IRS Blesses Employee Choice Between HRAs and Profit-Sharing Plans

by Prof. Robert Bloink and Prof. William H. Byrnes

Last year’s regulations on health reimbursement accounts (HRAs) added significant value for employees who have access to this savings option—but not every employee has the ability to make use of the HRA vehicle. Recently, the IRS released a private letter ruling (PLR) blessing a contribution arrangement where employees were given a choice in whether to allocate available employer contributions to HRAs or 401(a) profit-sharing plans. Given the substantial uncertainties that employees are facing in the wake of COVID-19 and the new rules that expanded the value of HRAs for 2020, clients should pay close attention to this type of arrangement to provide employees with flexibility in allocating savings dollars to best suit their individual needs.

HRAs and 401(a)s: The Basics

HRAs are a type of tax-preferred health savings option that only allows for employer contributions—employees are not permitted to make their own salary reduction contributions. Public employers are permitted to offer HRAs to employees like any other employer.

On the other hand, these employers are limited in the types of retirement plans they can provide. Namely, they are not entitled to set up a 401(k) plan, with its higher limits for pre-tax employee elective deferrals. Public employers are, however, entitled to make pre-tax contributions to 457(b) and 401(a) profit-sharing plans on behalf of employees.

HRA funds can be used to reimburse employees for qualifying medical expenses which, as of 2020, may now include the cost of individual health insurance premiums. With some employees now facing increased health expenses due to COVID-19 uncertainties, some employers are looking for creative solutions for allocating scarce employment benefit resources.

The IRS Ruling

The IRS recently blessed an amendment to a profit-sharing plan that would also permit employees to make HRA contributions. The issue up for consideration was whether a profit-sharing plan covering collectively bargained employees could be amended to allow participants to allocate contributions toward HRAs and the plan on an annual schedule (a default would apply in the absence of an election).

In other words, under the proposal, the employees are able to choose the level of future employer contributions that will be contributed to the HRA or to the Section 401(a) profit sharing plan.

The IRS found that the proposed amendment would not cause the plan to be treated as a 401(k), because it would not create an opportunity for participants to elect cash or to use the contributions to pay for taxable benefits. Therefore, the profit-sharing plan would not offer a cash or deferred arrangement under IRC Section 401. The IRS also found that the arrangement would not violate the HRA rules.

There were, however, restrictions that applied in influencing the IRS’ decision. The employees’ annual elections had to be irrevocable and made before the beginning of the plan year to which they would be allocated. All available employer allocations had to be allocated between the plans (the employee could not elect to receive cash).

Further, elections must comply with the 401(a) contribution limits each year (also considering any other contributions made toward the plan in a given year) and the amounts can only be used to provide qualified medical benefits (rather than death benefits, separation pay, etc.). As long as the HRA otherwise complies with the rules governing HRAs, distributions are excluded from the employees’ income.

Conclusion

Of course, IRS private letter rulings cannot be relied upon other taxpayers. They do, however, give employers a sense of the IRS’ enforcement stance on any given issue. Allowing employees to make their own choices with respect to allocation of employer contributions to valuable tax-preferred savings accounts gives the employee substantially greater control over the future employment benefits they will eventually receive.