Assessing the Positive and Negatives of Setting up Negative Elections to HSAs

This column is an excerpt (Question 166) from a book to be published later this year to help guide account owners, employers, benefits managers, and administrators understand Health Savings Account compliance issues. The format consists of a common question, an explanation in easy-to-understand English (often with an appropriate example), and a citation from government documents to support the answer. The book is designed to inform. It is not a legal document, and the contents should not be construed as legal advice.

Question: I want to encourage my employees to make pre-tax Health Savings Account contributions. Under our new program, their payroll deductions for medical premiums decline. Can I set the payroll system to automatically deposit that difference into their Health Savings Accounts as an employee contribution?

?Answer: Yes. What you describe is referred to in Internal Revenue Service guidance as a negative election. Many employers have adopted this approach to increase participation in 401(k) and other employer-based retirement plans. The term has unfortunate connotations for a concept that helps employees increase their asset base. We use the alternative and more positive sounding term default election here

You can set up default elections if you’ve established a Cafeteria Plan (also called a Section 125 Plan to reflect the relevant section of the Internal Revenue Code) to govern employer and employee contributions. You must provide employees with written notice about the plan, including the default elections, and allow them to opt out of the default at any time.

Default elections are an effective way of helping employees build their Health Savings Account balances. The practice is based on sound principles in the field of behavioral economics. People practice inertia (the tendency to do nothing) in many aspects of their lives, particularly areas that they don’t fully understand or involve actions that someone else has taken on their behalf. Employers leverage this principle to help new employees by setting an initial level of compensation as a payroll deposit into employees’ accounts.

Good marketers understand this concept. When a consumer enrolls in a subscription program, she’s committed to regular purchases. That’s why Amazon offers lower unit prices to customers who order coffee pods through an auto-ship plan, and newspapers and magazines discount subscriptions to readers who agree to extend their subscriptions automatically by placing a debit card on file. If you’re old enough, you remember when you could select four records for $1 when you enrolled on a music plan and committed to at least one additional purchase monthly at standard prices.

Default elections are an underutilized tool. You do your employees a favor by establishing a baseline of contributions so that they begin to build a balance to help pay future out-of-pocket medical costs. Employees enrolled on HSA-qualified coverage and funding a Health Savings Account have a more favorable impression of their coverage when they – consciously or unconsciously – build an account balance and are prepared financially when they receive care for which they have out-of-pocket financial responsibility.

Employees often don’t notice the default election if it doesn’t affect their net pay (you deposit the difference between the old and new payroll deduction for medical premium) or it’s otherwise hidden (the default value rises with a scheduled pay raise). When employees are newly enrolled on the plan and you deduct premiums from their paychecks, most workers aren’t engaged enough to break down the drop in their net pay and realize that you’re deducting not only premiums, but an employee Health Savings Account contribution as well. That’s especially true for new employees, who have no point of reference of what their net pay should be. It’s also true when you give these workers an annual raise and bump up their payroll deduction for Health Savings Account contributions by an additional 1% of pay. They can calculate that a 4% raise on a $50,000 salary equals an additional $2,000 of income annually, but they know that some of that raise is absorbed by an indeterminate increase in taxes withheld. Few workers take the time to retrieve an electronic pay stub to do the math.

A criticism of default elections to retirement plans carries over to Health Savings Accounts as well. Some employees who understand the default elections may believe that their employer is setting the ideal funding level rather than a minimal amount that employees might not notice in their paychecks but can make a meaningful difference over time. Most financial professionals know that a 3% retirement savings rate won’t fund a sound financial future. Similarly, a 3% funding level on a $50,000 salary ($1,500 contributed annually) to a Health Savings Account may be inadequate to cover a family’s qualified medical, dental, and vision expenses.

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IRS Notice 2004-50:

?Q-61. Can employers provide negative elections for HSAs if offered through a cafeteria plan?

A-61. Yes. See Rev. Rul. 2002-27, 2002-1 C.B. 925.

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.

HSA Question of the Week is published every week, alternating every other Wednesday with HSA Wednesday Wisdom and every other Monday with HSA Monday Mythbuster.