02 Jul HSA How-To
Health Savings Accounts can be tricky, employees have the control, employers and insurance companies are there to guide them in the right direction. Here is a how to helping guide to assist your customers to the right HSA plan.
If an employer wants to offer employees pretax payroll deferrals to their health savings accounts, the employer needs to first create a Section 125 plan or cafeteria plan that allows HSA deferrals.
A cafeteria plan is the only way for employers to offer employees a choice between taxable and nontaxable benefits, “without the choice causing the benefits to become taxable,” the IRS says. “A plan offering only a choice between taxable benefits is not a Section 125 plan.”
Here are five things to know about HSAs and Section 125 plans.
1. A Section 125 plan is just one of several ways for employers to help employees with funding their HSAs.
Employers offering HDHPs face the choice of whether and how to help their employees with the funding of the employees’ HSAs. The options include the following:
- Option 1 – Employee after-tax contributions. Employers are not required to help with the employees’ HSAs and may choose not to. In this case, employees may open HSAs on their own and receive the tax deduction on their personal income tax return. This option allows for income tax savings, but not payroll taxes. A variation on this option is for employers to allow for post-tax payroll deferral (basically, direct deposit of payroll funds into an HSA without treating the deposit any differently than other payroll which may also be directly deposited into an employee’s personal checking account).
This does not change the tax or legal situation, but it does provide convenience for employees and will likely increase HSA participation and satisfaction.
- Option 2 – Employee pretax payroll deferral. Employers can help employees fund their HSAs by allowing for HSA contributions via payroll deferral. This is inexpensive and can be accomplished by adding a Section 125 cafeteria plan with HSA deferrals as an option. Employers benefit by not having to pay payroll taxes on the employees’ HSA contributions. Employees save payroll taxes as well. Plus, HSA contributions are not counted as income for federal, and in most cases, state income taxes. Setting up automatic payments generally simplifies and improves employee savings.
- Option 3 – Employer-funded contributions. Employers may make contributions to their employees’ HSAs without a Section 125 plan if the contributions are made directly. The contributions must be “comparable,” basically made fairly (with a lot of rules to follow). This type of contribution is tax deductible by the employer and not taxable to the employee (not subject to payroll taxes or federal income taxes and in most cases, not subject to state income taxes either).
- Option 4 – Employer and employee pretax funding. Employers can combine options 2 and 3, where the employer makes a contribution to the employees’ HSAs and the employer allows employees to participate in a Section 125 plan and enabling them to defer a portion of their pay pretax into an HSA. This is a preferred approach for a successful HDHP and HSA program, as it ensures that employees get some money into their HSA through the employer contribution and allows for the best tax treatment to allow for employees to contribute more on their own through payroll deferral.
- Options for more tax savings. Some employers go beyond these options to increase tax savings even more. Although a number of strategies exist to increase tax savings, using a limited-purpose FSA (or HRA) is a common one. Generally, FSAs are not allowed with HSAs; however, an exception exists for limited-purpose FSAs. Limited-purpose FSAs are FSAs limited to payments for preventive care, vision and dental care. This provides more tax savings and employees use the FSA to pay for the limited-purpose expenses (dental and vision) and save the HSA for other qualified medical expenses.
HRAs can also be used creatively in connection with HSA programs. The HRA cannot be a general account for reimbursement of qualified medical expenses, but careful planning can allow for a limited-purpose HRA, a postdeductible HRA, or other special types of HRAs.
2. There are several benefits for an employer using a Section 125 plan combined with an HSA.
- Employees can make HSA contributions through payroll deferral on a pretax basis.
- Employees may pay for their share of insurance premiums on a pretax basis.
- Employers and employees save payroll taxes (7.65 percent each on FICA and FUTA for contributions).
- Employers avoid the “comparability” rules for HSA contributions although employers are subject to the Section 125 plan rules.
3. The employer is responsible for administering the Section 125 plan.
For payroll deferral into an HSA through a Section 125 plan, the employer must reduce the employees’ pay by the amount of the deferral and contribute that money directly into the employees’ HSA.
