How Health FSA Extenders Affect HSA Eligibility

If your general Health FSA has a grace period or a carryover of unused balances, this extender may affect your eligibility to open and fund a Health Savings Account.

In last week's column, we focused on the eligibility issues when a general Health FSA and an HSA-qualified medical plan have different effective dates. Let's briefly review that discussion, then focus on how a grace period or balance carryover can further complicate the compliance problem.

The Misalignment Conundrum

When a company offers a general Health FSA and a Health Savings Account with different anniversary dates, Health FSA participants face a compliance issue when they want to enroll in the Health Savings Account program. A Health FSA is a distinct medical plan under the federal tax code. And because a general Health FSA (which reimburses the first dollar of qualified medical expenses, with no deductible applied) isn't an HSA-qualified plan (which requires a deductible of at least $1,500 for self-only and $3,000 for family coverage), anyone covered by a general Health FSA is disqualified from opening and funding a Health Savings Account before the end of the Health FSA plan year.

As a result, employers must either terminate the general Health FSA plan early or convert the plan to a Limited-Purpose Health FSA (a permitted design that reimburses only qualified dental and vision expenses). The other options are to allow the disqualification, delay the Health Savings Account program for a year, or try to change the anniversary date of the medical plan.

The Other Alignment Challenge

Another problem may arise even when the general Health FSA and medical plan years are in sync. If participants have more than 12 months to spend their elections, they may extend the time during which they're disqualified from opening and funding a Health Savings Account. The two plan features that extend the time to spend balances are a grace period and a carryover. Employers can offer either feature, but not both, on the same plan.

Both options address the top concern among prospective Health FSA participants: that they'll forfeit unused balance. Under federal tax law, any unused funds are returned to the company and are usually used to offset plan expenses. By giving participants additional time to spend their balances, the grace period or carryover reduces the risk of forfeiture.

Grace period. The grace period is span up to an additional two months and 15 days (usually expressed as 2 1/2 months) to spend all remaining balances. In effect, the grace period is an unlimited balance carryover for a limited time.

Example: Jolene has a $475 balance in her Health FSA at the end of the plan year on Dec. 31, 2023. Her employer had adopted the grace period. Jolene has until March 15, 2024, to spend her remaining 2023 balance.

Carryover of unused funds. The carryover feature allows a participant to move unspent funds - up to a limit prescribed by tax law - to the following Health FSA plan year. The prescribed limit is up to 20% of the annual election ceiling, or $610 (20% of the $3,050 election limit) in 2023. Think of the carryover as an unlimited time (since balances can carry over for years) to spend a limited amount of remaining election.

Example: Alberto has the same $475 balance. His company adopted the carryover feature. He can carry over the entire $475 balance into the following plan year. But his co-worker Alexandra, who has a $722 balance at the end of the plan year, can carry over no more than $610.

Grace Period and Health Savings Account Eligibility

When the Health FSA and medical plans renew on the same date, the grace period may create a problem for a participant who wants to become HSA-eligible. That's because she's still covered by the general Health FSA when the Health Savings Account program begins. If she carries a balance into the grace period, she can't open and fund a Health Savings Account for three months - on the first day of the first month after the end of the 2 1/2-month grace period.

Example: Madison has $24.57 left in her general Health FSA when the plan year ends Dec. 31, 2023. She can spend that balance on qualified expenses purchased as late as March 15, 2024. She enrolls in the HSA-qualified plan effective Jan. 1, 2024. She can't open her Health Savings Account, accept an employer contribution, or make personal deposits before April 1, 2024.

A participant can solve this problem herself by spending her balance by the end of the 12-month plan year. If she has no remaining election amount to spend at the end of 12 months, the grace period doesn't apply to her. Thus, she's no longer covered by the general Health FSA effective Jan. 1, so she can open and fund her Health Savings Account immediately (if she's not otherwise disqualified).

An employer can also address the issue prospectively (before the end of the 12-month plan year, effective at the end of the 12-month plan year) by either terminating the grace period or turning the grace period into a Limited-Purpose Health FSA (limiting reimbursement during the grace period to qualified dental and vision expenses). These changes apply to all Health FSA participants, including those enrolled in the company's other medical plans and workers who waive employer coverage (typically covered on a spouse's or parent's plan). Employers can't split their Health FSA populations during the grace period (or at any point during a plan year) to offer a Limited-Purpose Health FSA to employees who want to become HSA-eligible and leave the general Health FSA in place for employees enrolled on another plan or who waive medical coverage (and are usually enrolled on a spouse's or parent's plan).

