Would Health Savings Account Expansion Kill Health FSAs?

If every American could open and fund a Health Savings Account, regardless of medical coverage, would this expansion doom Health FSAs?

Several members of Congress have introduced legislation that would expand Health Savings Accounts by eliminating the requirement that the accounts are limited to people who are covered by an HSA-qualified medical plan and meet other eligibility requirements. This change would continue until the pandemic state of emergency is lifted.

The idea behind the expansion is that the pandemic and resulting economic disruption have introduced increased uncertainty into Americans' financial and medical planning. Health Savings Account owners can use an account to build an emergency fund or pay current medical expenses at a discount through preferential tax treatment of contributions, balance growth, and distributions.

The Plans' Similarities

Health Savings Accounts and Health FSAs offer similar tax advantages. Contributions are deducted from paychecks before federal income and payroll taxes and state income taxes are applied. (Note: Taxpayers in California and New Jersey don't receive a state income-tax reduction on Health Savings Account contributions.) Distributions for qualified expenses are tax-free from both accounts.

The list of qualified expenses for both accounts include items and services that diagnose, treat, mitigate, or cure an injury, illness, or condition. They include non-cosmetic medical, dental, vision, and hearing expenses, as well as over-the-counter drugs, medicine, equipment, and supplies. (In addition, certain medical premiums qualify for tax-free reimbursement from a Health Savings Account.)

Both accounts offer similar short-term tax benefits. Whether someone participates in one account or the other often is decided by her employer, who in many cases offers one program or the other, but not both.

The Health Savings Account Advantage

Similar tax benefits aside, Health Savings Accounts have some important advantages over Health FSAs.

Time. Health FSAs are annual reimbursement accounts whose balances must be used during the plan year (with an employer option to allow a little additional time to incur expenses or a limited carryover of unused funds). They represent a great way to save on taxes, but they reimburse current qualified expenses only.

In contrast, Health Savings Accounts are lifetime financial accounts whose balances grow over time and aren't tied to (or expire at the end of) a plan year. A growing number of financial and retirement advisors, and their clients, understand that Health Savings Accounts represent an opportunity to build medical equity - funds available to reimburse retirement expenses - in a tax-efficient manner.

Flexibility. Health FSA owners make an annual election that's binding unless they experience a qualifying life event. They must project their qualified expenses during the next year and pay the price if they elect too little (lost tax benefits) or too much (forfeit unused balances).

In contrast, Health Savings Account owners aren't tied to an election. They can adjust their contributions - start, stop, increase, or decrease - at any time, even when they contribute through pre-tax payroll deductions.

Ownership. Health FSA programs are owned and managed by employers and are available to only traditional employees. In most cases, a participant's access to the program ends when her employment terminates.

In contrast, Health Savings Accounts are owned by individuals, independent of their employment status. They can be employed, unemployed, or retired and continue to enjoy the benefits of Health Savings Accounts, including access to their accumulated balances.

Contribution limits. The Internal Revenue Service sets the limit on elections to a Health FSA. In 2020, the limit is $2,750. It's expected to rise to $2,800 in 2021 - though the IRS hasn't yet released the new figure.

In contrast, Health Savings Account owners can contribute $3,550 if they have self-only coverage and $7,100 if they're enrolled on a family plan in 2020. Those figures increase to $3,00 and $7,200 in 2021. In addition, an owner age 55 or older can contribute an additional $1,000 annually.

The Expansion Dilemma

With all the benefits of a Health Savings Account over a Health FSA, how would Health FSAs fare in a market in which people would no longer have to enroll in a qualified High-Deductible Health Plan to own and fund a Health Savings Account?

That's an important question within the reimbursement industry. If Health Savings Account expansion reduces the number of Health FSA participants, there will be winners and losers among account providers. Many administrators - including my employer, Benefit Strategies, LLC - offer both programs.

But there is a clear delineation in the industry. The Health Savings Account market is dominated by a handful of large trustees who administer one million or more accounts. In most cases, these companies established strong Health Savings Account programs and then added Health FSAs to their menu to accommodate employers who offer both options and want to deal with only one vendor partner. Companies with 1,000 or more employees typically choose these providers to administer these plans.

