Why a Limited-Purpose Health FSA? Let Me Count the Reasons . . .

This column is an excerpt (Question 31) 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.

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Question: My employer offers a Limited-Purpose Health FSA. If I participate, am I disqualified from opening and funding a Health Savings Account? And why would I participate, since I can reimburse the same qualified services from my Health Savings Account?

?Answer: No. A Limited-Purpose Health FSA is a specific limited Health FSA design that does not disqualify participants from opening and funding a Health Savings Account. The plan limits reimbursement to qualified dental and vision expenses, plus certain select preventive care services that aren’t covered in full under federal law.

Employers aren’t required to offer a Limited-Purpose Health FSA. Many companies that offer a Health Savings Account option and a general Health FSA also sponsor a Limited-Purpose Health FSA. Many administrators provide both plans for a single annual fee, thereby reducing a financial barrier to offering the option.

Why Add a Limited-Purpose Health FSA?

?Why would you make an election to a Limited-Purpose Health FSA? After all, you’re correct that you can reimburse qualified dental, qualified vision, and select preventive services from your Health Savings Account and enjoy the same tax advantages. All Health FSAs, even Limited-Purpose designs, require an annual binding election and carry the risk of your forfeiting unused balances. In this sense, a Limited-Purpose Health FSA is less flexible than a Health Savings Account. And because only about 4% of Health Savings Accounts are funded to the limit, many owners are better served by increasing their contributions rather than enrolling in a Limited-Purpose Health FSA.

Here are five distinct reasons to consider making an election to a Limited-Purpose Health FSA if your employer offers this option:

Increase your tax savings. You can fund your Health Savings Account up to your maximum contribution and make an election to your Health FSA up to your employer’s limit. If you’re under age 55 and have family coverage, instead of reducing your taxable income by only $8,550 in 2025 (up from $8,300 in 2024) with a Health Savings Account contribution, you can lower your taxable income by another $3,200 (the 2024 statutory limit, although employers can set a lower amount) by electing that amount into your Limited-Purpose Health FSA.

Manage high expenses. You may have a year in which you project that your qualified expenses will exceed your statutory maximum annual contribution to a Health Savings Account, particularly if your account has a small balance, you have self-only coverage, and you’re under age 55. If you anticipate out-of-pocket medical expenses that approach your maximum account contribution and are undergoing qualified dental or vision expenses (such as orthodontia or a root canal and crown), you can pay all (or most) of your bills with pre-tax dollars this year by maximizing your Health Savings Account contribution and making a Limited-Purpose Health FSA election. Note: You can always incur qualified expenses greater than your Health Savings Account contribution limit and reimburse them in future years with future contributions. Utilizing a Limited-Purpose Health FSA allows you to reimburse them now and realize an immediate tax advantages.

Preserve your Health Savings Account balances. Your strategy may be to use your Health Savings Account in whole or in part to accumulate balances that you can spend tax-free on qualified medical expenses in retirement. If so, making an election to a Limited-Purpose Health FSA allows you to purchase qualified dental and vision services with tax-free funds and build your Health Savings Account balances by reimbursing those qualified expenses from the FSA.

Enjoy an interest-free loan. All Health FSA elections are subject to uniform coverage rules, which means that you can spend your full election at any point during the plan year. This is a feature of a Health FSA that employers must offer. If you overspend your account (reimbursements exceed payroll deductions at that point in the plan year), you in effect receive an interest-free loan from your employer. You continue to repay that loan in equal installments through level payroll deductions.

In contrast, because you don’t make a binding Health Savings Account election (you can vary your contributions, as we discuss in Question 59), you can withdraw no more than your cash balance (although some account providers and employers now offer programs that provide accelerated employer contributions or other means to allow you to access future employer contributions to pay an immediate qualified expense. The instant access to your full election in a Health FSA allows you to negotiate prompt-pay discounts with dental and vision providers to reduce further (beyond tax benefits) the net price of your care.

Reimburse non-dependent children’s qualified expenses tax-free. If your child is no longer your tax dependent, you can’t reimburse her qualified expenses tax-free from your Health Savings Account (see Question 108). A Health FSA, however, follows certain medical-plan rules, including the provision that you can cover an adult child to the end of the year that he turns age 26, even when the child is no longer your tax dependent. You can reimburse your adult non-tax-dependent children’s qualified dental and vision expenses from your Health FSA (up to the end of the year that a child turns age 26), even if they’re not covered on your medical plan or aren’t HSA-eligible.