In a worst-case scenario, the participant carries any amount into the grace period and the employer doesn't alter the grace period. In that case, the participant is disqualified from opening and funding a Health Savings Account for three months. She can reimburse her qualified expenses with her remaining general Health FSA funds. But if she's new to Health Savings Accounts, she can't retroactively reimburse qualified expenses incurred during those first three months because she hadn't established her Health Savings Account until the first day of the first month after the end of the grace period.

Carryover and Health Savings Account Eligibility

The carryover feature creates a potentially more serious compliance issue, but also offers more attractive ways to avoid problems.

Unused funds (up to the federal limit, or a lower ceiling established by the employer as plan sponsor) carry over into the following 12-month plan year. Thus, a mistake may disqualify the participant from opening or funding a Health Savings Account for 12 months.

Example: Wyatt has $100 remaining in his general Health FSA at the end of the plan year. That balance carries over into the new plan year. Wyatt enrolls in the company's Health Savings Account program for the first time. Because he has funds in a general Health FSA - even if they're the result of a carryover, rather than a new election - he's disqualified from opening or funding a Health Savings Account until the end of the new general Health FSA year.

Thus, the potential compliance issue is more severe. But the remedies are more palatable.

1. He can simply spend his full election before the end of the plan year, leaving no balance to carry over into the following year.
2. The company can prospectively terminate the carryover provision.
3. Because it's a new Health FSA plan year, the company can carry the balance into a Limited-Purpose Health FSA. He can spend the carryover amount on qualified dental and vision expenses, which are permitted coverage.
4. If all else fails, he can refuse the carryover.

An attractive benefit of the carryover feature is that the employer can treat Health FSA participants differently (which isn't permitted during the grace period because it's an extension of the plan year and the participant population can't be split). Unused funds carry over into a new plan year, so the company can deposit unspent balances into a Limited-Purpose Health FSA for employees who want to become HSA-eligible and into a general Health FSA for other workers.

Example: Esther and Juan are both enrolled in their company's general Health FSA program and are carrying over $200 each into the following plan year. Juan enrolls in the company's new Health Savings Account program. The company carries Esther's balance into a general Health FSA and Juan's into a Limited-Purpose Health FSA. Both can make an election up to their employer's limit into their respective Health FSAs (the carryover doesn't offset their election limit).

Spousal and Child Coverage

Under federal tax law, Health FSAs automatically cover the employee, a spouse, tax dependents, and children to age 26. This is true even if these family members aren't enrolled on the employee's company's medical plan, are aware that they can reimburse their expenses through the employee's Health FSA, or make a conscious effort not to seek reimbursement.

When the employee brings a balance into a grace period or carries over unused funds, the employee's company can do nothing to help other family members who may want to become HSA-eligible promptly at the end of the 12-month Health FSA plan year. The employee must spend the full balance during the 12-month plan year, as described above. If the employee's company offers a carryover and sponsors a Limited-Purpose Health FSA plan, balances can be deposited into that plan, allowing family members to become HSA-eligible at the end of the 12-month plan year. If the company doesn't offer the Limited-Purpose Health FSA and the employee has a balance at the end of the plan year, he can renounce the carryover to allow a family member (or himself) to become HSA-eligible immediately after the end of the 12-month plan year.

The Bottom Line

Offering an extender - a grace period or carryover of unused balances - is an effective way to boost Health FSA participation because it reduces the risk (and leading prospective participant fear) of forfeiting unspent funds. But either the grace period or carryover can disqualify employees from opening and funding a Health Savings Account. Fortunately, employers who recognize the issue during the Health FSA plan year can prospectively alter their programs - although some approaches may have negative effects on certain participants. And even absent employer changes, participants who want to become HSA-eligible when they first enroll in an HSA-qualified plan can, if they understand the rules, take action themselves to ensure that they're not disqualified.

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The content of this column is informational only. They are not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.