349 / What is a Health Reimbursement Arrangement (“HRA”) and how is it taxed?

An HRA is an arrangement that (1) is solely employer-funded and not paid for directly or indirectly by salary reduction contributions under a cafeteria plan, and (2) reimburses employees for substantiated medical care expenses incurred by the employee and the employee’s spouse and dependents, as defined in IRC Section 152, up to a maximum dollar amount per coverage period.

Unused amounts in an individual’s account may be carried forward to increase the maximum reimbursement amount in subsequent coverage periods.¹ HRAs are not available for self-employed individuals.

Employer-provided coverage and medical care reimbursement amounts under an HRA are excludable from an employee’s gross income under IRC Section 106 and IRC Section 105(b), assuming all requirements for HRAs are met.²

For taxable years beginning after December 31, 2010, and before 2020, reimbursements for medicine were limited to doctor-prescribed drugs and insulin. After 2020, a doctor’s prescription is no longer required for over-the counter medicines to count as qualified expenses.

According to Notice 2002-45, an HRA may not offer cash-outs at any time, even on termination of service or retirement; it may continue to reimburse former employees for medical care expenses after such events, however, even if the employee does not elect COBRA continuation coverage. An HRA is a group health plan and, thus, is subject to COBRA continuation coverage requirements ( Q 356 to Q 376).

On a one-time basis, an HRA may make a qualified HSA distribution, that is, a rollover to a health savings account, of an amount not exceeding the balance in the HRA on September 21, 2006 ( Q 414).³

HRAs may not be used to reimburse expenses incurred before the HRA was in existence or expenses that are deductible under IRC Section 213 for a prior taxable year. An unreimbursed claim incurred in one coverage period may be reimbursed in a later coverage period, so long as the individual was covered under the HRA when the claim was incurred.⁴

The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.⁵

An employee may not be reimbursed for the same medical care expense by both an HRA and an IRC Section 125 health FSA. Technically, ordering rules from the IRS specify that the HRA benefits must be exhausted before FSA reimbursements may be made. An HRA can be drafted to specify that coverage under the HRA is available only after expenses exceeding the dollar amount of an IRC Section 125 FSA have been paid. Thus, an employee could exhaust coverage, which generally may not be carried over, before tapping into the employee’s HRA coverage, which can be carried over.⁶ (Note that the IRS now allows a health FSA to be amended in order to allow up to $500 of unused amounts remaining at the end of a plan year to be paid or reimbursed to participants during the following plan year, provided the FSA does not also allow for a grace period, see Q 3515.)⁷

Employer contributions to an HRA may not be attributable in any way to salary reductions. Thus, an HRA may not be offered under a cafeteria plan, but may be offered in conjunction with a cafeteria plan. Where an HRA is offered in conjunction with another accident or health plan funded pursuant to salary reductions, then a facts and circumstances test is used to determine if salary reductions are attributable to the HRA. If a salary reduction amount for a coverage period to fund a non-HRA accident or health plan exceeds the actual cost of the non-specified accident or health plan coverage, the salary reduction will be attributed to the HRA. An example of the application of this rule can be found in Revenue Ruling 2002-41.⁸

Because an HRA may not be paid for through salary reduction, the following restrictions on health FSAs are not applicable to HRAs:

(1)     the ban against a benefit that defers compensation by permitting employees to carry over unused elective contributions or plan benefits from one plan year to another plan year;

(2)     the requirement that the maximum amount of reimbursement must be available at all times during the coverage period;

(3)     the mandatory 12-month period of coverage; and

(4)     the limitation that medical expenses reimbursed must be incurred during the period of coverage.⁹