IRS Issues HSA Rollover Rules

(Published March 8, 2007)

The Tax Relief and Health Care Act of 2006 allows employees to elect to directly roll over amounts remaining in their flexible spending accounts (FSAs) or health reimbursement accounts (HRAs) at the end of a plan year into health savings accounts (HSAs). Rollovers must be made into HSAs by January 1, 2012. The IRS has issued a notice covering these rollovers.

Grace-Period Plans Only 

In general, employees covered by high-deductible health plans (with HSAs) can't be covered by any health plan that isn't a high-deductible health plan. This precludes employees from also having general-purpose FSAs or HRAs. In addition, FSAs are allowed a 2½-month grace period after the end of a plan year during which employees may submit receipts to use up the last year's contributions.

The first key point the notice makes is that these rollover rules apply only with respect to FSAs that offer the 2½-month grace period. The notice outlines the conditions employers must satisfy before rollovers may be made. Before the end of the FSA plan year, the following steps must be taken. 

• Employers must amend the FSA plan (not the underlying health plan) to allow for direct rollovers.

• Employees must elect to make direct rollovers by the last day of the plan year.

• Employers must freeze employees' year-end FSA balances. 

• The FSA or HRA must make no further reimbursements to employees after the last day of the plan year. 

• No other direct rollovers of employees' FSA or HRA amounts have been made.

• As of the first day of the month during which the rollovers occur, employees have coverage under the high-deductible health plan. 

• Within 2½ months after the end of the plan year, employers must transfer the funds directly to the HSA trustee. 

• After the rollover, employees have a $0 balance in their FSAs or HRAs and they no longer participate in any non-HSA-compatible health plan, or their FSAs or HRAs are converted into HSA-compatible FSAs or HRAs. 

The second key point is that if employees don't roll over the entire remaining balance of their FSAs into HSAs, the amounts that are rolled over are included in their income and, worse, they must pay a 10% additional tax. Reason: Since there's a balance in their FSAs, they're covered under a health plan that's not a high-deductible health plan. 

The third key point the notice makes is to reiterate that for FSAs without a grace period, the use-it-or-lose-it rule still applies. So if there's no grace period, unused amounts remaining in employees' FSAs at the end of a plan year are forfeited and can't be rolled over into an HSA. 

How Much Can Be Rolled Over 

Under the 2006 law, amounts that can be rolled over into HSAs are limited to the lesser of the balance in employees' FSAs as of September 21, 2006, or the cash balance in those accounts as of the distribution date. The notice clarifies that the cash balance is the balance as of the determination date, without counting expenses incurred that haven't been reimbursed as of that date. Thus, pending claims, claims submitted, claims received, or claims under review that haven't been paid as of the determination date aren't counted for purposes of figuring employees' account balances. In addition, employees' FSA balances as of the determination date must be calculated by applying the uniform coverage rule (i.e., the maximum reimbursement available for the plan year minus prior reimbursements paid as of the determination date).

Transition Relief Through March 15, 2007  

Under special transition relief, there's no requirement to freeze the year-end balances in employees' FSAs. In addition, the plan amendment, employees' elections, and direct rollovers must be made by March 15, 2007. Finally, employees must be covered under the high-deductible health plan as of the first day of the month during which the rollover occurs. 

To read the notice, which also contains numerous examples, point your browser to: http://www.irs.gov/pub/irs-drop/n-07-22.pdf.

Related Topic(s): Benefits - Flexible Benefits