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New Law Enhances HSA Flexibility

Before the 109th Congress rode into the sunset, it gave the benefits world a parting gift: the Tax Relief and Health Care Act of 2006. This law adds substantial new flexibility to health savings accounts (“HSAs”) that many employers may find attractive.

Contribution Limits No Longer Linked to Deductible

Under prior law, the maximum contribution to an HSA was limited to the annual deductible of the associated high deductible health plan. Now participants may contribute up to the statutory limit (presently $5,650 for family coverage), regardless of their deductible.

One-Time, Tax-Exempt Rollovers

One particularly intriguing change made by the law is that HSAs are now permitted to receive one-time rollovers from health reimbursement arrangements (“HRAs”), health flexible spending arrangements (“FSAs”), and even IRAs. The rules applicable to such rollovers vary according to the rollover’s source.

A rollover from an HRA or FSA is limited to the lesser of the HRA or FSA balance on September 21, 2006, or the balance at the time of the rollover. Any rollover from an HRA or FSA must also be made before 2012. A qualifying rollover does not reduce the amount that the participant may contribute to the HSA that same year.

A rollover from an IRA to an HSA is treated much like a conventional contribution to an HSA. Such a rollover reduces the amount that a participant may contribute to his or her HSA that year, and the rollover may not exceed the participant’s HSA contribution limit.

Regardless of what type of rollover is made, if an HSA participant ceases to be eligible to contribute to the HSA within one year of making a rollover, the rollover amount will be subject to income tax plus a 10 percent excise tax. Employers should also note that HRAs and FSAs may need to be amended to permit rollovers to HSAs.

HSA Contributions Permitted During FSA Grace Period

Previously, IRS rules generally prohibited individuals from making HSA contributions while they were eligible to use the 2½-month “grace period” permitted by some FSAs. The new law creates an exception to this rule that should ease a participant’s transition from an FSA to an HSA.

If an individual would be disqualified from making a contribution to an HSA solely because of an FSA’s grace period, the individual may still contribute to the HSA if he or she has no balance in the FSA at the end of the prior year. Thus, if a participant either spends down the FSA balance or rolls it into an HSA by the end of the prior year, he or she may contribute to an HSA even during the FSA’s grace period.

Full-Year Contributions for Partial-Year Participants

The new law provides that individuals who become participants in an HSA after a year has begun may contribute up to the limit for a full year. The converse, however, is not true: Participants who drop out of an HSA before the end of a year may contribute only a pro-rated portion of the annual limit.

Other Changes

Other changes made by the law may make it easier for employers to design effective plans that use HSAs. Employers may now make greater HSA contributions for nonhighly paid employees than for highly paid employees. Also, the Treasury Department is now required to issue the next year’s HSA cost-of-living adjustments by June 1, thereby facilitating the open enrollment process.