On December 20, 2006, President Bush signed the Tax Relief and Health Care Act of 2006 (the “Act”) (H.R. 6111, Public Law 109–432). The Act includes a number of provisions intended to make Health Savings Accounts (“HSAs”) more attractive, such as new contribution limits and rules providing for rollovers from health flexible spending accounts (health FSAs), health reimbursement arrangements (“HRAs”) and Individual Retirement Accounts (“IRAs”). Most of the HSA related provisions of the Act are effective for tax years beginning after December 31, 2006. This article discusses the new HSA rules and the guidance issued by the Internal Revenue Service (“IRS”) on February 15, 2007, on health FSA and HRA rollovers.
Elimination of HSA Annual Deductible Contribution Limit
Prior to the Act, an individual’s annual HSA contribution could not exceed the lesser of:
- the annual deductible under his or her High Deductible Health Plan (“HDHP”) coverage; or
- the statutory limit for the year.
Hence, if an individual’s HDHP annual deductible was $1,000, the individual could only contribute $1,000 to his HSA instead of the maximum statutory contribution for the year ($2,700 for self-only coverage in 2006). The new HSA rules eliminate the annual deductible limitation. Thus, the maximum aggregate annual contribution that may be made to an HSA is the yearly maximum provided by the Internal Revenue Code and the IRS; the annual contribution limit for 2007 is $2,850 for self-only coverage and $5,650 for family coverage.
Because HSA contributions may be made on a pre-tax basis under a Section 125 cafeteria plan, employers may wish to consider amending the Section 125 plan to allow participants to make pre-tax HSA contributions up to the new higher limits if its HSA contribution provisions are not already tied to the statutory limits.
Mid-Year Enrollees May Make Contribution for Whole Year
Under the Act, individuals who become eligible for an HSA mid-year are now entitled to contribute up to the annual maximum HSA contribution limit for that year. Previously, contribution limits were prorated based on the number of months an individual was actually HSA-eligible. For example, if an individual enrolled in an HDHP in December with a $1,200 annual deductible, he or she would only be eligible to contribute $100 to his or her HSA, or 1/12 of $1,200. Effective for tax years beginning after December 31, 2006, an individual who becomes eligible to contribute to an HSA after the start of the year, and who remains HSA-eligible through the end of the last month of that taxable year (December for taxable years that are concurrent with the calendar year), will be treated as if he or she had been covered by the same HDHP all year for purposes of calculating the annual contribution limit. Thus, an individual who becomes HSA-eligible in October 2007 and who remains HSA-eligible through December 2007 may contribute up to the 2007 annual limit ($2,850 for self-only coverage and $5,650 for family coverage) to his HSA.
Exclusion from Federal Income Tax Depends on Continued Eligibility during Testing Period
Any contributions that are made for months during which the individual was not actually HSA-eligible will be excludable from federal income tax only if the individual remains HSA-eligible during the testing period, which is the twelve month period following the end of the taxable year when the individual became HSA-eligible. (The annual contribution is prorated, and treated as if 1/12 of the total contribution were made in each month of the year, regardless of the period of HSA-eligibility.) In the above example, contributions that are attributable to the months from January 2007 through September 2007 will be excludable from federal income tax if the individual remained HSA-eligible throughout 2008. If the individual does not satisfy this requirement, contributions that are made for these months will be subject to federal income tax and to a 10% excise tax (with certain exceptions for death or disability).
If an employer’s Section 125 plan permits employees to make HSA contributions through the plan on a pre-tax basis, the employer may wish to consider amending the Section 125 plan to allow midyear HDHP enrollees to contribute up to the full HSA contribution limits.
Certain Health FSA Grace Period Coverage May Be Disregarded to Allow HSA Eligibility
Under prior law, an individual who was covered under a general purpose health FSA that provided for a 2 1/2 month grace period following the end of the plan year, was not eligible to make contributions to an HSA during any portion of a taxable year that coincided with the grace period, even if his or her account balance in the health FSA was zero. Such an individual could not make an HSA contribution until the first day of the first calendar month after the grace period ended. (Note: A general purpose health FSA is a health FSA that reimburses all qualified medical expenses. A limited purpose health FSA pays or reimburses expenses for preventive care and “permitted coverage” (e.g., dental care and vision care) only.)
