Understand Health Savings Account (HSA) Contribution Eligibility Requirements
As we have come to know, health savings accounts (HSAs) are useful tools to help offset out-of-pocket expenses for many folks. In addition, they offer significant tax advantages for both the employer and the employee.
The eligibility to contribute to an HSA is more restrictive than many employees realize. To make or receive HSA contributions, an individual generally must be covered by an HSA-qualified high-deductible health plan (HDHP), have no disqualifying coverage, not be enrolled in Medicare, and not be claimed as a dependent on another person’s tax return.
Employees can inadvertently lose HSA eligibility in numerous ways, such as:
- Enrolling in Medicare
- Participating in a general-purpose health FSA or HRA, including through a spouse
- Obtaining other health coverage that provides medical benefits before the HDHP deductible is satisfied.
Because HSA eligibility is determined on a month-by-month basis, even a minor change in coverage can result in excess contributions and potential tax consequences if not identified and corrected promptly. We’re going to focus on two disqualifying scenarios that come across our desk frequently: enrollment in Medicare and health FSAs.
How Medicare Enrollment Affects HSA Contribution
As a general rule, once an individual is enrolled in Medicare (Part A, B, C, or D), they are no longer eligible to make or receive HSA contributions. Medicare enrollment is designated as disqualifying coverage, and enrollment in any part of it, including premium-free Part A, makes an individual ineligible to contribute to an HSA. This applies even if the individual remains actively employed and covered under an employer-sponsored HDHP. Notably, Medicare enrollment does not require an individual to drop their HDHP. Medicare enrollees can remain enrolled in their employer’s HDHP as long as they remain eligible, and they can also continue to use the funds they’ve accumulated in their HSA.
Many employees decide to work past age 65, remain enrolled on their employer’s plan, and delay their Medicare enrollment. In instances like that, individuals should be aware that when later enrolling in Medicare, Medicare Part A may be awarded retroactively (up to six months). This means that the participants’ HSA contribution limit for the year is prorated according to that retroactive coverage date, not according to when they enrolled in Medicare. Individuals who don’t account for this and contribute over and above their prorated HSA limit run into an excess HSA contribution scenario.
Excess HSA contributions can lead to increased income taxes and a 6% excise tax. To remedy this, individuals should consider following these steps:
- Determine by how much, if any, they have exceeded their annual HSA contribution limit due to retroactive Medicare coverage;
- Contact the HSA custodian and request a return of any excess contributions and any associated earnings; and
- Report the amounts appropriately on the individual’s tax return.
If the corrections are made by the tax filing deadline (including extensions), the individual can generally avoid the 6% excise tax, although the contributions and associated earnings remain taxable. If the corrections aren’t made by the tax filing deadline, the 6% excise tax will apply for all taxable years the excess funds remain in the HSA.
Check Your Health FSA Coverage Before Contributing to an HSA
Let’s shift over to another savings vehicle, health flexible spending accounts (FSAs). A health FSA is an employer-sponsored benefit account that allows employees to set aside money on a pre-tax basis to pay for eligible healthcare expenses, such as deductibles, copayments, prescription drugs, and certain other medical expenses not covered by insurance. Unlike an HSA, however, a health FSA is generally subject to a “use-it-or-lose-it” rule, meaning unused funds may be forfeited at the end of the plan year unless the employer’s plan provides a carryover or grace-period feature.
Sometimes employers incorporate a general-purpose health FSA into their benefits package, and employees with HSAs consider switching to the health FSA. This process can be a bit tricky and confusing.
A general misconception is that once an individual has an HSA, they can continue contributing to it regardless of future health plan elections. While it is true that an employee can always keep and spend existing HSA funds, once they enroll in a plan that includes a general-purpose health FSA, they become ineligible to make new HSA contributions. However, employees who elect the health FSA for the new year sometimes forget to stop their HSA contributions. Because these employees are no longer HSA-eligible, that type of inadvertent mistake results in excess contributions. As discussed in the previous section, this creates a tax risk that needs to be remedied.
On the other end of the spectrum, health FSA grace periods and carryovers often cause problems for employees enrolled in an HDHP who want to switch from the general-purpose health FSA to an HSA. As long as the employee still has access to an unused year-end balance in the general-purpose health FSA through a grace period or carryover, the health FSA continues to be considered disqualifying coverage that prevents HSA contributions.
Preserve HSA Eligibility With a Limited-Purpose Health FSA
To solve for this issue, at the beginning of the new plan year, employers with grace periods can convert all residual participant funds to limited-purpose health FSAs that restrict reimbursements to certain expenses (vision, dental, etc.) and that don’t prevent HSA eligibility. Alternatively, those with a balance would not be eligible to contribute to an HSA until the grace period is exhausted. On the other hand, because carryover dollars can be used any time during the subsequent plan year, these arrangements prevent HSA eligibility for the entirety of that plan year unless the employer allows participants to waive the carryover or make the carryover funds limited-purpose. Unlike with grace periods, employers can convert carryover health FSA funds to limited-purpose just for those who enroll in the HDHP without impacting other participants.
Although limited-purpose health FSAs inherently restrict how participants can spend their remaining funds, these conversion options are nonetheless a viable compromise for employees who want to begin contributing to their HSA right away while still being able to take advantage of their prior year’s health FSA balance. Employers that choose to convert general-purpose health FSA balances to limited purpose in order to facilitate HSA contributions should clearly communicate the timing and implications of doing so to their participants.