If you’re reasonably certain that you’ll incur qualified medical and dental expenses during the Limited-Purpose Health FSA plan year, you can enjoy any of or all these five benefits[cfm1]? with little risk of forfeiture. In contrast, if you’re not certain that you will incur these qualified expenses, you may want to make an additional contribution (up to your annual maximum) to your Health Savings Account, where funds aren’t subject to the use-it-or-lose-it provision that’s part of a Health FSA.

If you do participate in a Limited-Purpose Health FSA, be sure to seek reimbursement for your qualified dental, qualified vision, and select preventive services from that account first. If you use your Health Savings Account funds, you deplete balances in an account without a use-it-or-lose-it feature and risk forfeiting unused Limited-Purpose Health FSA funds.

If you make this mistake and your Limited-Purpose Health FSA and Health Savings Account are managed by the same company, a quick phone call or completed form can move funds between the two accounts to correct the mistake. This adjustment takes place only when you identify the problem and request the correction, however. Your administrator won’t notify you because reimbursing qualified dental and vision expenses from either account is permissible, so the administrator’s system won’t flag the transaction for review.

Tips

?If the same administrator manages both your Health FSA and your Health Savings Account, it may issue one double-purse debit card for both plans. If so, the card will be coded to reimburse dental and vision expenses from the Limited-Purpose Health FSA purse until you exhaust the balance in that account, then charge subsequent dental and vision expenses to your Health Savings Account purse. The card reimburses all medical, prescription-drug, and over-the-counter expenses from the Health Savings Account.

This coding is imperfect. Be sure to monitor your account (online or via monthly statements that administrators often e-mail to participants) to make sure that the appropriate expenses are applied to the correct accounts. You don’t want to reimburse a dental or vision expense through your Health Savings Account if you have funds remaining in your Health FSA because you may forfeit your Health FSA balances not spent by the end of the plan year. If you see a mistake, contact the administrator, who can move money between your Health FSA and Health Savings Account as appropriate.

If your employer uses separate administrators for the two plans, you won’t face these issues. You’ll have a separate debit card for each plan. But the onus will be on you to use the correct card for each expense. If you make a mistake (for example, using the Health Savings Account card to reimburse a dental expense), your Health Savings Account administrator won’t be able to move money between the two accounts easily because it doesn’t manage the Limited-Purpose Health FSA. You may be able to file a mistaken-distribution form to replace the funds in your Health Savings Account and then file a manual claim with your Health FSA administrator. But you must know the process and complete the task.

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IRS Notice 2004-45:

?Under section 223, an eligible individual cannot be covered by a health plan that is not an HDHP unless that health plan provides permitted insurance, permitted coverage or preventive care. A health FSA and an HRA are health plans and constitute other coverage under section 223(c)(1)(A)(ii). Consequently, an individual who is covered by an HDHP and a health FSA or HRA that pays or reimburses section 213(d) medical expenses is generally not an eligible individual for the purpose of making contributions to an HSA. See Rev. Rul. 2004-38, 2004-15 I.R.B. 717, which holds that an individual who is covered by an HDHP that does not provide prescription drug coverage and a separate prescription drug plan or rider that provides benefits before the minimum annual deductible of the HDHP has been satisfied is not an eligible individual for HSA purposes.

However, an individual is an eligible individual for the purpose of making contributions to an HSA for periods the individual is covered under the following arrangements:

Limited-Purpose Health FSA or HRA. A limited-purpose health FSA that pays or reimburses benefits for “permitted coverage” (but not through insurance or for long-term care services) and a limited-purpose HRA that pays or reimburses benefits for “permitted insurance” (for a specific disease or illness or that provides a fixed amount per day (or other period) of hospitalization) or “permitted coverage” (but not for long-term care services). In addition, the limited-purpose health FSA or HRA may pay or reimburse preventive care benefits. The individual is an eligible individual for the purpose of making contributions to an HSA because these benefits may be provided whether or not the HDHP deductible has been satisfied.

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See Internal Revenue Code Section 213 (c)(1)(B)(ii[cfm2]?).

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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.

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