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Congress'
"Midnight Special" Overhauls HSAs
Supercharged
Rules Apply for 2007
BenefitsLink.com, Lockton Compliance Alert, Edward Fensholt, J.D., December
11,
2006
On December 9, 2006, the U.S. Senate passed the Tax Relief and
Health Care Act of 2006, a last-minute piece of House-initiated
legislation that includes exciting changes to the health savings
account landscape. The President is expected to sign the bill. The law
dramatically shakes up the options for high deductible health plan
sponsors who are preparing for, are in the midst of or recently closed
an open enrollment window for 2007.
Here’s an overview of the law as passed by Congress:
Repeal of Contribution Limit Tied to Deductible
The law rips through the HSA contribution ceiling for most qualifying
high deductible health plan (“HDHP”) enrollees by removing
the limitation tied to the plan’s deductible. Beginning in 2007
the monthly contribution maximum for an HSA-eligible employee is simply
1/12th of the statutory annual maximum contribution ($2,850 for single
coverage, $5,650 for family coverage) even if the HDHP’s deductible is much less!
For example, assume an employer has an HDHP in place for 2007 with
deductibles of $1,100 for single coverage and $2,200 for family
coverage. Under prior law an employee’s monthly maximum
contribution for 2007 would be $91.66 for single coverage, or $183.33
for family coverage. But under the new law the employee’s monthly
maximum skyrockets to $237.50 for single coverage or $470.83 for family coverage!
Employers might wish to revamp payroll systems to allow employees to
make HSA contributions for 2007 that exceed the HDHP’s deductible.
Partial-Year Enrollees May Contribute Full Annual Maximum
A person who is eligible to make HSA contributions for the last month of a given taxable year (usually the calendar year) is deemed to have been eligible for the entire year.
However, the person must then remain
eligible to make HSA contributions during all of a “testing
period” that includes the remainder of that last month of the
year and the ensuing 12 months.
If he does not he’s taxed on the contributions he made for the
prior year that he could not have made but for this special
“deeming” rule. And the rules tack on a 10 percent excise
tax for good measure.
The taxes apply for the year in which, during the testing period, the
person ceases to be eligible to make HSA contributions. No tax applies
if the reason for ineligibility is the person’s death or
disability.
It’s unclear how much responsibility the employer will have to
report the taxability of the contributions where the employee enrolls,
during the testing period, in disqualifying coverage through the
employer. We suspect the IRS will not hold the employer responsible
either for reporting the taxability of the prior contributions or for
making any kind of tax withholding with respect to the prior
contributions, but that remains to be seen.
Comparable Contributions Not Required for the Highly Compensated
Under current law an employer who makes contributions to the HSA of any
employee is required to make “comparable” contributions to
the HSAs of “comparable” employees. There’s an easy
way around this limitation: An employer who allows its employees to
make their own HSA contributions through the employer’s cafeteria
plan may make non-comparable contributions.
There’s now a statutory
exception, effective for 2007 and beyond, that allows an employer to
ignore highly compensated employees when determining
“comparable” employees. “Highly compensated
employees” are defined in the Tax Code’s qualified
retirement plan rules. This change will have little utility. It’s
still ridiculously easier for an employer to make non-comparable
contributions by allowing employees to make their own pre-tax HSA
contributions.
FSA “Grace Period” Doesn’t Disqualify Some HSA-Eligible Employees
In 2005 the IRS authorized flexible spending accounts
(“FSAs”) to offer a 2-1/2-month “grace period”
after the end of a year, to allow employees with residual year-end
balances to consume those balances by incurring additional claims
during the grace period. Problem is, that grace period usually
disqualified an employee from making HSA contributions for the three
months touched by the grace period.
Applying current law, for example, assume an employee enrolls in the
employer’s HDHP effective January 1, 2007, but participated in
the employer’s health FSA for 2006 and the FSA has a grace period
that extends the 2006 coverage period to March 15, 2007. Unless that
FSA grace period provides only “limited” benefits (dental,
vision or preventive care) for all participants during the grace
period, the employee cannot make HSA contributions for the months of
January through March, 2007.
But that changes under the new law. Beginning January 1, 2007, if:
-
A person is participating in an FSA as of the end of a prior year,
- The FSA has a “grace period,” and
- The only reason the person is disqualified from making HSA contributions in the current year is due to the grace period,
a special rule applies. The employee may nevertheless make HSA contributions during the grace period if either:
- His FSA balance was zero as of the end of the
prior FSA year (i.e., the person could obtain no FSA benefit during the
grace period), or
- The person makes a transfer from the FSA to his
HSA of his residual balance as of the end of that prior year
(transfers, newly authorized by this law, are discussed below).
Back to the example above, assume that on December 31, 2006, the
employee has either a zero balance in the FSA or has, say, an $800
balance that he moves to his HSA in a qualifying
transfer. The employee may make HSA contributions for the months of
January through March, 2007, assuming he’s not otherwise
ineligible (e.g., assuming he’s not disqualified because of
non-HDHP coverage elsewhere, such as through his spouse’s
employer).
