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Guest Article

(From the June 9, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues More Guidance on Health Savings Accounts

The Internal Revenue Service on June 4, 2008 issued guidance on certain changes to the rules for health savings accounts (HSAs) made by the Health Opportunity Patient Empowerment (HOPE) Act of 2006 (P.L. 109-432). Notice 2008-51 explains the process for making a one-time transfer from an IRA or Roth IRA to an HSA, and Notice 2008-52 provides guidance on certain changes to the HSA contribution rules. The latter is of particular interest to employers because it describes how new employees and others who first become eligible to fund an HSA during the middle of a year can still make a full contribution to their HSA for that year. This is one of several provisions in the HOPE Act designed to make HSAs easier for employers to integrate into their consumer-directed health plan (CDHP) designs.

The HOPE Act also included various other employer plan-friendly provisions. These include (1) permitting a one-time transfer of health flexible spending arrangement (FSA) and health reimbursement arrangement (HRA) balances to HSAs; and (2) permitting employers to make larger contributions to the HSAs of non-highly compensated employees than to the HSAs of highly compensated employees (HCEs) without violating the comparable contribution requirement. Notices 2008-51 and 2008-52 do not address these provisions. However, the IRS in 2007 issued extensive guidance on transferring health FSA and HRA balances to HSAs. Unfortunately, the IRS has not released any guidance to date on the HCE exception to the comparable contribution rules.

Calculating the HSA Annual Contribution Limit

In order to be eligible to fund an HSA, an individual generally must be covered by a high-deductible health plan (HDHP) and not by any other health plan that is not an HDHP. These eligibility criteria are applied monthly, on the first day of each month. For every month an individual is eligible to fund an HSA (i.e., an "eligible individual"), he or she may contribute up to 1/12th of the applicable annual contribution limit to his or her HSA. The annual HSA contribution limit in 2008 is $2,900 for eligible individuals with single coverage, and $5,800 for eligible individuals with family coverage. (The contribution limits for 2009 will be $3,000 and $5,950, respectively.) Thus, an employee with single coverage who becomes an eligible individual on July 1, 2008 and maintains that status for the rest of the year can contribute $1,450 (6/12 x $2,900) to his or her HSA for 2008.

Effective for taxable years beginning after December 31, 2006, the HOPE Act created a special "full contribution" rule permitting anyone who is an eligible individual as of the first day of the last month of his or her tax year (December 1 for calendar year taxpayers) to make the maximum annual contribution to his or her HSA for that year even if he or she was not an eligible individual for the entire year. However, in order to take advantage of this full contribution rule the employee must maintain eligible individual status for all of the next taxable year. Otherwise, he or she will have to include in income, and pay a 10 percent penalty on, the amount of HSA contributions that could not have been made but for the full contribution rule.

Notice 2008-52 makes several important points about the full contribution rule and its application:

