Reprinted with permission of the Employee Benefit Plan Review – January 2018.
According to an Employee Benefits Research Institute (EBRI) issue brief, approximately 20 million individuals maintained health savings accounts (HSAs) in 2016.[i] Of the 5.5 million HSA accounts represented in EBRI’s HSA database, 77 percent were established since 2013. A 2016 employer health benefits survey conducted by the Kaiser Family Foundation indicates that 24 percent of employers that offered health benefits in 2016 provided a combination high deductible health plan (HDHP) with an HSA.[ii] Based on these statistics, it is clear that HSAs are becoming increasingly popular with employers and employees.
It is not unusual for an employer to discover that an ineligible individual has enrolled in the employer’s HSA program one or two months into a plan year—well after the dust of open enrollment has settled. This can occur for a number of reasons, including the employee’s ignorance of HSA eligibility requirements, computer glitches, or insufficient communication between the employer and third party administrators. Alternatively, after a plan year has ended, an employer sometimes finds that one or more employees exceeded the annual HSA limit. Whatever the nature or cause of the error, it is critical for an employer to promptly take corrective action if it discovers that its HSA program is not in full compliance with applicable requirements. This article will discuss correction of a few common HSA errors.
By way of background, an HSA is a trust or account that is established for the purpose of paying or reimbursing qualified medical expenses. HSAs must be established with a qualified trustee such as a bank, insurance company or other entity that’s approved by the Internal Revenue Service (IRS) to serve as a trustee of individual retirement arrangements (IRAs).
HSAs can only be established by an individual who satisfies all three of the following requirements:
- The individual is covered under a high deductible health plan (HDHP) on the first day of the month;
- The individual has no other health coverage unless otherwise permitted by the Internal Revenue Code; and
- The individual can’t be claimed as a dependent on another person’s tax return.
Contributions to an HSA can be made by an eligible individual on a pre-tax basis or by the individual’s employer. HSA contributions made by an eligible individual’s employer are not taxable. The amount of contributions made to an HSA on behalf of an eligible individual, whether by the eligible individual or his employer, is subject to an annual limit. For 2018, the limit on HSA contributions for an eligible individual with self-only HDHP coverage is $3,450. The 2018 HSA contribution limit for an individual with family HDHP coverage is $6,900. If an eligible individual is age 55 or over, both limits increase by $1,000.
Amounts contributed to an HSA on behalf of an eligible individual that exceed the annual dollar limit are referred to as “excess contributions.” Excess contributions would be subject to a 6-percent excise tax, unless the contributions are timely corrected—by distributing them by the eligible individual’s due date for filing his tax return, including extensions.
Correcting HSA errors
Correction of errors under an HSA program depends on the nature of the error. The following describes three common types of HSA errors, and the action that should be taken to correct them.
Employee was never eligible to establish an HSA
As noted above, except in limited cases, an eligible individual can have no health coverage other than an HDHP. For example, an employee who participates in a health flexible spending account (health FSA) during a tax year is ineligible to make contributions to an HSA for such year.
In Notice 2008-59[iii], the IRS provides guidance if an employer contributes to an HSA on behalf of an employee who was never eligible to maintain an HSA. An example is an employee who elects HDHP coverage with an HSA contribution for the first time in 2018. The employee never before contributed to an HSA. In March 2018 the employer discovers that the employee’s spouse is making contributions to a health FSA maintained by her employer. The spouse’s health FSA reimburses expenses incurred by, not only the spouse, but also the employee. Thus, the employee is not eligible to contribution to the employer’s HSA program for 2018.
In such a case, the IRS approach is that the account was never actually an HSA.
If the error is discovered in the year of the contribution, the employer, at its option, can request that the HSA trustee return the employer contributions to the employer by the end of the year in which the contributions were made. If the employer does not make such a request, any employer contributions not returned to the employer by the end of the year of contribution, plus any employee contributions made during such year, must be included in gross income and wages on the employee’s Form W-2.
If the error is discovered in a subsequent year, amended Forms W-2 should be issued for open tax years with employer and employee contributions to the account for the applicable year included in the employee’s gross income and wages.
Since the employee was never eligible to maintain an HSA, arguably the employee should be able to use the money in the account as he wishes. However, the employer and the employee should contact the HSA trustee to confirm it is willing to take this approach. Alternatively, the HSA trustee may require that the account be used for qualified medical expenses notwithstanding the fact that the account does not qualify as an HSA.
Employee maintains an HSA and ceases to be eligible during the testing period
In determining eligibility, the IRS permits an employee to use a rule sometimes referred to as the “last month rule.” Under this rule, if an employee is an eligible individual on the first day of the last month of the prior tax year, i.e., December 1, the employee will be considered an eligible individual for the entire year and is treated as having the same level of HDHP coverage as was in place on December 1 of the prior year. For example, if an employee was an eligible employee on December 1, 2017, he or she could be considered as an eligible individual at the same level of coverage throughout 2018 even if the employee changed his or her level of coverage. However, the employee must remain eligible to make HSA contributions during the entire testing period. (The testing period in the above example is December 1, 2017 through December 31, 2018.)
Publication 969 provides that if an employee fails to remain an eligible individual during the testing period, the contributions made on behalf of the individual during the period of ineligibility are not treated as “excess contributions.” Instead, such contributions are included in the employee’s gross income and subject to a 10-percent additional tax. The employee completes Part III of Form 8889 to report and pay the additional taxes.
Correcting excess contributions without 6-percent penalty
There are two options for correcting contributions to an HSA that exceeds the dollar limits described above.
Under the first option, the excess contributions made during the year, plus any earnings thereon, are removed from the HSA by the due date of the employee’s tax return (including extensions). The employee receives no deduction for any portion of the excess contributions that are employee contributions. The employee may not exclude from gross income the portion of the excess contributions that come from the employer.
The employer should report the excess contributions on the employee’s Form W-2. IRS Publication 969 indicates that if the excess contributions are not reported on the Form W-2 by the employer, the employee must report the excess contributions as “other income” on his or her tax return. Publication 969 also states that the employee must report any earnings on the excess contributions as “Other income” on his or her tax return.
Correcting excess contribution with 6-percent penalty
The second option for correcting an excess contribution is for the employee to leave the excess contributions in the HSA account and take a deduction for such contributions on the next year’s return (provided the employee does not otherwise exceed the maximum HSA contribution for the next year). Under this option, the employee pays the six-percent excise tax on the portion of the HSA contribution that can’t be deducted in the year of contribution (or the portion that can’t be excluded from gross income, in the case of employer contributions).
Given their popularity, HSAs are here to stay. However, employers must remain vigilant and take necessary corrective action whenever HSA errors are discovered.