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FSA Grace Periods May Clash With HSA Rules

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Some employers may face a collision between flexible spending arrangement rules and health savings account rules in early 2006.

The collision could force affected employers to choose between offering HSA programs in 2006 for only part of the year or making major changes in their 2005 FSA plan grace period programs, according to Internal Revenue Service Notice 2005-86.

Susan Relland, health policy legal counsel at the American Benefits Council, Washington, says many benefits lawyers and consultants have called her about the notice.

The possibility that employers may have to change FSA plans on the fly to start HSA programs on time is disappointing, she says.

“It’s an open question whether you can really make a change like that mid-year,” Relland says.

Simply changing FSA plan documents will take time, and moves that take FSA benefits away mid-year could be particularly tricky, she says.

The collision is occurring because the federal government is offering employers two new benefits tools: the FSA grace period and the HSA program.

Employees earmark a portion of their compensation to fund FSAs. Traditionally, FSA plan participants who failed to spend all assets in their personal FSA by the end of the plan year lost the assets. Most FSA holders can spend plan assets without first meeting a deductible.

The IRS released a ruling in May that allows FSA plan sponsors to offer a grace period of up to two months and 15 days. The ruling means the sponsor of an FSA plan with a plan year that started Jan. 1, 2005, can give participants until March 15, 2006, to spend all account assets.

Meanwhile, the IRS and other federal agencies are encouraging employers to adopt HSA programs. Companies that want to sponsor HSA programs for employees must combine the accounts with high-deductible health insurance.

If an employer with a calendar-year, no-deductible FSA plan is offering a grace period that will end March 15, 2006, and that same employer tries to start an HSA program Jan. 1, 2006, the HSA program and the FSA plan grace period will conflict, Shoshanna Tanner, an IRS tax-exempt entities specialist, writes in IRS Notice 2005-86.

Tanner points out that HSA holders can have “limited purpose FSAs” that cover only expenses for preventive care, dental care, vision care or other qualified types of care.

HSA holders also can have “post-deductible health FSAs” that start covering eligible medical expenses only after the HSA holders have met their annual health insurance deductibles, Tanner writes.

Under the current rules, employees who have general purpose health FSAs with grace periods ending March 15, 2006, will not be eligible to contribute to HSAs until April 1, 2006, Tanner writes.

In that case, the employees would be able to contribute only 75% of the 2006 HSA contribution limit to their HSAs, Tanner writes.

Employers can get around the conflict by converting the general purpose health FSA to an HSA-compatible FSA during the grace period for all participants, Tanner writes.

Tanner does offer some transition relief for cafeteria plans with plan years ending before June 5 and grace periods ending before Sept. 1.

The sponsors of those plans can let members of general purpose health FSAs contribute to HSAs if the employees have used up their FSA contributions, Tanner writes.

An employer also can let members of a general purpose health FSA join an HSA program if the employer changes the “cafeteria plan document to provide that the grace period does not provide coverage to an individual who elects [high-deductible health plan] coverage,” Tanner writes.

In theory, employees might object to the idea of an employer changing the terms of the FSA grace period just weeks before the grace period starts.

But “the extension didn’t come out until later in the year,” says Daniel Meracle, president of Benefitdecisions Inc., Chicago, a benefits and human resources consulting firm.

Because the majority of FSA plan years start Jan. 1, most FSA plan participants probably made their FSA elections without knowing that there would be any grace period, Meracle says.

Employers might have more trouble complying with the new ruling because few of them understood that a decision to offer a health FSA grace period might affect a decision to offer an HSA program, he says.

In some cases, the new IRS ruling may cause complications for FSA sponsors that want to set up HSA programs in 2007 as well as those that want to set up HSA programs in 2006, Relland says.

Many benefits buyers who have been considering HSA programs already know about the potential conflict with FSA plans, but the level of awareness is probably lower among benefits buyers who are just starting to think about HSAs, Relland says.

The IRS released a ruling in May that allows FSA plan sponsors to offer a grace period of up to two months and 15 days


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