IRS clarifies FSA use-it-or-lose-it rules: What to tell workers

While employers and employees alike welcomed the feds’ changes to a 30-year-old FSA rule late last year, the move raised plenty of questions. Now the agency has responded.

As employers are well aware, the IRS recently announced flexible spending account (FSA) holders can carry over unused account funds into the next year (up to $500).

And one of the major questions this move prompted was: Will carrying over FSA funds prevent an employee from participating in a health spending account (HSA)?

Office of Chief Counsel memorandum

In its recent informal guidance – via a memorandum from the agency’s Office of Chief Counsel – the IRS said yes, carrying over any FSA funds will prevent individuals from participating in an HSA if the carryover funds come from a general-purpose FSA.

Here’s a real-life example of how this would impact an employee, courtesy of employment attorneys Chris Rylands and Sarah Wise:

Say someone carries over $500 in FSA funds from the previous plan year and uses it toward Lasik eye surgery. That employee would be ineligible to participate in the company’s HSA for the entire plan year.

IRS’ reasoning: Employees who carry over FSA funds can’t participate in an HSA because of the HSA rules regarding “other coverage.”

To qualify for an HSA, individuals must be covered under an HDHP and have no other health coverage.

Because a general-purpose FSA can be used for medical expenses that include co-pays and deductibles, it counts as other coverage.

And that disqualifies individuals from participating in an HSA.

Remember: It’s up to benefits pros to make sure workers understand that carrying over any unused funds from a general-purpose FSA will automatically disqualify them from taking advantage of an HSA.

An IRS exception

Like most federal guidance, there is an exception to this rule.

IRS exception: If your cafeteria plan offers an HSA-compatible health FSA, employees may carry over unused FSA funds from a general-purpose FSA into that plan – and workers can participate in an HSA.

An HSA-compatible FSA – also known as a limited-purpose HSA-compatible FSA – covers only dental, vision, some preventive care and post-deductible expenses.

The guidance also says if employers’ cafeteria plans offer both a general-purpose health FSA and an HSA-compatible health FSA, they can automatically add any FSA carryover funds of high-deductible plan participants to the HSA-compatible FSA for the following plan year.

The grace-period factor

There are several things employers should take into account regarding this guidance. First, this memo is informal guidance and subject to change if the IRS sees fit.

Also, the clarifications in the guidance only apply to plans that have opted for the carryover feature.

If you remember, employers that offer FSAs can offer the carryover option or the FSA grace-period (where leftover FSA funds can be used for the first two-and-one-half months of the following plan year) but not both.

Debit card substantiation

It’s worth mentioning that the IRS also included a memorandum on unsubstantiated payments via FSAs that use a debit card.

It clarified the procedures plans must have in place in the event employees don’t substantiate health expenses reimbursed through an FSA debit card.