Employee contributed to HSA and also inadvertently contributed to a traditional medical FSA

We have a client who had an employee contribute $6,750 to their HSA and $800 into the FSA in 2023. The FSA contribution was meant to go into a limited purpose account, but they just learned that there was no limited purpose account set up, and the funds were coming from the full-purpose FSA.

Prior to this, they had a rule set up in their system, which prevented the enrollment. The only reason they allowed the election to pass was because they thought it was a limited purpose account.

We are currently working with the carrier to set up the limited purpose account so this will be corrected going forward.

The employer did instruct the employee at the time that the FSA was to be used for dental and vision only. How should we advise the client for what occurred in 2023?

Unfortunately, the employer is responsible for monitoring whether the employee has disqualifying coverage through the employer.  The employee was never HSA-eligible based on disqualifying coverage (general purpose FSA) through that employer. So in this case, they are responsible for correcting the HSA contributions for the employee. 

The correction here is to include the HSA contributions in the employee's taxable income for 2023.  That will required a corrected W-2.  

• More details: https://www.newfront.com/blog/hsa-mistaken-contributions

The employee will also need to take a corrective distribution by 4/15 to avoid a 6% excise tax on those ineligible contributions.

• More details: https://www.newfront.com/blog/correcting-excess-hsa-contributions

Here's the relevant cites:

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

https://www.irs.gov/irb/2008-29_IRB#NOT-2008-59

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.

IRS Notice 2004-50:

https://www.irs.gov/irb/2004-33_IRB#NOT-2004-50

Q-81. Are employers who contribute to an employee’s HSA responsible for determining whether the employee is an eligible individual and the employee’s maximum annual contribution limit?

A-81. Employers are only responsible for determining the following with respect to an employee’s eligibility and maximum annual contribution limit on HSA contributions: (1) whether the employee is covered under an HDHP (and the deductible) or low deductible health plan or plans (including health FSAs and HRAs) sponsored by that employer; and (2) the employee’s age (for catch-up contributions). The employer may rely on the employee’s representation as to his or her date of birth.

Slide summary:

2024 Newfront Go All the Way with HSA Guide

Thanks Brian.  I thought this would be the case.  So, is there a situation where the FSA could be ineligible (forfeited) and the employee could keep the HSA in tact?  Would the IRS regs allow for that scenario?  They contributed $6,750 to the HSA versus $800 to the FSA.  Clearly, there is more to spend in the HSA which would benefit the employee more.    

That's not really how it's supposed to work because the employee was actually eligible for the FSA.  It's only the HSA for which the employee was ineligible.  

I suppose you could try to argue that there was a systems error with the general purpose health FSA enrollment, thereby making any FSA payments improper.  I'd consider that aggressive but not crazy.  

• If you took that approach, here's an overview of how it would be handled: https://www.newfront.com/blog/correcting-improper-health-fsa-payments