for the insurance premiums and a separate cafeteria plan document for an FSA, for ease of administration most will include a POP component with in their flexible spending plan document.

According to the 2007 proposed cafeteria plan regulations (Treas. Reg. §1.125-1(c)(6))

(6) Failure to satisfy written plan requirements. If there is no written cafeteria plan, or if the written plan fails to satisfy any of the requirements in this paragraph (c) (including cross-referenced requirements), the plan is not a cafeteria plan and an employee’s election between taxable and nontaxable benefits results in gross income to the employee.

In simple terms, failure to have a written plan document employees would be treated as if they had a taxable benefit (e.g wages) even though they received a nontaxable benefit (e.g. health insurance).

The cafeteria plan document is what allows pretax salary reductions and contains the rules the IRS permits. It’s an important document to have and to understand.

 

 

 

Healthcare FSAs Uniform Coverage Rule – an Employer’s Risk

Risk

Under the uniform coverage rule, the full amount an employee elects under a health flexible spending account (health FSA), must be available from the first day of the plan year and must remain available at all times during the coverage period. It requires employers to reimburse expenses up to the full employee health FSA election amount, even if such reimbursements exceed the employee’s year-to-date contributions.

This means an employee can potentially terminate employment having been reimbursed under the health FSA for more than they contributed up to the time of their termination.

EXAMPLES:

  • Tom enrolls for the first time in his employer’s health FSA, electing the full 2019 IRS limit of $2,700 for their April 1, 2019 – March 31, 2020 plan year.  Tom resigns effective April 30, 2019. By the end of that month, he has paid $225 into his health FSA account via salary reductions. On his last day of work (April 30, 2019), Tom submits a claim to be reimbursed for $1,900 of medical expenses that he incurred for his sons recent surgery on April 22, 2019. Tom’s employer must reimburse the full $1,900, even though he only contributed $225 before his employment ended (assuming the expenses are adequately substantiated) and the employer may not recoup the difference. 
  • Mary enrolls in her employer’s calendar year (1/1- 12/31) health FSA, electing the full 2019 IRS limit of $2,700. Mary is paid semimonthly. Throughout the year, Mary submits medical expenses totaling the full amount of $2,700.  Mary resigns effective 11/15, leaving her health FSA overspent (i.e. more was reimbursed than contributed via payroll deduction) by $337.50. Mary’s employer may not withdraw the balance from her last paycheck. 

The uniform coverage rule is part of the risk an employer takes when establishing a health FSA.  The point of the rule is that the employer must bear the risk of loss (i.e. operate like an insurance plan, rather than a mere reimbursement account) in order for the arrangement to qualify as a health FSA.

Although the uniform coverage rule is a risk, in my experience, most employers with health FSAs when looking at the plan year as a whole, do not pay out more in claim reimbursements than they receive in employee contributions. In fact, because of the risk of the  ‘use it or lose it rule’ for employees which generally requires employees forfeit to the employer any unused amounts left in their accounts at the end of the plan year, most employers total contributions exceed total reimbursements for the year.

 

Unsubstantiated FSA card transactions

credit card

Code §§105 and 125 require the substantiation (e.g., a receipt or bill) of all medical expenses paid or reimbursed from a health flexible spending account (FSA). Generally, substantiation occurs prior to funds being released, however, many FSAs allow access to the funds using a debit/credit card when the service is provided or item purchased.

When the card is swiped, IRS guidance allows certain purchases to be auto-adjudicated (i.e. they do not require further substantiation) while other purchases are allowed to be to be paid at the time of the swipe but require additional information to be submitted to the FSA administrator after-the-fact. This additional information is reviewed and then a determination is made whether the expense was/wasn’t eligible under the plan.

If employees use health FSA funds and the expenses weren’t verified, (i.e. additional information for proper substantiation is not subsequently provided) of if they used the money for an expense that was determined not to be eligible, then certain correction procedures need to be followed to recoup the money for the claims improperly paid. The employer’s FSA plan documents should contain substantiation rules and correction methods.

However, in general per Proposed Treasury Reg. §1.125-6(d)(7) the employer must ask that the employee repay the plan.  If the employee fails to repay the plan, the employer must withhold the amount from the employee’s pay, to the extent allowed by law.  If neither of the aforementioned methods results in full repayment, the employer must apply an offset against properly substantiated claims incurred during the same plan year.  As a last resort and after exhausting other required collection procedures, an employer may include unsubstantiated FSA expenses in an employee’s gross income.  The amount would be included in the year in which it was forgiven (e.g., included in the W-2 for 2019 if an amount owed from 2018 was forgiven in 2019).

However, imputed income should be the exception rather than the rule, and used as a last resort. Per, Chief Counsel Advice 201413006 (Feb. 12, 2014) “Repeated inclusion in income of improper payments suggests that proper substantiation procedures are not in place or that the payments may be a method of cashing out unused FSA amounts.”

Although employers generally are using a TPA for FSA administration and perhaps the contract/agreement with the TPA outlines whose role it is regarding claims substantiation, at the end of the day, it is the employer’s responsibility to ensure the plan is administered correctly.  {The term “administrator” in a cafeteria plan document equals employer. It is not the same as Third Party Administrator. (i.e. an employer can’t pass off the liability to a TPA. If the TPA doesn’t perform, it’s still on the employer.)}

If a plan fails to comply with the substantiation requirements, it’s an “operational failure” and the entire plan will be disqualified, with employees’ elections between taxable and nontaxable benefits resulting in gross income to the employees.

Mistakes happen!

mistake-1966448_960_720

Even HR & Benefit professionals with excellent processes in place to follow the rules for cafeteria plan administration, may stumble upon a mistake.  I probably receive a question at least monthly, on some type of oversight.

For instance, most recently I received an email from an employer who discovered during a payroll audit, they failed to take the correct amount of premiums from an employee’s paycheck per the terms of the salary redirection agreement (e.g. enrollment form) signed by the employee during open enrollment. The employee was enrolled in the correct benefits with the carriers effective 1/1 but somehow the wrong employee pretax deductions occurred and too little premium withheld.

Unfortunately, there really aren’t IRS regulations or guidance addressing what to do when a mistake like this occurs (they only address a few narrow areas). However, my understanding of “cafeteria plan administrative errors” corrections is generally, an employer will want to correct the mistake so the employee and the plan are put back into the position they would have been in had the mistake never occurred.

For example, knowing there hadn’t been enough money withheld, the employer would want to let the employee know an oversight occurred and depending on the amount of the money needed to be made up, either ask for the employee to pay the entire amount or perhaps have double-premiums deducted until the shortfall is corrected.

However, whenever a mistake is discovered, and yes mistakes do happen, the best course of action is to contact an experienced benefits attorney, who can provide legal advice before implementing corrections to ensure all federal & state wage/tax laws are considered. (Let me know if you need one. I can refer you to the best!)