Understanding the basics of HSAs, HRAs, and FSAs

Thursday, February 9, 2017

Employers and employees have a number of options for setting aside pre-tax dollars to pay medical expenses. The pros and cons of the three most common plans are summarized in this article, but employers should check Internal Revenue Service guidance for specifics. For example, each plan uses the term “qualified medical expenses,” but the costs that may be reimbursed differ slightly, and some plans have contribution limits that are revised annually.

Primer on HSAs

A health savings account (HSA) is set up with a qualified trustee such as a bank or insurance company.

Pros:

  • May be sponsored by the employer or set up by an individual without employer involvement.
  • The employer, individual, or family members may contribute.
  • Contributions, interest earnings, and withdrawals for qualified medical expenses are tax free.
  • Funds roll over year after year.
  • The individual keeps the HSA even if changing employers or leaving the workforce.
  • An individual who is no longer eligible may still take tax-free distributions for medical expenses (but may not make further contributions).
  • Upon reaching age 65, an individual may withdraw funds for any reason, not just for medical expenses (but non-medical distributions are taxable income).

Cons:

  • To be eligible, an individual must be under a high-deductible health plan (HDHP), not enrolled in Medicare, and not claimed as a dependent on someone else’s tax return.
  • Other than the HDHP, the person cannot have other health coverage, except coverage for a specific disease or illness, accident or disability insurance, dental or vision care, long-term care insurance, or Veterans Administration benefits.

Individuals must keep records to show that distributions were used for qualified medical expenses and that those expenses had not been claimed as an itemized deduction.

Primer on FSAs

A flexible spending arrangement (FSA) may be offered with other benefits as part of a cafeteria plan.

Pros:

  • The employer and employee may contribute, and contributions are excluded from taxable income (except employer contributions for long-term care insurance).
  • Distributions for qualified medical expenses are tax free.

Cons:

  • Unused funds are lost at the end of the year, although the plan may provide either a grace period of up to 2.5 months or a carryover of up to $500. A carryover does not affect the maximum contributions in the next year.
  • The employee must elect an annual amount at the start of the year and may not change the election unless a qualifying event occurs. Employees must guess at how much they’ll need, and risk losing unused funds.

One other “pro” for employees is that they may use the maximum annual election at any time, regardless of the amount contributed. This may be a “con” for employers because an employee could spend more than he or she contributed, then change jobs and leave the plan with a loss.

Individuals must provide a written statement from an independent third party stating the amount of the expense and that it was not paid or reimbursed under any other health plan.

Primer on HRAs

A health reimbursement arrangement (HRA) may be offered with other benefits, including FSAs.

Pros:

  • Contributions may be excluded from taxable income.
  • Reimbursements are tax free if used for qualified medical expenses of current and former employees, spouses and dependents of those employees, or any person the employee could have claimed as a dependent.
  • Funds carry over each year.
  • For small employers, an HRA may be a stand-alone plan.

Cons:

  • Only employers (not employees) may contribute to the plan.
  • For large employers, the HRA must be offered with a group health plan.
  • The company owns the plan and must verify that distributions are for qualifying reasons.

Employers thinking about adding such a plan should consider which option best fits their workforce, as well as their obligations for administering the plan.

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