Integrating a Limited-Purpose Health FSA into your HSA program
By William G. (Bill) Stuart
A growing number of companies are introducing Limited-Purpose Health Flexible Spending Accounts (FSAs) to their new or existing Health Savings Account (HSA) program. This Limited-Purpose Health FSA provides employees with additional flexibility to cover high bills immediately, increase tax savings, build a long-term medical emergency fund, and pay some family members’ qualified expenses that can’t be reimbursed tax-free from an HSA. A Limited-Purpose Health FSA is a low-cost addition to the benefits menu that may appeal to employees who want to fund an HSA and achieve other financial goals.
Health FSAs as Disqualifying Coverage
Health FSAs are treated like medical plans under many provisions of federal law. Why? Well, employees pay a premium (reflected in pre-tax payroll deductions) and receive a limited benefit (reimbursement of qualified expenses) in return. That premium – we call it an election – is different for each participating employee. The principle, however, is the same: Employees covered by the Health FSA can receive their full benefit at any time during the plan year. As with other insurance, they may pay more in premiums than they receive in benefits (they forfeit unused election balances) or they may receive more than they pay (they spend more than their payroll deductions, then leave the company).
A general Health FSA represents disqualifying coverage because participants can reimburse non-preventive medical services before they satisfy a deductible of at least $1,400 (self-only coverage) or $2,800 (family plan). Unless the Health FSA is designed to exclude this coverage (more below), the plan is disqualifying.
Another complication: Under federal tax law, a Health FSA automatically covers the employee, a spouse, tax dependents, and children to age 26 (even if they’re no longer tax dependents). Thus, an otherwise-eligible person can’t open and fund an HSA if his spouse participates in her company’s Health FSA plan because that spousal Health FSA automatically covers him – even if he’s unaware or never files a medical claim. Similarly, a 24-year-old who enrolls in her employer’s HSA-qualified group plan isn’t HSA-eligible if she can still access reimbursements through a parent’s Health FSA.
Defining a Limited-Purpose Health FSA
A Limited-Purpose Health FSA isn’t disqualifying. Plan documents specify that reimbursement is limited to dental and vision services, including over-the-counter items (like reading glasses, eye drops, and mouth guards) related to dental and vision care. It doesn’t reimburse medical services, prescription drugs, or over-the-counter items related to medical care (like antacids, bandages, and antiseptic creams).
Note: Some account administrators give employers the option to expand the list of qualified expenses to include medical, prescription-drug, and over-the-counter items once employees attest that they’ve incurred at least $1,400 (self-only coverage) or $2,800 (family coverage) of deductible expenses. The Limited-Purpose Health FSA can then reimburse deductible expenses beyond those thresholds.
All Health FSA designs and HSAs enjoy the same tax treatment on contributions and distributions for qualified expenses. Contributions are free of federal income and payroll taxes and state incomes taxes (except in California and New Jersey, which exclude Health FSA elections but not HSA contributions from state income taxes). Withdrawals from all Health FSA designs and HSAs aren’t included in taxable income if the expense is qualified.
The benefits of a Limited-Purpose Health FSA
Limited-Purpose Health FSAs offer four distinct advantages to different segments of a typical employee population:
- Enjoy immediate access to elections. The full amount of a Health FSA election is available to a participant on the first day of the plan year under federal tax law. Thus, a Health FSA offers cash-flow benefits in addition to tax advantages. Participants who incur expenses early in the plan year can draw on future elections to pay for services now. This cash-advance feature provides peace of mind to families without an emergency fund who face a high dental or vision bill. Also, patients can sometimes negotiate prompt-pay discounts to reduce their net cost further. HSAs don’t offer this feature under federal tax law, though some administrators (including Voya Financial®) offer employers the option to create a similar cash-advance program.
- Increase tax savings. Employees can maximize their tax savings by funding their HSA to the statutory limit ($3,600 or $3,650 for self-only coverage in 2021 and 2022, respectively, or $7,200 or $7,300 for family coverage) and elect up to an additional $2,750 (the federal limit in 2021, though a company may set a lower ceiling) in a Limited-Purpose Health FSA. This strategy improves an employee’s financial situation only if she doesn’t forfeit some of her unused Health FSA balance, which can reimburse only dental and vision expenses.
- Build HSA balances. A growing number of HSA owners appreciate the value of incorporating the account into their retirement planning. They can use a Limited-Purpose Health FSA to reimburse their qualified dental and vision expenses, thereby preserving HSA balances (which can pay the same expenses) to grow through investments and reimburse future qualified expenses tax-free.
