Advice memos released by the Office of Chief Counsel at the Internal Revenue Service (IRS) address the interaction between carryovers from health flexible spending accounts (FSAs) and eligibility for contributions to health savings accounts (HSAs), and correction procedures for improper health FSA payments.
To contribute to an HSA, an employee generally must be enrolled in a qualifying high-deductible health plan (HDHP) and not enrolled in any non-HDHP coverage. But while HSA participants may not be enrolled in “general purpose” health FSAs, the IRS makes an exception for “limited purpose” health FSAs. These HSA-compatible FSAs may reimburse dental, vision or preventive care expenses only, or reimburse medical expenses after the participant has satisfied the HDHP deductible.
In October 2013, the IRS decided to allow health FSA carryovers of up to $500 to the next plan year, but there have been questions about the interaction between the carryover feature and HSA eligibility.
Health FSA carryovers and HSA contribution eligibility
The IRS memo reaches the following conclusions about the interplay between carryovers from health FSAs and eligibility to make HSA contributions:
- A participant in a general purpose health FSA cannot make HSA contributions even if he or she is in the general purpose FSA due to a carryover of unused amounts from the prior plan year.
- A participant in a general purpose health FSA may not contribute to an HSA during the entire FSA plan year. This restriction applies, for example, even for months in that plan year after the FSA carryover balance has been used up.
- A participant in a general purpose health FSA who elects to participate in an HSA-compatible health FSA for the next year may also elect to have any unused amounts from the general purpose health FSA carried over to the HSA-compatible health FSA.
- An individual who elects to deposit a carryover balance from a general purpose health FSA into an HSA-compatible health FSA in the following year may contribute to an HSA during that following year.
- A cafeteria plan that offers both a general purpose health FSA and an HSA-compatible health FSA may automatically consider an employee who joins an HDHP for the following year as enrolled in the HSA-compatible health FSA. In this situation, any unused amounts from the general purpose health FSA would be carried over to the HSA-compatible health FSA for the following year.
- A cafeteria plan may provide that a participant in a general purpose health FSA with a carryover feature may decline or waive the carryover balance before the next plan year, thereby remaining eligible to make HSA contributions.
- If an employee elects to carry over unused amounts from a general purpose health FSA to an HSA-compatible health FSA, he or she may use the remaining balance for any permissible medical expenses incurred before the general purpose health FSA plan year ends. In addition, any covered claims must be timely reimbursed up to the amount elected for the HSA-compatible health FSA plan year. Any claims in excess of the elected amount may be reimbursed after the run-out period when the amount of any carryover is determined. An example in the advice memo further explains these rules.
Correcting improper FSA payments
An improper payment is typically a reimbursement for medical expenses that was not properly substantiated or that later turns out to be for an item or service that isn’t a qualified medical expense. The guidance addresses three points:
- Improper payments under a health FSA may be corrected using the regular correction procedures that were articulated in prior IRS guidance for improper debit card payments:
Although employers may apply the above correction procedures in any order (as long they are consistent for all participants), an employer may proceed to the fifth step only after trying the other steps first. Correction procedures should be applied during the plan year in which the improper payment was made. Finally, repaid amounts are available for reimbursing other claims incurred during that plan year (or in the next plan year, if the plan has a carryover feature).
If the employer treats the improper FSA payment as a business debt because it was not repaid by the employee, the amount is considered income to the employee and thus subject to withholding for federal income tax, FICA and FUTA purposes. It should be reported as income on the employee’s Form W-2 in the tax year in which the debt is forgiven.
- Until the improper FSA payment is recovered, the employer must deactivate the debit card, and the employee must use other methods to request FSA reimbursements, such as submitting a receipt or invoice.
- The employee must repay the improper FSA payment to the cafeteria plan.
- If the employee fails to make the repayment, the employer must withhold the improper payment amount from the employee’s pay.
- If the employer is unable to recover the full amount, claims substitution or offset must be used where possible. For example, if an employee receives an improper payment of $200 and subsequently submits a substantiated claim for $250, the employer reimburses only $50.
- If the employer is still unable to recover the improper payment, it should be treated in the same way as any other business debt.
Sponsors of both a health FSA and an HSA should consider whether to have an FSA carryover feature and, if so, the best way to coordinate the two accounts. For example, an employer could require any carryover from an FSA (up to $500) to be carried over to an HSA-compatible FSA, such as a limited purpose FSA or post-deductible FSA. Employers could also give FSA participants the option to decline or waive the carryover amount to preserve their eligibility to make HSA contributions. In light of the recent IRS guidance, employers also should review and determine the corrective steps that will be used when improper payments have been made from a health FSA.