WASHINGTON—Employees who start health savings accounts next year could be shortchanged if their employers offer flexible spending accounts with grace periods.

In such situations, the maximum tax-free contribution made to an employee's HSA could be cut by as much as 25% during the first year of HSA enrollment, reducing funds available to pay for current year's health care expenses.

"If you have adopted a grace-period FSA, it can be very damaging for those who want to make maximum contributions to their HSAs," said Jay Savan, health and group welfare leader in the St. Louis office of consultant Towers Perrin.

The problem arises from Internal Revenue Service rules governing HSAs and grace-period FSAs. Those FSAs are so named because, unlike traditional FSAs in which employees forfeit unused account balances at the end of year, employees in grace-period FSAs can tap balances that remain at the end of a year to pay for uncovered health care expenses incurred during the first 10 weeks of the next year.

The IRS, under pressure from Congress, in 2005 authorized grace periods for FSAs to reduce the impact of the end-of-year FSA forfeiture requirement, which has come to be known as "use it or lose it."

IRS rules, though, say that, with very limited exceptions, the only health plan that HSA-enrolled employees can be covered by is the high-deductible health insurance plan that must be linked to the HSA. A health care FSA is considered a health care plan and, as a result, an employee with an FSA would be considered to have "other" health care coverage and not be eligible for the HSA.

Even a new HSA enrollee with a zero FSA account balance at the end of the year would be considered to be covered by the FSA during the grace period.

As a result, neither the employee nor the employer could make contributions to the HSA during the FSA grace period.

Under IRS rules, HSA contributions can start only in the first full month after the end of the grace period. In the case of a 10-week FSA grace period--the maximum that the IRS allows--that restriction would allow HSA contributions only in the remaining nine months of the year.

Since extra contributions are not allowed to make up for periods when employees are not considered eligible HSA participants, the maximum contribution to employees' HSAs could be cut by as much as 25%. This cut would occur in only the first year an employee is enrolled in the HSA since the employee in successive years no longer would covered through a grace-period FSA.

Still, that shortchanging could make it a lot tougher to encourage employees to enroll in HSAs. "This is not a good thing if you are trying to launch a new program," said Andy Anderson, of counsel with Morgan, Lewis & Bockius L.L.P. in Chicago.

Employers would face the same problem communicating the issue every year to employees who are first-time HSA enrollees.

The problem is not new. Indeed, the IRS late last year laid out its position on the issue.

But the IRS, in those November 2005 rules, also provided some temporary relief. The rules said, among other things, that HSA contributions would be allowed for the full year for HSA enrollees who were also covered by a grace-period FSA so long as they had exhausted their FSA balances by the end of the plan year.

But now the issue is back on the front burner for employers. First, the IRS relief expired at the end of June. Additionally, a big increase is expected next year in the number of employers that will offer HSAs, increasing the likelihood of HSA-FSA grace-period interaction.

"We expect our business to at least double over the next year," said Tom Hricik, national director-HSA-product distribution with ACS/Mellon Financial Corp., a big HSA administrator in Pittsburgh.

While there are remedies that would allow the maximum contribution to be made to employees' HSAs during the first year, those approaches, in turn, cause problems.

For example, an employer now offering a grace-period FSA could rescind the grace period before the end of year. That, though, could upset employees who have saved in anticipation of utilizing health care services early in the next year.

Alternatively, employers could adopt so-called limited-purpose FSAs during the grace period. Limited-purpose FSAs are those that, under IRS rules, reimburse expenses for preventive, dental and vision care and for medical expenses incurred after the minimum annual deductible for the high-deductible plan has been satisfied. Under IRS rules, contributions to employees' HSAs can be made for employees enrolled in limited-purpose FSAs.

"There are no good solutions," Mr. Anderson said.

Whatever the approach, some employees "will feel some pain," said Jeff Munn, a consultant in the Falls Church, Va., office of Hewitt Associates Inc.

Federal legislators are aware of the problems associated with the interaction of grace-period FSAs and HSAs. The House Ways and Means Committee has passed legislation that would allow the maximum contribution to employees' HSAs if there is a zero balance in their FSAs at the end of the year before the grace period began or if they transferred the balance to the HSA.

But no one knows if legislators will take up that bill during the brief special session after Congress returns following the November elections.

Some benefits experts say that one permanent strategy employers might take is to convert their grace-period FSAs to limited-purpose FSAs during the grace period during the first 10 weeks of 2007 and then get rid of the grace period for 2008. In succeeding years, HSA enrollees would be offered a limited-purpose FSA and other employees would be offered a traditional FSA with no grace period. In that approach, the maximum contribution could be made to employees' HSAs in the first year.

While employees would lose grace periods, some believe their value has been overstated. "Grace-period FSAs just make things more complicated and don't really add that much," said Scott Keyes, a senior consultant with Watson Wyatt Worldwide in Stamford, Conn.

Indeed, with so many types of health care-related expenses eligible for FSA reimbursement, the likelihood that employees will forfeit FSA balances at the end of the year is very low, said Kathy Dupree, insurance risk/benefits manager in the Orlando, Fla., office of Ocwen Financial Corp., a loan servicing company.

The risk of significant FSA forfeitures is "overblown," Ms. Dupree added.

Another purported advantage of grace-period FSAs--they encourage greater employee participation in the FSA because of reduced fear of forfeiture--also may be overstated.

Hewitt Associates, for example, says it hasn't seen much change in FSA participation in grace-period FSAs that it administers for employers.