Congress Changes HSA Contribution Rules

On December 20, 2006, President Bush signed the Tax Relief and Health Care Act of 2006. This bill primarily contains extensions to popular tax provisions—such as tax breaks for business research and development and for college tuition expenses—that were about to expire. This tax bill was amended at the last minute to include some beneficial changes to health savings accounts (HSAs). In short, the new law changes the following HSA rules.

  • HSA contributions are no longer limited by a health plan’s deductible amount, thus raising contribution amounts for most HSA holders.
  • HSA cost-of-living adjustments will be published much earlier each year.
  • Many HSA holders that are eligible for only part of the tax year may make a full-year contribution.
  • HSA holders with health flexible spending accounts (FSAs) (sometimes called cafeteria plans) that allow for the 2½-month grace period will not be automatically ineligible to contribute to an HSA for the first three months of the year.
  • HSA holders may make a one-time health FSA or employer-sponsored heath reimbursement arrangement (HRA) asset transfer to an HSA.
  • IRA holders may make a one-time “direct rollover” to an HSA.
  • “Comparable contribution” requirements are relaxed by allowing employers to exclude highly compensated employees (HCEs).

These changes are generally effective for individuals’ 2007 taxable years.

Contribution Amounts
The first big rule change breaks the connection between the statutory annual contribution limit and the limit imposed by the specific deductible amount contained in the HSA owner’s high deductible health plan (HDHP). Currently, if an individual’s HDHP deductible is less than the statutory maximum HSA contribution, he may only contribute that lesser deductible amount. If an individual is only eligible to contribute to an HSA for part of a year, he must prorate that deductible amount for the number of months he has eligible HDHP coverage for the year. Starting in 2007, the statutory contribution limit is used as the starting point, irrespective of the deductible amount. For example, using the 2007-indexed amount for single coverage ($2,850), an individual with an HDHP deductible of $1,100 could contribute $237.50 for each month that he’s eligible, rather than only $91.66 under the old scheme.

This law also changes the timing of HSA cost-of-living adjustments (COLAs). The IRS has typically issued HSA COLAs for the coming year in the fall, but beginning with the 2008 COLAs, the IRS must release the HSA COLAs for the coming year by June 1 (i.e., 2008 HSA COLAs will be out by June 1, 2007). This should make it easier for insurance companies, employers, and financial organizations to incorporate and update benefit enrollment periods and systems programming for the annual change in contribution limits.

Contribution Eligibility
Many individuals who become HSA-eligible after the beginning of the year will now be allowed to make contributions up to the maximum statutory contribution limit. Currently, HSA owners must prorate the annual contribution amount for the number of months in a year that they are HSA-eligible. But the new rule, while allowing individuals to make full-year contributions, also requires an HSA owner to maintain eligibility throughout the “testing period,” which runs from the last month of the initial eligibility year through the end of the 12-month period following that month. If the HSA owner is not eligible for this entire testing period, she must include in her gross income the contributions made for the months when she was not otherwise qualified. This amount will also be subject to a 10 percent penalty. The tax and penalty do not apply if the HSA owner is no longer HSA-eligible because she dies or becomes disabled.

Transition Issues
Current HSA contribution and eligibility rules have prevented many people from making the transition to saving for medical expenses with HSAs versus saving in employer-sponsored arrangements, such as FSAs or HRAs. The following provisions make it easier for individuals to transition to HSAs by allowing people to fund HSAs up front with money saved in other types of arrangements.

FSA Grace Period
Participation in a health FSA plan that allows remaining year-end balances to be used during a 2½ month grace period in the new year will not automatically disqualify an HSA owner from making a contribution in those months, if certain requirements are met. Currently, if an FSA allows such amounts to be used up during a grace period, an HSA owner is not eligible to contribute to an HSA during that grace period. The new rule doesn’t disqualify an HSA owner from making a contribution merely because the FSA allows the grace period—provided the HSA owner has no FSA balance at year end.

FSA and HRA Transfers to HSAs
For a limited time, health FSA or HRA balances may be directly transferred to HSAs to help individuals avoid losing those assets that are not used up during a tax year. The new law indicates that an HSA owner may transfer the lesser of the September 21, 2006, balance or the balance on the date of distribution. (This rule creates some uncertainty in the calculation of the maximum amount that is eligible for transfer, so clarification may be needed.) Such transfers are treated as rollovers for reporting and tax purposes. If a taxpayer does not remain HSA-eligible (for reasons other than death or disability) for 12 months following the month of the transfer, the amount transferred is subject to taxation and a 10 percent penalty. Such transfers may only be made after the date of enactment and before January 1, 2012.

IRA Rollovers to HSAs
HSA owners now have a one-time option to roll over Traditional or Roth IRA assets to an HSA, limited to the annual HSA contribution amount. Again, if the taxpayer does not remain HSA-eligible (for reasons other than disability or death) for 12 months following the rollover, he must include the rolled-over amount in income and a 10 percent penalty applies.

Employer Contributions
Currently, employers must meet certain comparable contribution requirements if they contribute to any employees’ HSAs—or face a stiff penalty. Under the new law, highly compensated employees (HCEs) and nonhighly compensated employees do not have to be treated as “comparable participating employees” for purposes of determining employer compliance. So HCEs could be excluded from receiving a contribution. The practical effect of this provision may be relatively small because employers may already bypass the comparable contribution rules by operating a cafeteria plan for employees to make pretax contributions to their own HSAs.