Ugh! Not Renewing a New HSA Program and the Last-Month Rule.

How do you help employees when you're very generous with contributions to a Health Savings Account program that starts late in the calendar year?

Benefits advisors are a common source of topics for this weekly column. This edition is no exception, as my longtime friend Kevin posed a dilemma. It's not a common situation. And it's largely the result of the company's generosity. The company is looking for a solution that doesn't negatively affect employees.

Let's unwind this dilemma.

Rethinking the Health Savings Account Program

An employer - let's call it Pilgrim LLC - changed its medical coverage to an HSA-qualified plan effective Oct. 1, 2022. Employees had to meet a new deductible for the final three months of the calendar year. This situation negatively affected workers, so Pilgrim LLC responded by contributing the equivalent of the full deductible into enrolled employees' Health Savings Accounts for the three months of coverage in 2022. Employees were understandably grateful.

Now, Pilgrim LLC is considering whether to retain the Health Savings Account program at the 2023 renewal date. Normally, this wouldn't be a big deal. Prudent companies review their benefit options every year. In this case, however, employees may be negatively affected because of Pilgrim LLC's generosity in 2022.

Funding a Health Savings Account

Health Savings Account owners who aren't eligible all 12 months of the calendar year (contribution limits are always tracked on the calendar year) have two options in calculating their contribution limit. The common approach (mandatory if the account owner loses eligibility during the calendar year) is to prorate their contribution based on the number of months that they're HSA-eligible.

Example: Raul, age 43, becomes HSA-eligible Oct. 1, 2022, and is enrolled in self-only coverage. His prorated maximum contribution is 3/12 of the statutory maximum limit for self-only coverage ($3,650 in 2022). Thus, he can't contribute more than $912.50 ($3,650 divided by 12 months is $304.16 per month, or $912.50 for three months).

When an individual becomes HSA-eligible during the year (as opposed to losing eligibility after Jan. 1), she has a second option. If she's HSA-eligible Dec. 1, she can leverage the Last-Month Rule, which allows her to contribute up to the statutory maximum if she remains eligible through the end of the following calendar year.

Example: Lissa becomes HSA-eligible July 1, 2022. She's covered on a family plan. She contributes $7,300 for 2022. If she remains HSA-eligible through the end of calendar-year 2023, she can retain that contribution.

The downside of the Last-Month Rule is the consequences of failure to remain HSA-eligible through the testing period (the end of the following plan year). If the account owner doesn't remain HSA-eligible, her maximum contribution for that partial year of eligibility is the prorated amount. She must include any amount above that figure (and earnings associated with that excess contribution) in her taxable income and pay an additional 10% tax as a penalty.

The Rule Applied to Our Client

Perhaps you've identified the problem for Pilgrim LLC employees. The company fully funded the Health Savings Account, or $2,000 for self-only coverage and $4,000 for a family plan. Those figures are well above the prorated ceilings of $912.50 and $1,825. If these employees don't remain HSA-eligible through the end of 2023, they must include at least $1,087.50 (self-only) or $2,175 (family) in their 2023 income - and more (dollar-for-dollar) for any personal funds that they deposited into the account for 2022. And on top of that higher taxable income, they pay an additional 10% tax (at least $108.75 and $217.50, respectively).

The client doesn't want to put employees through this exercise (and tax liability). At the same time, if the Health Savings Account program isn't working for the company or employees, it wants to offer different coverage at the 2023 renewal.

What's a company to do?

Potential Solutions

Here are several strategies that the company can pursue:

ONE. Leave it alone. Pilgrim LLC can renew the Health Savings Account program for another year. That way, these employees will remain HSA-eligible through the testing period and thus face no tax liability for their 2022 contributions above the prorated amount. And their deductibles won't be reset by enrollment in a new plan effective Oct. 1, 2023.

TWO. Alter the program Oct. 1. A second approach is to fix employee concerns without changing the underlying medical plan. For example, if employees struggle to pay their deductibles and coinsurance, the company can add a Post-Deductible HRA on anniversary (or even earlier, if it chooses). A Post-Deductible HRA reimburses expenses above a certain figure (no less than $1,500 for self-only and $3,000 for family coverage in 2023). The HRA is funded exclusively by the employer.

Example: Northeast Marine Services offers an HSA-qualified plan with a $4,000 self-only and $8,000 family deductible. The company reimburses all deductible expenses above $1,750 and $3,500. This HRA doesn't disqualify employees from making or receiving contributions to their Health Savings Account because the HRA itself is an HSA-qualified plan (meets minimum deductible).

This approach modifies the coverage by reducing enrolled employees' out-of-pocket financial responsibility without changing the medical plan (and resetting deductibles).

THREE. Alter the program Jan. 1, 2024. Pilgrim LLC can renew the medical plan and then introduce an HRA at the beginning of 2024 (when the deductible probably resets). At this point, employees have satisfied the Last-Month Rule's testing period and don't face any taxes and penalties for excess 2022 contributions. The company can offer an HRA that does disqualify employees from funding a Health Savings Account if it chooses and that approach makes financial sense for employer and employees.

Example: Abel's Cane Manufacturing chooses an HSA-qualified plan with a $2,000/$4,000 deductible to reduce premiums for both the company and employees. It adds an HRA that reimburses the first $1,500/$3,000 of deductible expenses, leaving employees with no more than $500/$1,000 of deductible responsibility.

This HRA design is disqualifying because it reimburses medical expenses below a $1,500/$3,000 deductible.

FOUR. Change the medical plan effective Oct. 1, 2023, or Jan. 1, 2024. Pilgrim LLC can always change the underlying medical coverage by moving away from an HSA-qualified plan and then choosing whether or not to add another element like an HRA. Changing the plan effective Oct. 1, 2023, results in employees' failing the testing period (and thus including a portion of 2022 contributions as taxable income and incurring the 10% additional tax) and perhaps having a reset deductible for the final three months of the calendar year. Making the change effective Jan. 1, 2024, avoids both these issues, but an insurer is unlikely to allow a mid-year plan change.

Which Option Is Best?

Hmmm. The answer depends on the company's goals. But these options can meet a number of employer goals.

If the company wants to help employees with their deductible expenses and also to leave them eligible to fund a Health Savings Account, Option 2 achieves this goal.

If the company wants to move away from a Health Savings Account program, Option 3 does so with the benefit of allowing employees to satisfy the testing period. Option 4 also achieves this goal, but employees' tax situations are affected if the plan changes Oct. 1, 2023.

If the company's goal is to minimize change in 2023, Option 1 satisfies this objective (although Option 3 achieves the same goals for 2023 and adds value to employees in 2024).

The Bottom Line

Employers considering dropping a Health Savings Account program at a mid-year renewal must understand that doing so will affect employees who have contributed more than their statutory maximum that year (or are in a testing period because of their date of hire or the company's recent mid-year introduction of the Health Savings Account program). But they also must understand that they have options to minimize the financial effect on employees' account contributions.

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