In contrast, Health FSAs have historically been offered by smaller third-party administrators, or TPAs. These companies started out offering FSAs and perhaps COBRA, then expanded into Health Reimbursement Arrangements and Health Savings Accounts as these products became available. Health FSAs remain their bread and butter, and they often win the business of companies with 1,000 or more employees.

If Health Savings Accounts supplant Health FSAs, these smaller firms will lose a primary stream of income. That's the concern within the industry about the effect of Health Savings Account expansion on the survival of smaller TPAs.

The Health FSA Advantage

But it's not difficult to imagine a world in which Health FSAs more than hold their own even when Health Savings Accounts are expanded. Here are some reasons why:

A rising tide lifts all boats. When I was kid a half century ago, Friendly's restaurants were the go-to dining option for many traveling families. Then, a new McDonald's appeared across the street from the Friendly's in Westboro, Mass. Many people predicted the doom of Friendly's, as McDonald's had lower prices and faster service. But both eateries thrived, as the presence of a second competitor made that intersection a destination for travelers along Rt. 9.

The same thing could happen with Health Savings Accounts and Health FSAs. The presence of a second option for employees may result in more education about medical reimbursement programs, which will result in more employees' appreciating the benefits that both plans offer.

Fewer restrictions. Any employee eligible for benefits can enroll in a Health FSA, regardless of her medical coverage or whether she enrolls in her employer's medical plan. That's a sharp contrast from Health Savings Accounts, whose owners must be enrolled on a particular medical plan and meet other eligibility requirements to fund their account.

Uniform coverage. Health FSA participants can spend their entire election at the beginning of the plan year. This key feature adds cash-flow benefit to the list of advantages of this plan. In contrast, Health Savings Account owners can't spend more than their current balance (although a growing number of administrators and trustees offer a program like a cash advance). For employees new to reimbursement accounts, a Health FSA generally offers superior cash-flow advantages when they have an expensive service - vision-correction surgery, restorative dental work, an inpatient stay with cost-sharing - scheduled early in the year.

Doubling up. Employees who contribute to a Health Savings Account can't have a general Health FSA (nor can their spouse!). But they can enroll in a Limited-Purpose Health FSA, which reimburses dental and vision expenses. Participating in both plans increases tax savings. It allows people to build Health Savings Account balances more quickly because they can enjoy tax savings when they buy dental and vision services without dipping into their Health Savings Account balances. And they can tap their Health FSA funds immediately.

Don't forget the kids. Health Savings Account owners can't reimburse tax-free any qualified expenses incurred by a child who's no longer their tax dependent. That's true even if a child remains covered on the parent's medical plan. But Health FSAs follow some rules that govern medical coverage, including the provision that children are covered to age 26. Thus, when my adult daughter needed two dental implants and two crowns because she didn't have adult second bicuspids in her lower jaw, I couldn't help her pay her bill from my Health Savings Account (unless I were willing to pay income taxes and an additional 20% tax on the withdrawal). But I could enjoy tax benefits by reimbursing those expenses from my Health FSA.

The Bottom Line

Health Savings Account expansion faces an uphill battle. A bill probably won't pass as stand-alone legislation, so the best hope is for the provision to be attached to a pandemic-relief bill. But those efforts have stalled in Congress in recent months. Speaker Pelosi and Treasury Secretary Mnuchin are talking once again, but Congress goes on recess at the end of this week. We may see a bill before the election - both parties are sensitive to the politics of giving money to voters shortly before ballots are cast - but it's not cast in stone.

If expansion does become a temporary reality, it's likely effect will be to expand the number of Americans who can pay their ever-rising out-of-pocket health-related expenses with pre-tax funds, rather than increase Health Savings Account ownership at the expense of Health FSA enrollment.

I'm director of strategy and compliance at Benefit Strategies, LLC, a third-party administrator of Health Savings Accounts and other reimbursement programs. You can subscribe to my biweekly blog here and follow me on LinkedIn to read my weekly HSA Monday Mythbuster and HSA Wednesday Wisdom columns, as well as my occasional Healthcare Update articles. My new book, How to Use Your Health Savings Account, will be published in October. My book HSAs: The Tax-Perfect Retirement Account, is the definitive source of information at the intersection of Health Savings Accounts, Medicare, and retirement planning.

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