Health savings accounts (HSAs) provide employers with a flexible tool for providing health benefits to employees. Employers and employees can vary their level of involvement in an HSA program to strive for an ideal balance both at the group level and the individual employee level.
The flexibility of HSA programs has led to rapid growth and acceptance of HSAs, but has also created misunderstandings for employers implementing HSA programs. Some employers assume that the individual nature of HSAs relieves the employer of all compliance burdens, while other employers assume they can exercise a greater amount of control over employees’ HSAs than is allowed.
This article focuses on the special rules that apply to employers implementing an HSA program and clarifies the responsibilities of the employer, employees, and the HSA custodian. [This article is updated and adapted from an article first published in Benefits Quarterly: Johnson, Whitney R., (2012, 3rd Quarter), HSA Programs for Groups: Employer Versus Employee Responsibilities, Benefits Quarterly, (Vol 28, pp. 43-51)].
Flexibility in level of employer involvement
Employers interested in HSAs face a variety of potential levels of involvement.
- Employer-provided HDHP or not: An employer may or may not offer a group High-Deductible Health Plan (HDHP). Employers are allowed to offer the HSA benefits described in this article to HSA-eligible employees even if the employer does not offer the corresponding health insurance.
- Employee-funded HSA: Employers are not required to help fund employees’ HSAs and may choose not to do so. In this option, the employee is on his/her own to open and fund the HSA. The employer could offer a direct deposit feature to the employees’ HSAs provided the employer properly reports the contribution as ordinary income on the employee’s Form W-2.
- Employee-funded HSA, pre-tax through payroll deferral: Employers can help employees fund their HSAs by allowing for HSA contributions pre-tax through payroll deferral. This requires that the employer adopt a Section 125 Cafeteria Plan with an HSA option.
- Employer pre-tax contributions: Employers may make direct contributions to their employees’ HSAs subject to the HSA comparability rules.
- Employer pre-tax contributions and pre-tax payroll deferral: Employers can combine an employer contribution with pre-tax payroll deferral to create the most powerful combination of HSA benefits for employees.
Pre-tax employer contributions trigger special rules
The IRS defines an “employer contribution” as a pre-tax employer contribution or a pre-tax employee payroll deferral and employers that make pre-tax HSA contributions trigger the special group HSA rules. HSAs are tax-driven accounts and basing the rules on the tax status is appropriate.
Accordingly, special HSA group level rules apply even if an employer has only one employee that receives a pre-tax HSA contribution. Conversely, an employer with many employees with HSAs is not subject to the HSA group rules provided the employer only allows after-tax payroll contributions into the HSAs or no contributions at all.
No employer pre-tax contribution eliminates special rules
Employers that offer no assistance for HSAs, or only offer after-tax HSA payroll deferrals, do not face any of the special rules that apply to group HSA plans. An employer in this position is capitalizing on the unique benefit of HSAs in health benefits law – that individuals can open and contribute to an HSA without employer involvement and still get a tax break. This allows for those employees that would benefit from an HSA to do so on their own. This approach works well for small businesses that are struggling to finance even a portion of the health insurance premium and are not equipped to expand employee benefits.
Given the low expense and administrative burden, a larger business should consider adding an HSA pre-tax payroll deferral option. Even very small employers are encouraged to offer this feature to employees because of the payroll tax savings. (Click or touch to enlarge chart.)
Employer HSA contributions bring tax benefits
Employers that allow pre-tax HSA contributions maximize the tax benefits for their employees and the business. The main tax benefit for most employees is income avoidance and employees get this benefit from personal HSA contributions (as a deduction from income) as well as employer contributions (as pre-tax). The additional tax savings from employer pre-tax contributions come from payroll taxes: Social Security (FICA), Medicare, Federal Unemployment Tax (FUTA), and possibly State Unemployment Tax (SUTA). Both employer-direct contributions and pre-tax payroll deferral HSA contributions avoid payroll taxes. The savings achieved by avoiding payroll taxes are worth the effort. FICA is 6.2 percent up to $118,500 (2015) on the employer side and another 6.2 percent for the employee side. Medicare is an additional 1.45 percent for both the employer and the employee on all income. The FUTA tax is relatively small and only the employer pays it (generally 0.8 percent on the first $7,000), but there may be savings for State Unemployment Taxes as well.
