Spent Your Health FSA Balance Early? Sorry, It's Still Disqualifying Coverage!

Federal tax law isn't coordinated to ease the transition from a Health FSA to a Health Savings Account. That's unfortunate for employees and spouses (and sometimes kids) when medical benefits and Health FSA anniversary dates aren't aligned.

Your (or your spouse's) Health FSA runs on the calendar-year. You have an opportunity to enroll in your company's HSA-qualified medical plan effective April 1. You're excited. But now one of two things is likely to happen. Either you learn enough to understand that you're not eligible to open and fund a Health Savings Account, which frustrates you, or you don't realize it, which puts you at compliance risk.

Why? Why should another benefits decision - particularly if it's your spouse's plan - affect your Health Savings Account? And how can you correct this situation if you recognize it in time? Read on.

A Health FSA is a Medical Plan

Individuals who want to open and fund a Health Savings Account must be covered on an HSA-qualified plan and can't be covered by a non-HSA-qualified plan, among other eligibility requirements. These provisions present a challenge - and, for some, an opportunity - for prospective account contributors.

A Health FSA falls within the federal tax code's definition of a medical plan. That's news to many people (as it was to your author when first presented). But it makes sense. Like a major medical plan,

• FSA participants pay a regular premium through payroll deductions. We call these deductions an "election," but in the eyes of the tax code, someone who elects $2,400 pays a $100 semi-monthly premium for that coverage. The difference from traditional medical coverage is that the participant chooses the premium and the corresponding benefit level.
• Employers, as the self-insured plan sponsor, reimburse all eligible claims presented to the administrator. Employee payroll deductions (in their role as premiums) reimburse the account from which claims are paid.
• Participants' full coverage levels (elections) are available on the first day of the plan year (a concept called uniform coverage in the Health FSA world).
• Participants may receive more benefit than they pay in premium (they spend more than their payroll deductions before exiting the plan mid-year, for example when they leave a job), may pay more in premium than they receive in benefit (the difference is retained by the employer and is labeled a forfeiture of unspent funds), or may have premiums equal to reimbursements (they spend their elections and remain covered during the full plan year).

The Compliance Issue

Now that we've established that the Health FSA is a medical plan, a general Health FSA presents two eligibility problems. First, it's disqualifying if it offers first-dollar coverage for all traditional [tax code section 213(d)] qualified expenses (including medical, dental, vision, and over-the-counter). Second, it's disqualifying if it covers the owner of the Health Savings Account who wants to contribute.

Health FSA plan design. Most Health FSAs provide first-dollar coverage (no deductible to satisfy before reimbursements begin) for all qualified expenses. An HSA-qualified plan must have a deductible of at least $1,400 (self-only plan) or $2,800 (family coverage) and apply all covered non-preventive services to that deductible. A general Health FSA doesn't include a deductible, so it's disqualifying coverage.

Coverage. Under federal tax law, a Health FSA automatically covers the participating employee, her spouse, her tax dependents, and her children to age 26. Her employer can design a narrower plan, but few do. Thus, not only the HSA owner's Health FSA, but also her spouse's (and perhaps her parents, if she's under age 26) may disqualify her from funding a Health FSA.

Solutions? No Solutions?

Fortunately, there are some solutions, though don't offer immediate aid to Health Savings Account owners who want to fund their accounts immediately.

Limited-Purpose Health FSA. This design limits reimbursement to dental and vision services, both of which are excepted benefits. That term simply means that an HSA owner can be enrolled in dental or vision coverage without being disqualified from funding a Health Savings Account. Sometimes the range of expenses qualified for reimbursement expands to include medical and over-the-counter once a participant attests that she has paid an amount at least equal to the applicable statutory minimum annual deductible (the $1,400/$2,800 figures cited above). In this case, the deductible for medical and OTC expenses makes the Health FSA an HSA-qualified plan. (This latter concept is referred to as a Post-Deductible Health FSA and can be offered as a stand-alone limited FSA - not restricting reimbursement to just dental and vision at any point, but paying no claims before the statutory minimum annual deductible for an HSA-qualified plan. But it's unattractive, confusing, and rarely seen in practice.)

Spending down balances. Another approach that some participants contemplate is spending down their general Health FSA balances before they become HSA-eligible. This strategy appears viable when the Health FSA (either the Health Savings Account owner's or her spouse's) plan year isn't aligned with the medical-plan year. Unfortunately, Health FSA coverage runs for the entire 12-month plan year, whether or not balances are spent. Thus, spending the full balance on your own or your spouse's calendar-year general Health FSA plan by March 31 to enroll in an HSA-qualified plan and fund a Health Savings Account effective April 1 is not a viable strategy. The general Health FSA remains disqualifying through the end of the plan year (Dec. 31), regardless of the balance. The employee can enroll in the HSA-qualified coverage but can't open or fund (or accept an employer contribution to her Health Savings Account before Jan. 1.

Disenrollment. Alternatively, some employees ask to be disenrolled from a Health FSA plan so that they can begin to fund a Health Savings Account. There are a handful of qualifying events (birth, adoption, marriage, divorce, death) that allow Health FSA participants to change their elections or start or stop their participation. But wanting to enroll in a Health Savings Account is not one of them. Participants are locked in for the full Health FSA plan year.

Quitting. For other employees, Health Savings Account participation might be the final impetus for the spouse to leave a job (and the associated general Health FSA) that he no longer finds fulfilling. If he leaves his job by March 31 and doesn't take his Health FSA with him (COBRA applies to Health FSAs only in very specific circumstances, and the participant can waive these rights), he and his family are no longer covered. His spouse can enroll in the HSA-qualified plan and open and fund her Health Savings Account immediately.

The Bottom Line

It's unfortunate that there's an inherent compliance conflict in families that are enrolled in a general Health FSA and want to open and fund a Health Savings Account. Current federal tax law doesn't offer the flexibility to disenroll easily from a Health FSA for any reason. Yet Health FSA participants - who understand the tax benefits that both accounts offer - are the people most likely to want to open and fund a Health Savings Account.

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