FSA rollover into HSA for terminating employee?

[SLuskin]

My client has 2 FSA's: a general purpose and a limited purpose. They also have an HSA. Both FSA's have a limited purpose 2 1/2 month extension period.

An employee in the limited purpose FSA also makes HSA contributions. She is leaving the firm. She wants to roll over her FSA balance into the HSA.

I cannot find anything that says you can roll over other than at plan year end. I have been over IRS Notice 2007-22 a few times, and it seems totally silent on this issue.

Also, assuming that she can do the roll over, do we always have to look at the FSA balance on September 21, 2006? What if the person was not an FSA participant in 2006, just 2007?

Thank you for your help.

[masteff]

First, the plan would have to be amended and would have to allow for distributions at termination (and not just year end).

The notice, under "Qualified HSA Distributions" says: "Although the unused amounts can be distributed to an HSA before the end of the plan year, because the health FSA coverage continues until the end of the plan year, an individual covered by the health FSA is not an eligible individual immediately after the qualified HSA distribution, and thus any such qualified HSA distribution is included in income and subject to an additional 10 percent tax. Similarly, an individual without HDHP coverage after a distribution is not an eligible individual after the distribution and thus the qualified HSA distribution is included in income and subject to an additional 10 percent tax."

Applying sentence one, since your EE is terminating, then no continued coverage after the mid-year distribution (as long as not elected in COBRA) so appears to be no problem. Applying sentence two, your employee would be subject to tax and penalty unless she has HDHP coverage after the distribution (such as by COBRA or thru another employer's plan).

Furthermore, she has to remain an "eligible individual" for 12 months or the rollover will be taxable: "If an individual ceases to be an eligible individual during the testing period, the amount of the qualified HSA distribution is included in the gross income of the individual and subject to an additional 10 percent tax."

And lastly, the notice says: "Thus, an individual who was not covered by a health FSA or HRA on September 21, 2006 may not elect a qualified HSA distribution."