Four Reasons to Make a Limited-Purpose Health FSA Election

When does it make sense to have more than one reimbursement account at your disposal to pay for qualified medical expenses?

Does it make sense to fund a Health Savings Account and also participate in a Health FSA? As we learned in the HSA Monday Mythbuster column earlier this week, it's possible to participate in a Health FSA (or have a spouse or parent do so) and fund a Health Savings Account if it's a Limited-Purpose Health FSA. This plan design reimburses qualified dental and vision expenses only.

But a Health Savings Account owner can reimburse the same qualified expenses tax-free from that account. So, why commit to participating in a less flexible account - the Limited-Purpose Health FSA - that has a use-it-or-lose it feature to it? If you anticipate receiving qualified services during the plan year, the Limited-Purpose Health FSA may fit nicely into your financial plan if one or more of the following situations applies to you.

One. You Want to Maximize Tax Savings

You can contribute up to the statutory maximum in your Health Savings Account ($3,850 for self-only and $7,700 for family coverage in 2023) and still elect up to your company's Limited-Purpose Health FSA maximum (not to exceed $3,050 in 2023). Both programs are funded by pre-tax payroll deductions, so your taxable income shrinks dollar-for-dollar with your contributions and elections. And not only are federal and state income taxes not applied to your payroll deductions (unless you live in California or New Jersey, the two states that don't allow a tax deduction for Health Savings Account contributions), but federal payroll taxes (15.3% for most taxpayers, split between employees and employers) aren't collected either.

Example: You fully fund your Health Savings Account and also elect $3,000 into your company's Limited-Purpose Health FSA. If you're in the 22% federal marginal income tax bracket, you save $660 in federal income taxes, plus $229.50 as your portion of federal payroll taxes. That's a total of nearly $900 in federal tax savings. If your state imposes a 6% income tax, your tax savings increase by an additional $180, to a total approaching $1,100.

But remember that all Health FSA programs have a use-it-or-lose-it feature if you don't spend your election. Your company may offer a grace period (an additional period, up to two and a half months, to continue to spend your annual election) or a carryover (permitting you to roll up to $610 of your balance into the following plan year). But ultimately, unspent funds revert to your employer as the plan sponsor. Thus, you must be confident that you'll incur qualified dental and vision expenses during the plan year before making an election to a Limited-Purpose Health FSA.

Two. You Want to Preserve and Build Health Savings Account Balances

If you want to pay for qualified expenses with tax-free funds, you can use either a Health Savings Account or a Health FSA. Or both. The Health FSA offers the same tax benefits (and is superior for residents of California and New Jersey, whose Health FSA elections, but not their Health Savings Account contributions through a Cafeteria Plan, are pre-tax).

The list of qualified dental and vision expenses is the same for a Limited-Purpose Health FSA and a Health Savings Account. If you want to maximize your Health Savings Account balance, consider reimbursing those qualified dental and vision expenses through a Limited-Purpose Health FSA. By doing so, you enjoy the same tax benefits while preserving your Health Savings Account balance to reimburse tax-free the qualified expenses that you incur later - next year, next decade, or in retirement.

Example: Same as above. By funding the Limited-Purpose Health FSA, you can spend $3,000 tax-free on dental and vision expenses and retain $3,000 in your Health Savings Account. Your tax savings are the same.

Three. You Anticipate High Qualified Expenses Early in the Plan Year

A key benefit of any Health FSA program is what's called uniform coverage. Simply stated, you can spend your full election at any point in the plan year - including the first day. If you spend more than the amount that's been deducted from your paycheck, your employer covers the shortfall - in effect extending an interest-free loan to you. You repay that amount with your level payroll deductions throughout the year.

Health Savings Accounts don't include the benefit of drawing on future payroll deductions because you're not bound to an annual election. Thus, if you need funds to pay for restorative dental work, orthodontics, or vision-correction surgery early in the plan year, a Limited-Purpose Health FSA offers a cash-flow benefit in addition to tax savings. And if you live in California or New Jersey, you can save 7.65% of your portion of payroll taxes (the figure is 1.45% if your income exceeds $160,200 in 2023) when you participate in a Limited-Purpose Health FSA.

Example: Your dentist informs you during your routine oral exam in October that you need a root canal or dental implant and a dental crown. The dentist runs a pre-estimate through your dental insurer so that you know your financial responsibility. You schedule the services in January, when the Limited-Purpose Health FSA plan year begins.

As a bonus, you may be able to negotiate a cash discount with your provider.

Example: We paid for my wife's vision-correction surgery with my and her Limited-Purpose Health FSAs and took advantage of a $500 prompt-pay discount. We paid up-front for a child's orthodontia, saving 15% by paying in advance with three parents' (father's, mother's, step-parent's) dental insurance and my Limited-Purpose Health FSA.

Four. You Want to Help a Non-Dependent Child under Age 26

You can reimburse tax-free your own, your spouse's, and your tax dependents' qualified medical expenses from a Health Savings Account. You can't reimburse tax-free qualified expenses incurred by a young-adult child who's no longer your tax dependent, even if the child remains covered on your medical plan to age 26.

In contrast, the list of qualified members whose expenses can be reimbursed tax-free from a Health FSA includes another group: non-tax-dependent children before the end of the year that they turn age 26. Health FSAs are governed by many of the same rules as a major medical plan. And under federal law, children remain covered on a medical plan until age 26, regardless of their status as a tax dependent.

Thus, if you want to help a non-dependent child pay for expensive dental or vision services, you can fund a Limited-Purpose Health FSA and pay those bills from the FSA (unless your employer doesn't allow reimbursement for family members, which is rare).

Why would you - the parent - want to pay expenses incurred by a child who makes enough money that she doesn't qualify as your tax dependent? That's your business. Perhaps the child has little discretionary income. Or maybe you want to make an intergenerational wealth transfer. Whatever the reason, know that if the child is no longer your dependent, you can't reimburse the expense tax-free from your Health Savings Account, but you can from a Limited-Purpose Health FSA (or a general Health FSA if you're not currently funding your Health Savings Account).

The Bottom Line

Federal tax law allows active Health Savings Account contributors to also participate in a Limited-Purpose Health FSA. If your company offers a Limited-Purpose Health FSA and you don't anticipate incurring qualified dental and vision expenses during the Health FSA plan year, you're better off contributing more to your Health Savings Account. After all, you never forfeit those funds. On the other hand, if one of the four situations above applies to you and you anticipate receiving qualified services, a Limited-Purpose Health FSA may be an important financial ally.

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Coming Sept. 19: #ICHRAinsights #ICHRA

The content of this column is informational only. It is 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.