November 29, 2005
IRS Issues Guidance Regarding FSA Grace Period and HSA Eligibility
On November 22, 2005, the Treasury and IRS issued IRS Notice 2005-86, which clarifies the interaction of the 2-1/2 month grace period for health flexible spending arrangements (health FSAs) (established earlier this year by Notice 2005-42) and eligibility to contribute to health savings accounts (HSAs). The guidance also clarifies a number of technical questions concerning the grace period. For a copy of IRS Notice 2005-86: http://www.irs.gov/pub/irs-drop/n-05-86.pdf.
Coverage during the grace period and HSA contributions. The Notice clarifies that coverage under a health FSA during the health FSA’s grace period disqualifies a covered individual from contributing to an HSA during the grace period. The covered individual is disqualified even if he/she can receive no benefits under the health FSA during the grace period because he/she has no unused contributions at the end of the plan year preceding the grace period.
However, the Notice provides some relief from the general rule of disqualification. For example, the Notice provides that the employer may amend the health FSA to be HSA-compatible during the grace period. Such an amendment could create a limited-scope health FSA (i.e., one that reimburses only vision, dental, or preventive care expenses) or a post-deductible health FSA (i.e., one that reimburses expenses incurred only after the deductible under the high deductible health plan (HDHP) has been satisfied). Such a provision would apply only during the grace period, but must apply to all covered individuals, not only those wishing to contribute to an HSA.
In addition, the Notice provides a special transition rule for coverage years ending before June 5, 2006. For those years, an otherwise eligible individual may contribute to an HSA while covered by a health FSA during the grace period if the individual’s health FSA has no unused contributions or if the employer amends the cafeteria plan to provide that the grace period is not available to individuals electing HDHP coverage during the grace period.
Technical clarifications. The notice clarifies the following points about the grace period:
- The grace period must be made available to all participants who are covered on the last day of the plan year, including participants whose coverage is extended to the last day through COBRA continuation coverage.
- The grace period must remain in effect for the entire period even though the participant terminates employment prior to the end of the grace period.
- Employers may limit the application of the grace period to only certain benefits (e.g., a plan offering a health FSA and a dependent care FSA could limit the grace period to the health FSA).
- The maximum grace period is until the 15th day of the third calendar month after the end of the plan year, but a shorter period may be adopted as a grace period.
If you have any questions regarding this guidance or if we can be assistance in amending your health FSA to coordinate with HSA eligibility, please contact us.