The employer may do this administration itself or it may use a payroll service or another type of third-party administrator. In any case, the cost of the Section 125 plan itself and the ongoing administration are generally small and offset, if not entirely eliminated, by employer savings through reduced payroll taxes.
Another administrative element is the collection of Section 125/HSA payroll deferral election forms from employees. Employers that have offered Section 125 plans prior to introducing an HSA program are familiar with this process.
Unlike other Section 125 plan deferral elections, which only allow annual changes, the law allows for changes to the HSA deferral election as frequently as monthly.
Although frequent changes to the elections create a small administrative burden on the employer, the benefit to employees is significant. Employers are not required to offer changes more frequently than annually.
The full extent of the administrative rules for Section 125 plans is beyond the scope of this discussion.
4. Contributions to HSAs under Section 125 plans are subject to nondiscrimination rules.
A cafeteria plan must meet nondiscrimination rules. The rules are designed to ensure that the plan is not discriminatory in favor of highly compensated or key employees.
For example, contributions under a cafeteria plan to employee HSAs cannot be greater for higher-paid employees than they are for lower-paid employees. Contributions that favor lower-paid employees are not prohibited.
The cafeteria plan must not: (1) discriminate in favor of highly compensated employees as to the ability to participate (eligibility test), (2) discriminate in favor of HCEs as to contributions or benefits paid (contributions and benefits test), and (3) discriminate in favor of HCEs as measured through a concentration test that looks at the contributions made by key employees (key employee concentration test). Violations generally do not result in plan disqualification, but instead may cause the value of the benefit to become taxable for the highly compensated employees or key employees.
The nondiscrimination rules predate the creation of HSAs and how the rules apply to HSA contributions is an area where additional government guidance would be welcome.
5. An employer needs a Section 125 plan to allow for HSA contributions through payroll deferral.
Can an employer allow for HSA contributions through payroll deferral without a Section 125 plan? No, not if the goal is to save payroll taxes. Employers can offer HSA payroll deferral on an after-tax basis without concern over the comparability rules or the Section 125 plan rules. Amounts contributed under this method are treated as income to the employee and are deductible on the employee’s personal income tax return. The lack of any special tax treatment for this approach makes it unattractive for most employers and with just a small additional investment of money and time, a Section 125 plan could be added allowing for pretax deferrals.
Here is an example: Waving Flags, Inc. does not offer health insurance or a Section 125 plan to its employees. Waving Flags does provide direct deposit services to its employees that provide it with their personal checking account number and bank routing number. Maggie, an employee of Waving Flags, Inc., approaches the human resources person and asks to have her direct deposit split into two payment streams with $100 per month being directly deposited to her HSA and the balance of her pay being deposited into her personal checking account. She provides Waving Flags the appropriate account and routing numbers and signs the proper election forms.
Waving Flags is not subject to the Section 125 nondiscrimination rules for pretax payroll deferral, nor is Waving Flags subject to the HSA comparability rules. Waving Flags is simply paying Maggie by making a direct deposit into her HSA. The $1,200 Maggie elects to have directly deposited to her HSA in this manner will be reflected in Box 1 of her IRS Form W-2 from Waving Flags as ordinary income. She will be subject to payroll taxes on the amount. She can claim an HSA deduction on line 25 of her IRS Form 1040 when she files her tax return.
Maggie benefits from this approach by setting up an automatic contribution to her HSA, which often improves the commitment to savings. Most HSA custodians will offer a similar system that HSA owners can set up on their own by having their HSA custodian automatically draw a certain amount from a personal checking account at periodic intervals. Employer involvement is not necessary. Individuals with online banking tools available to them may be able to set it from their personal checking account as well to push money periodically to an HSA.
Westerman, P (2 July 2018) “HSA How-To” [Web Blog Post]. Retrieved from https://www.benefitspro.com/2018/01/01/hsa-how-to/