Section 125 Plan required for pre-tax payroll deferral
Employers that choose to allow employee pre-tax payroll deferrals into an HSA must establish a Section 125 plan (a plan that meets the requirements of Section 125 of the Internal Revenue Code). Section 125 plans, or Cafeteria Plans, are relatively easy to establish and generally do not require the employer to submit any paperwork to the IRS or an annual IRS Form 5500 filing. The “Cafeteria” name is appropriate because the plans generally offer a choice of tax-deferred benefits: accident and health insurance premiums, dependent care, adoption assistance, group-term life insurance and HSA contributions. Many employers already have a Section 125 plan because the plan is necessary in order to allow an employee to pay a portion of the health insurance premium pre-tax. In that case, the employer must confirm that the plan allows for HSA deferrals. If not, the plan provider can likely add the necessary language for a small fee.
A Section 125 plan is a written legal document that the employer signs, maintains and administers. By signing the document, the employer agrees to comply with the rules contained in the document regarding types of benefits allowed, treating employees fairly, and other IRS requirements. The maintenance of the document itself generally means updating the document periodically to comply with law changes as well as keeping the signed copy on file in case of an IRS audit. Administering the Section 125 requires some work.
For payroll deferral into an HSA through a Section 125 plan, the employer must reduce the employees’ pay by the amount of the deferral and contribute that money directly into the employees’ HSA. The employer may do this administration itself or it may use a payroll service or another type of third-party administrator. In any case, the cost of the Section 125 plan itself and the ongoing administration are generally small and offset, if not entirely eliminated, by employer savings through reduced payroll taxes.
Another administrative element is the collection of Section 125/HSA payroll deferral election forms from employees. Employers that have offered Section 125 plans prior to introducing an HSA program are familiar with this process. Unlike other Section 125 plan deferral elections which only allow annual changes, the law allows for changes to the HSA deferral election as frequently as monthly. Although frequent changes to the elections create a small administrative burden on the employer, the benefit to employees is significant.
The ability to change deferral elections allows employees to adjust mid-year to what the year’s expenses actually are versus what they planned. An employee that initially expected a low expense healthy year and elected only a small HSA payroll deferral can adjust when surprised by a large medical expense. Conversely, an employee that elected to defer a large amount into the HSA but later faces lower than anticipated medical expenses (or faces higher than anticipated non-medical expenses) can adjust their deferral downward. Employers are allowed, but not required, to accept prospective monthly changes to deferral elections. Prospective means that the change cannot take effect until the month following the change date.
Offering pre-tax HSA payroll deferral makes sense for most employers that provide an HSA-eligible health insurance program. The cost, compliance and administrative burdens are low compared to the tax benefits for the employer and the employees. Employers can obtain these same tax benefits without a Section 125 plan by giving HSA money to the employees rather than using employee payroll deferral; however, then the employer must meet the comparability rules.
Comparability testing for employer pre-tax contributions
The most complicated compliance issue facing employers adopting HSA plans is comparability testing. Congress created the concept of “comparability” to ensure that employer-provided HSA contributions are made on a fair basis across employee groups. Those familiar with 401k plan discrimination testing understand the nature of these types of rules and the accompanying complexity. The comparability rules are long, difficult, and sometimes counter-intuitive. Plus, the government imposes a severe 35 percent penalty for failure to comply. One positive attribute of the severity of the penalty is that most employers are aware of this rule.
The burden of meeting the comparability rules is more than offset by the tax advantages. Employers meeting the comparability rules can deduct the amount of the HSA contribution as a business expense (IRC § 106(d)). Neither the employer nor the employee has to pay payroll taxes on the contribution and the employee avoids federal income taxes and in most cases state income taxes.
Although the IRS regulation includes the term “comparability testing,” the term refers to ensuring that the contributions are comparable at the time made. There is no need to test later, except as it relates to new hires. This simplifies the rule as compared to other benefit plan testing that occurs after the end of the period when corrections are more difficult. Also, employers are not required to submit the results of the comparability testing to the government, except possibly as part of an IRS or other government agency audit.