In
Notice 2005-86, IRS says an individual who is covered under the 2-month extension period for a health flexible spending account (FSA) is generally not eligible to contribute to a health savings account (HSA) during that period, unless the FSA is amended to provide for HSA compatibility. The Notice also provides transition relief for plan years ending before June 5, 2006.

Background. Earlier this year, IRS said that employers may amend their Section 125 plans to provide an FSA grace period of up to 2 months after the end of the plan year during which FSA plan participants may incur expenses and be reimbursed from account balances unused at the end of the prior plan year.

Under IRS rules governing HSAs, individuals are only permitted to contribute to an HSA for months they are covered by a high deductible health plan (HDHP) and generally have no other non-HDHP coverage (including general purpose health care FSAs either directly or through the employee’s spouse). There is an exception for limited purpose (e.g., dental and vision benefits only), post-deductible, and combined limited purpose and post-deductible FSAs.

HSA/FSA Grace Period Interaction. IRS has now clarified that coverage under a typical health FSA during the 2-month grace period makes an individual ineligible to contribute to an HSA until the first day of the month following the grace period, even if the individual’s account balance has been used up by the end of the plan year.

The Notice also clarifies the following points about the FSA grace period:

FSA Plan Amendment Needed. The IRS Notice describes how an employer can amend its FSA to be HSA-compatible. Employers can modify their Section 125 documents to automatically convert the general purpose FSA into a limited purpose, post-deductible, or combined limited purpose and post-deductible FSA during the grace period. The modification must be mandatory and may not permit employees to elect between a general or limited purpose FSA during the grace period. The modification must apply for the entire grace period and to all participants in the health FSA.

Transition Rule. The Notice also includes a special transition rule for plan years ending before June 5, 2006. During this transition, an otherwise eligible individual may contribute to an HSA during a health FSA grace period if there is no remaining balance in their health FSA at the end of the preceding plan year or if the employer amends its Section 125 plan to say that the FSA grace period does not apply to individuals who elect HDHP coverage.

Action Steps. Employers that have adopted the FSA grace period and who are also offering employees an HSA/HDHP option in 2006 should consider amending their FSA document to say that the FSA grace period does not apply to individuals who elect HDHP coverage next year. Otherwise, employees who have a health FSA this year will not be able to contribute to their HSA during the FSA grace period unless they have no FSA balance remaining at the end of this year. Long term, employers will need to weigh the value of accommodating employees with new HSA coverage versus continuing to provide unlimited grace period reimbursements for all FSA participants.