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Account transfer rules muddy CDHP efforts

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WASHINGTON--New Internal Revenue Service rules to implement a 2006 law giving employees financial incentives to move from first-generation consumer-driven health care plans to health savings accounts may complicate the process.

That law, the Tax Relief and Health Care Act of 2006, sought by HSA advocates, allows employers to transfer--tax-free--balances employees have built up in health reimbursement arrangements and flexible savings accounts to newly established HSAs.

Through such transfers, employees could have thousands of dollars in seed money, alleviating their concerns about having to pay uncovered medical bills at a time when their HSAs would not be well funded.

But as benefit experts dig through the IRS guidance issued earlier this month, they warn that the transfer mechanism may not be as easy or attractive as first thought.

"We are stuck with some very complicated rules," said Jeff Munn, a consultant in the Falls Church, Va., office of Hewitt Associates Inc.

"There is one trap after another for the unwary," said Andy Anderson, of counsel in the Chicago office of Morgan, Lewis & Bockius L.L.P.

"It is a mess," said Jay Savan, a principal with Towers Perrin in St. Louis.

Some of the problems in the IRS rules identified by experts include:

  • Shifting from an HRA-linked plan to an HSA before the end of a plan year will result in employees being taxed on the amount transferred to the HSA, as well as being hit with a 10% penalty.

  • Missing deadlines by as little as one day can result in the transferred balance not only being taxed, with the 10% tax penalty being added as well.

  • While transfers to HSAs from grace-period FSAs will receive favorable tax treatment--as long as certain conditions are met--the IRS rules close the door on the same tax treatment when moving from conventional FSAs. Grace-period FSAs allow employees to tap balances that remain at the end of a plan year to pay for expenses incurred during the first 2½ months of the next plan year.

    Indeed, the rules for FSA transfers lend themselves to confusion. Grace-period FSA balances must be rolled over at the end of the plan year to receive favorable tax treatment. However, if employees in conventional FSAs wait until the end of the plan year to roll over a balance, it will be forfeited.

    Who's to blame?

    While the rules are complicated, regulators are not solely to blame, experts say.

    In crafting the legislation, which includes other pro-HSA provisions such as allowing larger contributions, Congress created plenty of problems, too. For example, to prevent possible abuse, the law stipulates that the transferred HRA or FSA amount must be either the balance at the end of a plan year or as of Sept. 21, 2006--the date when the House Ways and Means Committee considered the legislation--whichever is less.

    For employees who have built up big balances in their HRAs, that could mean losing the bulk of those balances if their employers replace HRAs with HSAs.

    There is no requirement that employers replace HRAs, which the IRS authorized in 2002, with HSAs, which became available in 2004. Still, many experts believe HSA-linked, rather than HRA-linked, plans are the wave of the future for employers moving to CDHPs because their design may give employees stronger financial incentives to be more careful consumers of health care services.

    While HRA balances typically are forfeited when employment is terminated, HSAs are owned by employees, who can continue using the HSA to meet their medical expenses, including those incurred in retirement.

    At the moment, though, there has been no wholesale movement from HRA-linked CDHPs to HSA-linked plans. Given that many employers only recently added HRAs, they would be reluctant to move to another new design so quickly, said Tom Hricik, national director-HSA product distribution with ACS/Mellon Financial Corp. in Pittsburgh.

    Some companies are offering what Towers Perrin's Mr. Savanc described as a "blended" approach in which both HSAs and HRAs are offered and employees can choose either plan.

    For employers that make the switch from HRAs to HSAs and allow employees to roll over HRA balances to HSAs, a detailed set of rules must be followed for the transfers to receive favorable tax treatment.

    For example, by the end of a plan year, an employer must amend its plan to permit rollovers, an employee must elect the rollover and the balance must be frozen. Additionally, the funds must be transferred by the employer within 2½ months after the end of a plan year and result in a zero HRA balance.

    Timing is crucial for the transfer to receive favorable tax treatment. Take the case of an employee who enrolls in an HSA-linked high-deductible health plan on the second day of a month in which he or she was first eligible to enroll in the plan.

    That participant is not considered eligible to make any HRA transfers until the first day of the following month. If the HRA distribution occurs at any time during the month the employee enrolled in the high-deductible plan, the amount would be added to the employee's taxable income plus a 10% penalty. To prevent that result, the distribution could not occur until the start of the following month.