| Question 1: What are the requirements to make a tax free Qualified HSA Distribution (rollover from a Health FSA or HRA to a Health Savings Account)?
Answer: Section 302 of Health Opportunity Patient Empowerment Act of 2006 (“HOPE Act”), which was passed by Congress on December 20, 2006 as part of the Tax Relief and Health Care Act (Pub. L. 109-432), amended Internal Revenue Code (“Code”) Section 106 to allow Health Flexible Spending Arrangement (Health FSA) and/or Health Reimbursement Arrangement (“HRA”) participants to make a once in a lifetime transfer of unused Health FSA and/or HRA funds to an HSA without disqualifying the Health FSA and/or HRA. The once in a lifetime rollovers are called "Qualified HSA Distributions. The requirements to make a tax free Qualified HSA Distribution are set forth in IRS Notice 2007-22. Notice 2007-22 identifies the following requirements for a tax free Qualified HSA Distribution (emphasis added): • The account holder’s employer amends the written health FSA or HRA plan by the last day of the plan year to allow Qualified HSA Distributions;
• If the rollover is with respect to a Health FSA, the Health FSA has a grace period;
• The accountholder has not previously made a Qualified HSA Distribution for the Health FSA or HRA (remember, the Qualified HSA Distribution is a once in a lifetime transfer);
• The account holder elects to make a Qualified HSA Distribution by the last day of the plan year;
• No reimbursements from the Health FSA or HRA are made after the last day of the plan year (unless the plan is converted to a limited purpose Health FSA or HRA);
• The account holder’s employer makes the distribution directly to the HSA trustee by the fifteenth day of the third calendar month following the end of the immediately preceding plan year (and after the employee becomes an Eligible Individual);
• The distribution from the health FSA and/or HRA does not exceed the lesser of the “balance” of the health FSA or HRA on (i) September 21, 2006, and (ii) the last day of the plan year in which the Qualified HSA Distribution is elected.
• One of the following two results must occur as a result of the Qualified HSA Distribution: (i) the distribution from the Health FSA and/or HRA creates a zero balance in the health FSA and/or HRA (whichever is applicable) and the employee is no longer a participant in any non-HSA compatible health plan (i.e. any coverage that is not considered “disregarded coverage” in Code Section 223(c)(1)(B)) [such as permitted coverage and preventive care] or (ii) the Health FSA/HRA is converted to a limited purpose arrangement (as set forth in IRS Rev. Ruling 2004-45) effective on or before the date of the first Qualified HSA Distribution for all participants (i.e. on or before the last day of the plan).
It remains to be seen whether a Qualified HSA Distribution can be made tax free during the year if the distribution is made from a limited purpose Health FSA/HRA (i.e. an FSA/HRA that provides only disregarded coverage as defined in Code Section 223(c)(1)(B)). In Notice 2007-22, the IRS states that “if the FSA or HRA is not HSA compatible [i.e. limited to disregarded coverage], employees can only become eligible individuals only after transfers at the end of the plan year of the FSA or HRA that result in either disregarded coverage under 302(b) [of the HOPE Act] or the termination of the HRA coverage at the end of the plan year.” Although mid year transfers from an HSA compatible Health FSA or HRA are not identified in the list of requirements for tax free Qualified HSA Distributions set forth in Notice 2007-22 (and identified above), this statement in Notice 2007-22 suggests that Qualified HSA Distributions may be tax free if made during the year if the transfer is made from an HSA compatible Health FSa or HRA. Additional guidance is needed to further clarify.
In addition, the account holder must remain an eligible individual (as defined in Code Section 223) during the testing period established by the HOPE Act. The Testing Period begins in the month in the which the Qualified HSA Distribution is made and ends on the last day of the 12th month following such month.
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