Effective January 1, 2007, coverage during a grace period under a general purpose health FSA will be disregarded (i.e., an individual could be HSA-eligible) if:
- the individual’s balance in his or her health FSA at the end of the plan year is zero; or
- the individual makes a qualified HSA distribution of any balance remaining at the end of the plan year to an HSA (as permitted by the Act, and as described immediately below).
One-Time Rollover from a Health FSA or HRA Now Available
Under the new HSA rules, individuals who had a balance in their Health FSAs or HRAs as of September 21, 2006, may elect a one-time distribution of the lesser of this amount or the amount in his or her health FSA or HRA on the date of the distribution, into their HSAs. These “qualified HSA” distributions will not count against an individual’s annual HSA contribution limit for the tax year in which it is made and must be made before January 1, 2012.
On February 15, 2007, the IRS issued guidance for effecting qualified HSA distributions that are made at the end of a plan year. Notice 2007–22 (“Notice”) clarifies that a participant with a balance at the end of the plan year in a general purpose Health FSA with a grace period, or an HRA, may roll over this balance to an HSA if the following requirements are satisfied:
- the employer amends the health FSA or HRA plan by the end of the plan year to allow qualified HSA distributions;
- the employer’s health FSA or HRA did not previously make qualified HSA distributions available;
- the employee is HSA-eligible as of the first day of the month during which the qualified HSA distribution is made;
- the employee elects the qualified HSA distribution before year-end;
- the employee is not allowed to receive reimbursements from the health FSA or HRA after year-end;
- the employer makes the qualified HSA distribution to the HSA trustee by the fifteenth day of the third calendar month following the end of the immediately preceding plan year (i.e., March 15 for calendar year plans), but after the employee becomes HSA-eligible;
- the rollover to the HSA does not exceed the lesser of the balance in the health FSA or HRA as of:
- September 21, 2006; or
- the date of the distribution (determined on a cash basis); and
- after the employer makes the qualified HSA distribution:
- the employee has a $0 balance in the health FSA or HRA and the employee no longer participates in any non-HSA compatible health plan; or
- on or before the date of the first rollover from the health FSA or HRA, the employer converts the general health FSA or HRA to an HSA-compatible health FSA or HRA for all participants (e.g., conversion to a limited purpose health FSA).
The Notice clarifies that because the Act did not change the “use it or lose it rule” applicable to health FSAs, health FSAs without grace periods may not provide for rollovers into HSAs. This is because any amounts remaining in such a health FSA are subject to forfeiture at the end of the plan year and, therefore, cannot be transferred through a qualified HSA distribution to an HSA after the end of that plan year. The Notice further clarifies that if a health FSA or HRA are not HSA-compatible (HSA-compatible coverage includes limited purpose health FSAs or HRAs, post-deductible health FSAs or HRAs, retirement HRAs, or suspended HRAs), a covered employee cannot become an HSA-eligible individual until his HRA coverage terminates at the end of the plan year, or the health FSA or HRA is converted to an HSA-compatible plan. Thus, a tax-free rollover from a general purpose health FSA or HRA to an HSA generally may not be made unless it is made at the end of the health FSA or HRA’s plan year.
To illustrate how this new rule works, it is helpful to consider the following example. A general purpose health FSA has a grace period, and has been amended to allow year-end health FSA balances to be rolled over to an HSA beginning January 1, 2008. If an individual had a balance of $950 in his general purpose health FSA on September 21, 2006 and a balance of $700 on December 31, 2007 and elects HDHP coverage beginning January 1, 2008, the individual would be permitted to elect to distribute the entire $700 health FSA balance to his HSA on December 31, 2007, provided that the individual has no other non-HSA compatible coverage. The sponsor of the health FSA or HRA must contribute the rollover directly to the HSA trustee for the employee before March 15, 2008, but only after the employee is HSA-eligible (i.e., after January 1, 2008). We note that if the rollover does not result in a zero balance in the health FSA or HRA, the distribution will be includable in the individual’s gross income and subject to a 10% excise tax.
