HSA/FSA Grace Period Guidance Restricts Employer Options but Provides Limited Transition Relief

In Notice 2005-86, the IRS clarifies the effect of a health flexible spending account (FSA) grace period on health savings accounts (HSAs). Employees who participate in a health FSA with a grace period may not participate in an HSA until the first day of the first month after the grace period ends. The rule holds even for participants whose FSAs are empty. However, employers may convert their regular FSA coverage to HSA-compatible FSA coverage during the grace period, thus enabling participants to participate in an HSA as well. The notice also provides transition relief for plans whose plan years end on or before June 5, 2006.

FSA Grace Period and HSA Eligibility
Employees may not establish or participate in an HSA if they are also covered by nonqualifying, high-deductible health coverage that provides more than permitted coverage, preventive care and/or permitted insurance. An individual is considered to be covered if he or she was a participant or qualified beneficiary on the last day of the plan year.

In earlier guidance, the IRS provided a few exceptions to the HSA/FSA restrictions: limited-purpose health FSAs and post-deductible health FSAs. Limited-purpose FSAs reimburse expenses only for preventive care and permitted coverage, such as dental and vision care. A post-deductible health FSA reimburses expenses incurred after the participant satisfies the high-deductible health plan (HDHP) deductible.

Notice 2005-86 allows employers to convert coverage during the grace period to a permitted plan design, which could be a limited-purpose health FSA, a post-deductible health FSA or a plan that combines features of both. However, the conversion must be mandatory for all plan participants, whether or not they elect qualifying HDHP coverage.

Additional Guidance for Post-Deductible Health FSAs
According to the notice, post-deductible health FSAs may reimburse only general medical expenses incurred after the participant satisfies the deductible. The guidance suggests that employers cannot “hold” general medical expenses incurred before participants satisfy the HDHP deductible and then reimburse them after they have satisfied the deductible.

The notice does not explain how to treat an individual with additional family members under a health FSA for HSA eligibility and contribution purposes. It is not clear whether the post-deductible FSA would be tied to the single or family HDHP coverage. Although a health FSA that pays general medical expenses incurred after the participant satisfies the HDHP deductible does not conflict with HSA eligibility, the post-deductible health FSA must satisfy the statutory minimum deductible rules.

For example, assume that an employee, Joe, has single coverage under the HDHP with a $1,050 deductible and a post-deductible health FSA that covers him, his spouse and his children. The health FSA must satisfy the statutory minimum deductible. Because the health FSA is technically family coverage, it could pay only for dental, vision and preventive care that exceeds the statutory minimum deductible for family coverage ($2,100 for 2006). Thus, it appears that Joe may not establish or contribute to an HSA until he meets the family deductible.

Administration of the Grace Period
The grace period must be available to all individuals who, on the last day of the plan year, are covered under the plan as active participants or as qualified beneficiaries receiving COBRA continuation coverage.

Employees who terminate employment during the grace period remain covered until the grace period ends. So employers need not offer COBRA continuation of the grace period coverage to employees who terminate employment during the grace period. However, these employees may be eligible to elect COBRA continuation of current-year coverage, depending on the health FSA’s status as an excepted benefit and the employee’s account balance as of the termination date.

Employers may apply the grace period to one benefit but not to another. For example, employers may adopt a grace period for the health FSA but not for the dependent care FSA. It appears that employers may establish separate health FSA plans to accomplish different goals.

Transition Relief
The notice provides transition relief for plans whose plan years end on or before June 5, 2006. Otherwise-eligible participants covered by an FSA grace period may establish an HSA, as long as either: (1) they have no carryover funds, or (2) the employer amended the plan to exclude HDHP participants from the grace period. Employers may exclude FSA participants who enroll in an HDHP from the grace period only during the transition period.

The IRS did not provide transition relief for participants who entered a grace period before the notice came out and whose funds carried over into the grace period.

Summing Up
Plan sponsors and administrators that have adopted a grace period and plan to offer HDHP and HSA options in 2006 may need to do some fine-tuning to conform to this guidance. Most of these employers will need to further amend their plans to automatically convert the grace period coverage to permissible health FSA coverage.