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Mistaken FSA Election and HSA Contributions

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During open enrollment, an (childless) employee elects HDHP coverage and therefore (implicitly) to receive the employer's HSA "seed" contribution.  Unfortunately, the employee also intended to enroll in the general purpose health FSA but instead enrolled in the dependent care FSA.  The employer's systems obviously would not catch this error.

Well into the year (the employer's cafeteria plan does not currently provide for a time limit of providing notification) and after the employer HSA "seed" contribution was made, the employee notices the mistake and notifies the employer.  Pursuant to IRS guidance, the employer corrects the mistake and converts all of the year's prior and subsequent FSA amounts to the health FSA.

The change would certainly make all HSA contributions, including the "seed" amounts, excess contributions.  The employee can avoid the tax penalty if he or she takes a timely curative distribution.  If the employee does so, the effect would be that he or she would get addition compensation from the employer but only as a result of the employee's mistake.

Under these circumstances, can the employer ask the HSA custodian to return the "seed" contribution to it? 

Under the HSA regulations, there are only limited circumstances when this can be done, most notably when the employer was never HSA-eligible.  Here, the conversion means that in effect the employee was "never" HSA-eligible but it was solely as a result of a change made mid-year.

Any thoughts are appreciated.

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First of all, I think they made a mistake using the doctrine of mistake to move the employee's election from the dependent care FSA to the general purpose health FSA.  I find it hard to believe there's clear and convincing evidence the employee intended to elect the general purpose health FSA if enrolled in the HDHP, and they've now teed up a nasty HSA correction issue that could have been avoided.  It would have made much more sense to either refund the dependent care FSA contributions as taxable income (or move them to a limited purpose FSA).

Given that we play the hand we're dealt here--I would still treat this as a situation where the employee was not HSA-eligible for the entire year, and therefore the employer can recoup the ER HSA contributions if the HSA bank permits.

The IRS guidance here uses language suggesting that losing HSA-eligibility mid-year is a reference to a situation where the employee is HSA-eligible for some months of the year but not others.  In this case, even though it occurs retroactively because of the unusual doctrine of mistake application, the employee ultimately does not have any period of HSA eligibility. 

I've put that example I'm referring to in bold below:


Mistaken Contribution Exception #1: Employee Was Never HSA-Eligible

If an employer contributes to the HSA of an employee who was never HSA-eligible, the IRS takes the position that the HSA never actually existed because it was not properly established.  In that case, the employer can correct the error before the end of the calendar year by requesting that the HSA custodian return the contributions (adjusted for earnings and administrative fees) back to the employer.

Assuming the custodian agrees to return the funds, the employer should process the correction as follows:

  • Mistaken Employer Contributions: Retained by the employer;
  • Mistaken Employee Contributions: Returned to the employee as taxable income subject to withholding and payroll taxes.

Note that this correction method is available only if the employee was never HSA-eligible (or at least was not HSA-eligible during the year at issue—it is not clear if a period of HSA eligibility prior to the calendar year of the mistaken contribution affects the ability to correct under this method).  In other words, if the contributions were mistaken because the employee lost HSA eligibility mid-year, the contributions remain nonforfeitable.  In that case, any appropriate correction to address excess contributions would be exclusively a matter for the employee dealing directly with the HSA custodian.


IRS Notice 2008-59, Q/A-23-25:


Q-23. If an employer contributes to the account of an employee who was never an eligible individual, can the employer recoup the amounts?

A-23. If the employee was never an eligible individual under § 223(c)(1), then no HSA ever existed and the employer may correct the error. At the employer’s option, the employer may request that the financial institution return the amounts to the employer. However, if the employer does not recover the amounts by the end of the taxable year, then the amounts must be included as gross income and wages on the employee’s Form W-2 for the year during which the employer made the contributions.

Example 1. In February 2008, Employer L contributed $500 to an account of Employee M, reasonably believing the account to be an HSA. In July 2008, Employer L first learned that Employee M’s account is not an HSA because Employee M has never been an eligible individual under § 223(c).

Employer L may request that the financial institution holding Employee M’s account return the balance of the account ($500 plus earnings less administration fees directly paid from the account) to Employer L. If Employer L does not receive the balance of the account, Employer L must include the amounts in Employee M’s gross income and wages on his Form W-2 for 2008.

Example 2. The same facts as Example 1, except Employer L first discovers the mistake in July 2009. Employer L issues a corrected 2008 Form W-2 for Employee M, and Employee M files an amended federal income tax return for 2008.


Q-25. If an employer contributes to the HSA of an employee who ceases to be an eligible individual during a year, can the employer recoup amounts that the employer contributed after the employee ceased to be an eligible individual?

A-25. No. Employers generally cannot recoup amounts from an HSA other than as discussed above in Q&A-23 and Q&A-24. See Notice 2004-50, Q&A-82.

Example. Employee N was an eligible individual on January 1, 2008. On April 1, 2008, Employee N is no longer an eligible individual because Employee N’s spouse enrolled in a general purpose health FSA that covers all family members. Employee N first realizes that he is no longer eligible on July 17, 2008, at which time Employee N informs Employer O to cease HSA contributions.

Employer O’s contributions into Employee N’s HSA between April 1, 2008 and July 17, 2008 cannot be recouped by Employer O because Employee N has a nonforfeitable interest in his HSA. Employee N is responsible for determining if the contributions exceed the maximum annual contribution limit in § 223(b), and for withdrawing the excess contribution and the income attributable to the excess contribution and including both in gross income.


Slide summary:

2023 Newfront Go All the Way with HSA Guide


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