It's Health FSA-HSA Alignment Conundrum Season!

Health Savings Accounts and the most common Health FSA design don't mix. What can an employer do when the two programs' anniversary dates don't align?

Health Savings Accounts and general Health FSAs offer similar tax benefits. But offering both becomes problematic when the plans don't renew at the same time. This misalignment creates problems at the group level when the Health Savings Account is introduced and in every subsequent year that employees have a choice of at least one medical plan in addition to the HSA-qualified option.

What is the problem? What steps can an employer take to resolve the issue?

Note: In next week's issue, we'll build on this topic to discuss how an extender - a grace period or a carryover of unused balances - to the general Health FSA affects an employee's eligibility to open and fund a Health Savings Account for the first time.

The Argument for a Calendar-Year FSA

It's not unusual for a company to run its Health FSA and Dependent Care FSA programs on a calendar year. For most workers, the calendar year is the tax year, and FSAs are a tax benefit. Thus, the employer is aligning a tax benefit with the tax year.

Also, the Dependent Care FSA limit of $5,000 is tracked on the calendar year, regardless of when the company's medical plan renews.

The General Argument for Alignment

There are several good reasons to align the FSA and other benefit - including medical plan - renewals, whether or not the company offers a Health Savings Account program:

• It's easier administratively for the employer and more efficient for the employee to make all benefits decisions at one time.
• If the plan years aren't aligned and the employer makes a change to employees' out-of-pocket responsibility on the medical plan - for example, increasing the deductible from $1,000 to $2,000 or adding a prescription-drug tier with a much higher copay - employees can't make a mid-year change to their mid-year Health FSA election.
• When the company offers a Health Savings Account program, employees participating in a general Health FSA may be disqualified from making or receiving contributions to their Health Savings Account.

Whether the company has introduced or is planning to unveil a Health Savings Account program in the future, it's usually (but not always) optimal to align the medical plan and the Health FSA plan years. Employees aren't burdened by making one additional election (or two, if they participate in both the Health FSA and Dependent Care FSA) during open enrollment. And doing so avoids the problems we discuss below.

The Misalignment Conundrum

Federal tax law states that individuals aren't HSA-eligible unless they're

• enrolled in HSA-qualified coverage and
• can't be claimed as another taxpayer's tax dependent and
• aren't covered by a disqualifying plan.

When the company sponsors a calendar-year general Health FSA and renews its medical coverage later in the year - say, July 1 - employees enrolled in the general Health FSA can enroll in HSA-qualified coverage, but they can neither make nor receive a contribution to a Health Savings Account before the end of their general Health FSA plan year.

Why?

Under federal tax law, a Health FSA falls under the definition of a medical plan. An individual can be enrolled in more than one medical plan and be HSA-eligible, but only if all plans are HSA-qualified. A general Health FSA begins to pay benefits immediately (there is no deductible), which violates the requirement that a plan must have a deductible of at least $1,500 (self-only coverage) or $3,000 (family plan). Thus, a general Health FSA is disqualifying.

The Ugly Solutions

So, what happens when you're enrolled in a calendar-year general Health FSA and you want to enroll in HSA-qualified coverage on your company's July 1 anniversary date?

First, note that wanting to participate in a Health Savings Account program is not a qualifying event that allows you to terminate your enrollment in a Health FSA. Second, note that you're covered by a Health FSA during the entire plan year, even if you spend your election well before the end of the plan year. So, those options are off the table.

Here are an employer's options to allow Health FSA participants (the most likely enrollees in a Health Savings Account program, because they understand the benefit of paying qualified expenses with tax-free funds) to enroll in a Health Savings Account program during the Health FSA plan year:

Prospectively terminate the general Health FSA plan mid-year for all participants. A company can change its Health FSA program prospectively - including cancelling it - at any point during the plan year. This option is drastic. It helps participants who overspend their accounts, since payroll deductions stop when the plan terminates. On the other hand, employees who've saved their election for an expense later in the Health FSA plan year lose their unspent balances. Terminating the plan applies to all participants, not just those who want to become HSA-eligible mid-year. A company can't split the Health FSA population in two - one that disenrolls to become HSA-eligible and another that doesn't and can continue to participate.

Prospectively change the general Health FSA to a Limited-Purpose Health FSA mid-year. This option appears less drastic at first glance. The general Health FSA remains in place, but it becomes an HSA-qualified plan by limiting reimbursement to dental or vision expenses (which are permitted coverage for employees who want to open and fund a Health Savings Account). This prospective change applies to all participants. It allows them to continue to spend their elections, but narrows the range of qualified expenses. It benefits participants with remaining balances who had planned to reimburse dental and vision expenses. It hurts others who planned to spend their election on medical expenses - say, a deductible for maternity care - later in the plan year.

This solution keeps the general Health FSA program in place for all participants, but with a range of qualified expenses far narrower than those in place when employees made their election. Employees can open and fund a Health Savings Account immediately if they're otherwise eligible.

Proceed with the Health Savings Account Plan. In this scenario, the company adds an HSA-qualified plan without changing the general Health FSA. Employees who participate in the general Health FSA can enroll in any medical plan offered, including the HSA-qualified plan, but they can't open and fund a Health Savings Account. They can use their general Health FSA balances to reimburse their deductible (and other qualified) expenses.

The employer can change the future Health FSA plan year by renewing Jan. 1 on a short plan year that ends on the anniversary of the medical plan year (say, July 1). That way, employees in the future won't face the dilemma inherent in the misalignment of the different plan-renewal dates. A participant in a 2023 calendar-year general Health FSA who enrolls in the HSA-qualified plan July 1, 2023, can open and fund a Health Savings Account beginning Jan. 1, 2024, if she doesn't sign up for the general Health FSA again.

Delay the Health Savings Account program for a year. This option may or may not be feasible financially for the employer. In this scenario, the company delays the introduction of the Health Savings Account program for a year. It educates employees about the conflict between a general Health FSA and a Health Savings Account prior to the Jan. 1 renewal of the Health FSA plan.

Ideally, the company runs the Health FSA on a short plan year for six months. Employers can deviate from the standard 12-month Health FSA plan year for business purposes, such as aligning the plan year with the medical-coverage anniversary. This way, all employees can elect a general Health FSA to cover expenses incurred from Jan. 1 through June 30. Then, effective July 1, workers enrolling in the Health Savings Account program don't enroll in the general Health FSA. The company may also offer a Limited-Purpose Health FSA as another reimbursement option for Health Savings Account participants. Offering this option has no effect on the compliance issue.

This solution allows employees to fund a Health Savings Account as soon as they enroll in the HSA-qualified plan. But both the company and the employees face a delay of a year.

Reset the medical anniversary date. The medical insurer may allow the company to set Jan. 1 as the new anniversary date, thus creating a short plan year for the current plan (or plans). Employees would then re-enroll in coverage Jan. 1 rather than July 1. The insurer may balk at this unorthodox request. Even if it allows it, the company and insurer must decide whether the insurer grants deductible credits to create, in effect, an 18-month plan year (in our July 1 anniversary example) for out-of-pocket responsibility. Otherwise, enrolled employees could incur two years of out-of-pocket expenses during an 18-month period.

The Bottom Line

The best strategy in most cases is to align the Health FSA and medical plan years, whether or not a Health Savings Account program is part of the benefits mix (but stay tuned in two weeks, when we address when this alignment is not ideal). The best approach is to recognize the issue and address it before launching a Health Savings Account program. If you wait and recognize the issue on the eve of the launch, you may face some unappealing remedies to comply with federal tax law.

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The content of this column is informational only. They are 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.