As many clients have seen their out-of-pocket health-related expenses rise with the implementation of the Affordable Care Act, finding a tax-preferred method for funding those expenses has become more important than ever. The options, however, have expanded in recent years and the rules have grown more complex—meaning that more clients may have difficulty determining which supplemental health account best suits their needs.
For a client who is lucky enough to have access to both a health savings account (HSA) and a health flexible spending account (FSA) to fund these expenses, expert advice as to the rules governing each type of account can prove critical to making sure each client makes the most of his or her health savings vehicle.
When Does an HSA Fit?
As a basic matter, the IRS has established limits on the use of HSAs so that only individuals with certain types of health plans are eligible to participate. HSAs are geared toward plans with higher deductibles; to qualify, a high deductible health plan (HDHP) must have a deductible that exceeds $1,300 for an individual plan or $2,600 for a family plan in 2015. Annual contributions to HSAs in 2015 are limited to $3,350 for individuals or $6,650 for families.
HSAs allow the client to adjust his or her contribution limits throughout the year, so that if the client is uncertain as to the level of his or her out-of-pocket expenses for the year, there is some flexibility. Additionally, amounts contributed to an HSA are rolled over from one year to the next (indefinitely) if the client does not need to use the funds in the year of contribution.
Further, an HSA will not be lost if the client changes jobs (though his or her ability to contribute may be lost if a new employer offers health coverage that does not qualify as an HDHP).
HDHPs generally require the client to fund a greater portion of his or her own health care before the insurance actually kicks in, meaning that clients with these plans might be better off contributing to an HSA because it comes with a higher contribution limit.
Despite these advantages, the implementation of the ACA Cadillac tax in 2018 may serve to limit the tax advantages of the HSA. Because pre-tax HSA contributions will likely be counted in calculating the cost of employer-provided coverage, many employers are likely to limit HSA contributions to after-tax dollars in the future. The funds will still be withdrawn tax-free to pay for qualified medical expenses, but the benefit of reducing taxable income through contributions may be lost (though the final Cadillac tax rules have yet to be released).
The Health FSA Difference
A primary advantage to the health FSA when compared to HSAs is that the client does not have to be enrolled in an HDHP in order to take advantage of a health FSA. However, the contribution limits to these accounts are lower ($2,550 in 2015) and unused amounts are generally forfeited at the end of the year (though either a 2.5-month grace period or $500 carryover may be permitted, depending upon the specific FSA).
Contributions to a health FSA must be fixed at the certain times—either during open enrollment, or if the client experiences certain changes in employment or family status (marriage, birth of a child, etc.). Further, in some cases, FSA funds can be lost if the client changes jobs when unused funds remain in the FSA.
However, FSAs that are funded through salary reductions throughout the year can give clients access to the funds before the account has been fully-funded—for example, if the client chooses to contribute $2,550 to the FSA through bi-weekly payroll deductions, and submits a $2,000 claim for reimbursement in February, those funds will be available despite the fact that the client has not contributed the full $2,000.
Depending upon the type of FSA, a combination HSA / FSA strategy may be possible. If the FSA is a limited purpose FSA (i.e., an FSA used only to fund vision or dental expenses), the client may be eligible for both types of accounts—meaning that the limited purpose FSA funds can be used to fund vision or dental expenses while the HSA funds continue to grow in order to fund future medical expenses not covered by the FSA. Note that the client still must be enrolled in an HDHP in order to use the combination strategy.
While FSAs may also impact the Cadillac tax calculation, contribution limits to these types of accounts are lower—meaning that the impact will be less severe, potentially motivating employers to switch to the health FSA model in the future.
Most clients who qualify will (and currently should) opt for the HSA if possible—because the contribution limits are higher and funds can be rolled over from one year to the next, the tax savings are much stronger. However, as always, clients should pay close attention to future developments, especially as Cadillac tax planning begins to gain steam.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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