Transfers from HRAs and FSAs to HSAs
The law allows for a one-time “qualifying” transfer to an
individual’s HSA of a residual balance in his health
reimbursement arrangement (“HRA”) or health FSA. The
transfer may be made on or after the date the law is signed but not
later than December 31, 2011. The transfer is treated as a
"rollover” contribution to the HSA and therefore does not reduce
the HSA account holder’s maximum contribution for the year.
The law appears designed to allow an individual to establish
an HSA with seed money contributed from an FSA or HRA. It might be
particularly helpful for employers who, after establishing HRAs in a
prior year, install an HDHP. The law appears to permit employees with
residual HRA balances to move them to an HSA rather than forfeit them,
and to allow employers to accommodate the transfers rather than either
freeze the HRAs (i.e., allow no payments from them) or continue to
maintain the HRAs as “limited” HRAs reimbursing only
dental, vision and preventive care expenses.
It’s not clear if there are restrictions on when during the year the transfer may be made. There’s also a limitation on the amount
of the transfer. According to the statute the amount of the transfer
cannot exceed the lesser of (i) the balance in the HRA or FSA on
September 21, 2006, or (ii) the balance on the date of the transfer. We
expect the IRS will quickly provide clarification on this limitation.
For example, if an individual had a $900 balance in a health FSA on
September 21, 2006, had depleted the FSA to $250 by the date the new
law was passed, and then forfeited the balance on December 31 but
re-enrolls for a $2,000 FSA benefit for 2007, can he transfer $900 on
February 1, 2007? The answer is unclear.
As with the special “deeming” rule described on page one,
if the HSA account holder makes a qualifying transfer and then within
that month or the ensuing 12 months ceases to be eligible to make HSA
contributions, the amount of the transfer becomes taxable (and subject
to an additional 10 percent excise tax) for the year in which the
account holder ceases to be eligible.
For example, assume the person makes an $800 transfer on January 1,
2007, and on July 1, 2007, loses eligibility to make HSA contributions
because he enrolls in his employer’s non-high deductible health
plan (or such a plan of his spouse). The $800 transfer is taxable
income for 2007, and there’s also an $80 excise tax for 2007.
Apparently, the investment earnings on the transfer are not taxed but
the IRS, in future guidance, might dictate a different treatment for
the earnings.
Again, these bad tax results don’t apply if the person becomes
ineligible to make HSA contributions due to death or disability. As for
reporting the taxability, we suspect the IRS will not hold the employer
responsible either for reporting the taxability of the prior
contributions or for making any kind of tax withholding with respect to
the prior contributions.
Other bad things happen if the employer allows some but not all
persons who are eligible to make a transfer to actually do so. If the
employer discriminates in allowing HRA and FSA transfers the employer
is treated as having made noncomparable HSA contributions and is
slapped with a tax equal to 35 percent of the employer contributions
made to employees’ HSAs for the year.
An amendment to the FSA or HRA, authorizing transfers to HSAs, is
likely required in order for the employer to allow the transfers.
Rollovers from IRA to HSA
Individuals may make a one-time trustee-to-trustee transfer to an HSA
from an IRA other than a simplified employee pension or a simple
retirement account. This type of transfer differs in significant ways
from the HRA and FSA transfers described above.
The amount of the transfer is limited to the HSA maximum contribution
then in effect for the type of coverage—that is, single or family
coverage—that the person has under an HDHP at the time of the
transfer. Interestingly, if after—but during the same year of—the transfer the person changes from single to family HDHP coverage, he may make a second
transfer to bring the amount of the transfer up to the maximum amount
of HSA contributions permitted for a person enrolled in family HDHP
coverage.
In addition, any such transfer from the IRA reduces, dollar for dollar, the contributions the individual could otherwise make to his HSA for the year.
However, as with the HRA and FSA transfers, if the individual ceases to
remain eligible to make HSA contributions during the month of the
transfer or the ensuing 12 months the amount of the transfer becomes
taxable as ordinary income, and a 10 percent excise tax applies. But
the taxes don’t apply if the individual ceases to be eligible due
to death or disability.
Cost of Living Adjustments to be Announced in June
One of the great hassles faced by sponsors of calendar-year HDHPs has
been the guesswork associated with setting deductibles and contribution
maximums for the coming year. The IRS has announced annual adjustments
to those amounts in late October or early November, giving little time
for employers to communicate, and adjust systems to accommodate, the
changes.
That’s all fixed under the new law. The IRS must now announce
limits for the coming calendar year by June 1 of the prior year.
Not Legal Advice: Nothing in this Alert should be construed as legal advice.
Circular 230 Disclosure: To
comply with regulations issued by the IRS concerning the provision of
written advice regarding issues that concern or relate to federal tax
liability, we are required to provide to you the following disclosure:
Unless otherwise expressly reflected herein, any advice contained in
this document (or any attachment to this document) that concerns
federal tax issues is not written, offered or intended to be used, and
cannot be used, by anyone for the purpose of avoiding federal tax
penalties that may be imposed by the IRS.
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