- Help certain adult children. HSA owners can’t reimburse their children’s expenses when the children no longer qualify as the parent’s tax dependents. But a parent’s Limited-Purpose Health FSA can reimburse qualified expenses incurred by children until age 26. It’s not unusual for a young adult to remain on a parent’s medical plan, not qualify as a tax dependent, and not earn enough to pay for, say, major dental work. Parents can help by reimbursing the expense from a Limited-Purpose Health FSA, but they can’t withdraw funds tax-free from their HSA to pay the same expenses.
Risks to employers and employees
When an employer offers a general or Limited-Purpose Health FSA, the company accepts the risk that a participant may overspend her account (spend more than she deposits through payroll deductions) and leave employment. Employers can’t withhold the difference from a final paycheck under federal tax law. This risk is often offset in full or in part by employees who underspend their accounts (payroll deductions exceed their reimbursements) and forfeit unused balances. Employers typically apply those forfeited balances to offset Health FSA administration fees and potential losses from former employees’ overspending their accounts.
Employees risk forfeiting unused Health FSA balances. Elections can’t be altered mid-year without a corresponding qualifying event (defined under federal tax law, including marriage, birth, adoption, divorce, and death). In contrast, HSA balances roll over year-to-year, so any unspent funds are available to spend in future years.
Employees who anticipate a high dental or vision expense during the next plan year may want to think about timing before they decide to participate in a Limited-Purpose Health FSA in addition to an HSA. If they plan to incur and pay the expense early in the year and won’t have a sufficient HSA, they can spend their full Limited-Purpose Health FSA election early in the plan year and, in effect, receive an interest-free loan from their employer. But they risk forfeiting unused balances if they end up not incurring the expense.
In contrast, if they anticipate scheduling the service later in the year, they may want to forego the Limited Purpose Health FSA and instead direct that portion of their income into an HSA. They’ll save enough in their cash account to reimburse the expenses when they receive care (or they can reimburse it from future years’ contributions – a key benefit of HSAs). And if the service is cancelled or rescheduled in a subsequent plan year, employees don’t risk forfeiting unused HSA balances.
Employers almost universally pay all Health FSA administrative charges, which typically include an annual plan-renewal fee (a flat amount) and then a per-participant per-month (PPPM) fee. In many cases, companies that already offer a general Health FSA can add a Limited-Purpose Health FSA at either no additional cost or a low annual fee and then the standard PPPM fee. It’s typically a small investment that employers often recoup from their portion of the federal payroll tax savings. For example, a $1,000 Health FSA election typically generates $76.50 in employer payroll-tax savings. That’s usually enough to pay the monthly administration fee (typically $3.50 to $5.00 monthly) and a share of annual flat renewal charges.
A Limited-Purpose Health FSA may not be the right option in every situation. However, it’s important for employers to understand the potential value of supplementing their HSA program with the addition of a Limited-Purpose Health FSA, especially if they offer a general Health FSA as well. For little additional investment in employee education and administrative fees, they can offer additional benefits to lower-income workers who can benefit from a Health FSA’s cash-flow feature . . . higher-income workers who want to reduce their taxable income and use the savings on current or future medical expenses . . . forward-thinking employees who are funding their retirements . . . and parents of young adults who may need help paying major expenses.
Most companies’ work forces contain many employees who fall into one or more of these categories. Those employees will be able to make better financial decisions if they have more options at their disposal. The Limited-Purpose Health FSA is one such option.
For more information on Limited-Purpose Health FSAs and HSAs, visit https://www.irs.gov/forms-pubs/about-publication-969
William G. (Bill) Stuart is Manager, Planning and Business Analysis at Voya Financial. He has nearly three decades’ experience in employee benefits and had worked with Health Savings Accounts since their introduction in 2004. He chairs the American Bankers Association HSA Council’s compliance committee and is the author of HSAs: The Tax-Perfect Retirement Account.
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This information is provided by Voya for your education only. Neither Voya nor its representatives offer tax or legal advice. Please consult your tax or legal advisor before making a tax-related investment/insurance decision.
Health Account Solutions, including Health Savings Accounts, Flexible Spending Accounts, Commuter Benefits, Health Reimbursement Arrangements, and COBRA Administration offered by Voya Benefits Company, LLC (in New York, doing business as Voya BC, LLC). HSA custodial services provided by WEX Inc. For all other products, administration services provided in part by WEX Health, Inc.
This highlights some of the benefits of these accounts. If there is a discrepancy between this material and the plan documents, the plan documents will govern. Subject to any applicable agreements, Voya and WEX Health, Inc. reserve the right to amend or modify the services at any time.
The amount saved in taxes will vary depending on the amount set aside in the account, annual earnings, whether or not Social Security taxes are paid, the number of exemptions and deductions claimed, tax bracket and state and local tax regulations. Check with a tax advisor for information on whether your participation will affect tax savings. None of the information provided should be considered tax or legal advice.