The full contribution rule is available only if the individual is an eligible individual on the first day of the last month of his or her taxable year (December 1 for calendar year taxpayers). Someone who is an eligible individual for part of the taxable year, but not on the first day of the last month of such taxable year, must use the annual contribution limit based on the number of months he or she actually was an eligible individual. The notice illustrates this principle with the following example:
Example 6. Individual E, age 35, has self-only HDHP coverage and is an eligible individual for the months of May, June, and July 2008.
The full contribution limit under § 223(b)(8) does not apply to E for 2008 because E is not an eligible individual on December 1, 2008. E's contribution limit for 2008 is $725 (3/12 x $2,900).
The full contribution rule can apply even if the individual was covered by a non-HDHP for part of the year. In order to qualify, the individual must be an eligible individual on the first day of the last month of his or her taxable year; his or her status before that date is not relevant to determining eligibility to use the full contribution rule.
The type of HDHP coverage (i.e., self-only or family) the individual has on the first day of the last month of his or her taxable year determines the applicable annual contribution limit for purposes of the full contribution rule. For example, if someone first became an eligible individual on December 1, 2007 and had family HDHP coverage as of that date, then he or she is deemed to have had family coverage for all of 2007 pursuant to the full contribution rule. This means the individual's HSA contribution for 2007 could be $5,800 -- the annual limit for family coverage -- instead of the $2,900 contribution limit for individuals with self-only coverage.
The full contribution rule also applies to catch up contributions. In general, eligible individuals who are at least 55 years old as of the last day of the calendar year and who are not enrolled in Medicare can make additional catch up contributions to their HSAs. The catch up contribution limit for 2008 is $900, increasing to $1,000 for 2009 and future years. Like the annual contribution limit, an individual's annual catch up contribution limit generally is based on the number of months during the year he or she was an eligible individual. However, an otherwise eligible individual who is at least 55 years old and not enrolled in Medicare can use the full contribution rule to make a full catch up contribution if he or she is an eligible individual as of the first day of the last month of his or her taxable year.
Individuals who take advantage of the full contribution rule must maintain eligible individual status for a thirteen-month "testing period." According to Notice 2008-52, the "testing period" begins on the first day of the last month of the taxable year and ends on the last day of the 12th month following that month. So for a calendar year taxpayer who wants to use the full contribution rule in 2008, the testing period begins on December 1, 2008 and ends on December 31, 2009.
- All that is required is for the individual to maintain eligible individual status for the entire testing period. The eligible individual does not have to maintain the same level (i.e., selfonly or family) of HDHP coverage throughout the testing period.
There are income and excise tax consequences for any individual who takes advantage of the full contribution rule and fails to remain an eligible individual during the testing period, unless the failure is due to the individual's death or disability. Specifically, the difference between the amount such individual actually contributed pursuant to the full contribution rule and the amount he or she otherwise would have been eligible to contribute for that year (the "excess contribution amount") is included in his or her gross income and subjected to a 10 percent excise tax. However, any earnings attributable to the excess contribution amount are not included in the individual's gross income or subject to the 10 percent excise tax.
- There is no requirement to distribute excess contribution amounts from an HSA. If these amounts are distributed for any reason other than payment of qualified medical expenses they also will be subject to tax penalties for nonqualified distributions. In other words, such amounts may be subject to double taxation as the following example from the notice illustrates.
  Example 9. Individual H, age 25, enrolls in self-only HDHP coverage on June 1, 2008 and is an eligible individual on that date. H is not an eligible individual prior to June 1, 2008. H contributes $2,900 to an HSA on July 1, 2008. H is an eligible individual on December 1, 2008, and continues to be an eligible individual until February 1, 2009. On February 2, 2009, H withdraws $1,208.33 from his HSA. The $1,208.33 distribution is not used for H's qualified medical expenses (as defined in § 223(d)(2)).
  H is an eligible individual with self-only HDHP coverage on December 1, 2008. H's full contribution limit under § 223(b)(8) for 2008 is $2,900. H's sum of the monthly contribution limits is $1,691.67 (7/12 x $2,900). H's annual contribution limit is $2,900, the greater of $2,900 or $1,691.67. The testing period for 2008 HSA contributions ends on December 31, 2009. In 2009, H ceases to be an eligible individual during the testing period. In 2009, H must include in gross income $1,208.33, the amount contributed to the HSA minus the sum of the monthly contribution limits ($2,900 - $1,691.67). In addition, the 10 percent additional tax ($120.83) in § 223(b)(8)(B)(i) applies to the amount.
  The $1,208.33 withdrawn from the HSA is not used for qualified medical expenses and is not a withdrawal of an excess contribution. Therefore, under § 223(f)(2), $1,208.33 is also included in H's gross income and is also subject to the 10 percent additional tax in § 223(f)(4). As a result, H includes $2,416.66 ($1,208.33 with respect to § 223(f)(4) and $1,208.33 with respect to § 223(b)(8)) in gross income in 2009 and an additional tax of $241.66 ($120.83 with respect to § 223(f)(4) and $120.83 with respect to § 223(b)(8)).
Excess contribution amounts, as determined under the full contribution rules, are not "excess contributions" for purposes of IRC § 4973. In general, IRC § 4973 imposes a 6 percent excise tax on amounts contributed to an individual's HSA to the extent those contributions exceed the applicable contribution limit for the year. However, the 6 percent excise tax can be avoided if the excess contributions are withdrawn from the HSA before the last day (with extensions) for filing the individual's income tax return for that year.
- Because excess contribution amounts are not IRC § 4973 excess contributions, the 6 percent excise tax does not apply to these amounts. However, these excess contribution amounts also may not be withdrawn from an HSA pursuant to the IRC § 4973 excess contribution rules.

Notice 2008-52 includes extensive examples to illustrate these and other principles relating to applying the special full contribution rule.

Notice 2008-51

As noted, the IRS also has issued Notice 2008-51 to provide guidance on the special rule permitting onetime funding transfers from an individual's IRA or Roth IRA to his or her HSA. This guidance is not discussed in detail here because this special rule will only indirectly affect employers' CDHP designs featuring HSAs.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

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