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Full year contributions are allowed for partial year participants
An individual who commences HSA compatible HDHP coverage during the tax year (even in the last month of the tax year) is eligible to contribute up to the full statutory annual maximum even through they would not be covered under an HDHP for that entire tax year. This replaces the current rule that limits a participant’s contributions to the proportion of the year that the participant was covered under the HDHP. However, up to the full amount of the HSA contribution can be includible in the individual’s gross income and subject to a 10% excise tax if the individual ceases to be an HSA-eligible individual during the 12 months following the date that the HSA contribution is made. This provision will be particularly important for employers who are not on a January 1 plan year and for employees who become eligible for an HSA (changes in employment, employment classification etc…) during the tax year.

Health FSA grace period coverage does not disqualify HSA participation
Participants currently are not permitted to make HSA contributions for the first 2 ½ months of the plan year if they participated in a Health FSA plan that offers the extended grace period. The Act clarifies that Health FSA plans with the 2 ½ month extended grace period will not disqualify an individual from making HSA contributions during the first 2 ½ months of the subsequent year. The individual is permitted to make HSA contributions if the health FSA balance is zero at the end of the plan year or if the individual transfers the FSA balance into an HSA using the rollover provision described below.

Rollovers from FSAs and HRAs are permitted
The Act permits participants with funds in their health FSA or Health Reimbursement Arrangement (HRA) to rollover their funds into an HSA for a limited time. The amount that can be rolled over is limited to the lesser of a) the balance in a participant’s FSA or HRA as of September 21, 2006 or b) the balance in the FSA or HRA at the time of the distribution. The participant is permitted to have one rollover per FSA or HRA. The funds must be transferred directly from the employer into the individual’s HSA before January 1, 2012. The rollover amounts do not count towards a participant’s annual maximum contribution. The rollover amount is includible in the participant’s gross income and subject to a 10% excise tax if the participant ceases to be an HSA-eligible participant during the 12-month period starting with the month of the rollover contribution and ending 12 months later.

Rollovers from IRAs are permitted
The Act permits participants to make a one time transfer from an IRA into an HSA. The maximum amount that can be transferred is limited to the HSA maximum contribution amount for the year that the rollover occurs. The rollover must be a direct trustee-to-trustee transfer. Amounts transferred from a participant’s qualified IRA will count towards the annual maximum contribution. The rollover amount is includible in the participant’s gross income and subject to a 10% excise tax if the person ceases to be an HSA-eligible participant during the 12-month period starting with the month of the rollover contribution and ending 12 months later.

Comparable contribution requirements are more lenient
The Act modifies the rules that require employers to make comparable contributions for all comparable employees. Employers are permitted to make greater HSA contributions for non-highly compensated employees than for highly compensated employees by allowing an employer to ignore highly compensated employees when determining which employees are comparable. These comparability changes apply to employer HSA contributions made outside of a Section 125 plan. 

Cost-of-living adjustments will be made earlier in the year
The Act requires the IRS to publish the cost-of-living adjustments affecting HSAs by June 1 of the preceding year. The Consumer Price Index for the 12-month period ending March 31 of the calendar year will be used for making cost-of-living adjustments. This replaces the current period that ends August 31. This will be welcome news for employers that rely on the updated limits when establishing the plan design and developing communication materials.

What Do Employers Need to Do?
Most of these items become effective for tax years beginning after December 31, 2006. FSA and HRA rollovers can be made beginning December 20, 2006. While it is too late for most employers to alter their decisions for HDHPs that are beginning on January 1, it will encourage more employers to consider HDHPs for later in 2007 or beginning in 2008. A few considerations:

• Plan Design - Employers may consider reducing the annual deductible amount to encourage participation in the HDHP. Under existing laws, employers must offer plans with the highest deductible amounts permitted by law for participants to make the maximum contribution to an HSA. This makes HDHPs less attractive to participants with high out-of-pocket expenses because of the high deductible amounts. The Act allows an employer to make the HDHP benefits more attractive by reducing the annual deductible without restricting a participant’s maximum contribution to the HSA.
  
  
• Administration – The Act permits participants to transfer funds from a health FSA or HRA. The participant’s rollover cannot exceed the amount of funds in their account as of September 21, 2006. This places an administrative burden on FSA and HRA administrators to determine the balance in each individual’s account as of September 21, 2006 and to store this information in anticipation that it will be requested in the future. An employer will need to work with its FSA administrator to track this information.
  
  
• Communication –The Act provides participants with several ways to increase their HSA balances, while also creating additional tax consequences. Participants have new opportunities to rollover FSA, HRA, and qualified IRA amounts and to make the entire year’s maximum contribution even when enrolling mid-year. Participants need to understand the tax consequences of utilizing these options if they do not remain HSA-eligible for the subsequent 12-month period. Employers who presently offer HSA style plans would be advised to send a communication to their HSA participants advising them of the changes and outlining the new options that the participant has with respect to their HSA. (Note: ArlenGroup clients will receive sample employee notices by January 22, 2007.)

Additional Information 

• President Bush Signs Bill to Make Health Care more Affordable, Accessible (U.S. Department of the Treasury)
• List of HSA Improvements ( U.S. Chamber of Commerce)
• Congress Passes the Tax Relief and Health Care Act of 2006 (Michael Best & Friedrich, LLP)

This document is not intended to provide any legal advice or analysis. Please consult your own legal counsel for further information on the topics discussed in this issue of Insight.