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Posted on: Wednesday, April 12, 2006

In 2005, the IRS issued Notice 2005-42 that allowed employers to amend their Healthcare and/or Dependent Care Flexible Spending Account (FSA) Plans to include a grace period of up to 2½ months following the end of the Plan Year during which participants can continue to incur expenses and be reimbursed from any unused account balance from the prior year.

Then later, in Notice 2005-86, the IRS clarified that an individual cannot make contributions to a Health Savings Account (HSA) while enrolled in a Healthcare FSA (includes the Plan’s grace period), unless the Healthcare FSA is amended to be HSA compatible. The notice also clarifies technical questions about the grace period.

Individuals Enrolled In a Qualified HDHP and Healthcare FSA with Grace Period - What DoesThis Mean?
The individual (or family if enrolled) is disqualified from making HSA contributions until the first day of the month that begins after the end of the Healthcare FSA grace period. This is true even if the participant has no dollars remaining in his/her Healthcare FSA at the end of the Plan Year (prior to the start of the grace period).

For example, John is enrolled in his employer’s Healthcare FSA in Calendar Year 2006 and the plan includes a 2 ½ month grace period (1/1/07 to 3/15/07). If John enrolls in his employer’s qualified HDHP Plan as of 1/1/07, he may NOT contribute to an HSA until April 1, 2007. If John remains in the qualified HDHP medical plan for the entire 2007 calendar year, his HSA contribution maximum is capped at 9/12ths of the lesser of 1) the HDHP’s deductible or 2) the statutory cap on annual HSA contributions. This means John cannot make “catch-up” contributions for the three months he was disqualified from contributing to the HSA.

Automatically Converting the Healthcare FSA to “Limited Purpose” During the Grace Period
An employer can amend its Healthcare FSA plan so that during the grace period, the FSA automatically converts to a “Limited Purpose” FSA, meaning only qualified preventive care, and dental and vision expenses are eligible for reimbursement. The amendment must apply to ALL FSA plan participants during the grace period regardless of which medical plan option they are enrolled in – no exceptions. This hard and fast rule may make this an unattractive option for employers who have a majority of participants enrolled in non-HDHPs If the plan is amended as such, in our example above, John would be able to contribute to his HSA as of 1/1/07. NOTE: the Notice provides transition relief for FSA Plan Years ending before June 5, 2006. For more information on this option, contact Denman.

Employers who have implemented a Grace Period in 2005 or 2006 and who offer a qualified HDHP plan should consider:

1. Amending the Healthcare FSA Plan to become a Limited Purpose FSA during the grace period for all participants. This decision should be weighed against the potential negative effects it may have on other non-HDHP enrolled plan participants who, during the grace period, could only seek reimbursement for preventive care, dental and/or vision; or

2. Amending the Healthcare FSA Plan to eliminate the Grace Period for all participants; or

3. If you’ve not already done so, at the next open enrollment, offer a Limited Purpose Only Healthcare FSA plan to participants enrolling in a qualified HDHP plan (all non-HDHP enrollees would be offered the all-purpose Healthcare FSA). Plan Documents will need to be amended to clearly define these terms and limitations.

Notice Provides Additional Clarification Regarding FSA Grace Periods
    • The grace period, if adopted, must apply to all persons covered by the
        FSA as of the last day of the Plan Year (including COBRA coverage).
    • The grace period remains in effect for the entire period even if the
        participant terminates employment prior to the end of the grace period.
    • The employer may limit the adoption of a grace period to the Healthcare
        FSA only, Dependent Care FSA only, or apply it to both.
    • The grace period may be shorter than the 2 ½ months, at the employer’s
        discretion.
    • Coverage of employee “A” who is covered under a General Purpose FSA
        that is sponsored by employee “A’s” spouse’s employer still
        disqualifies “A” to make HSA contributions (assuming A is enrolled in a
        qualified HDHP), unless the spouse’s employer’s FSA plan
        restricts “A’s” eligibility (affirmatively makes all dependents enrolled in a
        qualified HDHP plan ineligible for participation/coverage).

For additional information, please refer to a copy of the Press Release.

Should you have any additional employee benefit questions or would like to discuss this material in detail, please don’t hesitate to call the Denman Team.

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