The IRS has also provided transitional relief for participants of general purpose health FSAs and HRAs which were not amended by December 31, 2006 to provide for qualified HSA distributions of balances as of December 31, 2006. The transition rules cover rollovers from general-purpose health FSAs and HRAs between December 31, 2006 and March 31, 2007, and are the same as the permanent rules described above with the exception of the following:
- the employer must amend the plan on or before March 15, 2007 to allow for qualified HSA distributions;
- the employee’s election and the qualified HSA distribution must be made prior to March 15, 2007; and
- there is no prohibition on the health FSA or HRA making reimbursements to the employee after the last day of the plan year.
Exclusion of Health FSA or HRA Rollover from Federal Income Tax Depends on Continued Eligibility during Testing Period
For a rollover from a health FSA or HRA to be excludable from federal income tax, an individual must remain HSA eligible during the testing period, which is the twelve month period beginning with the month the individual makes his or her HSA qualified distribution to the HSA. If the individual does not satisfy this requirement, the rollover will be subject to federal income tax and to a 10% excise tax (with certain exceptions for death or disability).
We note that the decision to amend a health FSA or HRA to provide for these qualified HSA distributions is completely in the employer’s discretion. However, if the employer decides to offer qualified HSA distributions to any employees, it must make them available to all employees who are covered under the employer’s HDHP, or face a 35% excise tax.
One-Time Rollover from Individual Retirement Arrangement (“IRA”) Now Available
The Act permits a one-time tax-free distribution of IRA funds (from a traditional IRA or a Roth IRA, but not from a SEP or SIMPLE IRA), up to applicable HSA annual maximum limits, into an HSA. This contribution must be made in a direct trustee-to-trustee transfer and will count against the annual HSA contribution limit for the tax year in which the rollover is made.
In general, only one IRA rollover to an HSA may be made during the lifetime of an individual. However, the Act permits an individual who switches from selfonly coverage to family coverage in the same year in which he or she rolled over IRA funds, to make a second IRA transfer in that year. The individual may contribute the difference between the statutory limits for self-only and family coverage. Thus, for example, if an individual with self-only HDHP coverage rolls over $2,850 from his IRA to an HSA on March 1, 2007, and on June 1, 2007 switches to family HDHP coverage, he is entitled to make a second IRA transfer of up to $2,800 ($2,850 + $2,800 = $5,650, the annual HSA contribution limit for family coverage).
Exclusion from Federal Income Tax Depends on Continued Eligibility during Testing Period
Any IRA rollover to an HSA will be subject to federal income tax unless the individual remains HSA-eligible during the testing period, which is the twelve-month period following the month of the contribution to the HSA. If the individual does not satisfy this requirement, the amount of the rollover will be subject to federal income tax and to a 10% excise tax (with certain exceptions for death or disability).
New HSA Rules Permit Higher Employer Contributions for Non-Highly Compensated Employees
Under the non-discrimination comparability rules applicable to HSAs, if an employer makes contributions to an HSA, the employer must make similar contributions to all employees with comparable coverage. For example, if an employer contributes $600 to an employee receiving employee-only HDHP coverage, it must contribute $600 to all employees receiving employee-only HDHP coverage (regardless of compensation). The Act amends the non-discrimination comparability rules to permit employers to provide higher HSA contributions to non-highly compensated employees than to highly compensated employees. Thus, for example, an employer is now permitted to make a $1,000 contribution to the HSA of each non-highly compensated employee for a year without making any contributions to the HSAs of any highly compensated employee. The definition of “highly compensated employee” is based on the same definition used for qualified retirement plans.
Earlier Determination Date for Annual HSA Maximum Contribution Limits
The Act requires the IRS to determine HSA-related Cost of Living Adjustments (“COLAs”) (e.g., adjustment of HSA maximum contribution limit for inflation) as of March 31 (as opposed to August 31 under prior law). The IRS must publish these COLA changes by June 1 of the year prior to the year the adjustments become effective. The earlier publication of these HSA related COLAs will allow employers additional time to plan for and to communicate these COLA changes to their plan participants.
If you have any questions regarding the HSA provisions of the Act or the recent IRS guidance regarding health FSA and HRA rollovers, please call the author of this article or the attorney with whom you normally work. We note the IRS has indicated that it intends to issue additional guidance in the near future to help clarify outstanding questions on the new HSA rules.