IRS Clarifies Rules for Rollovers to HSAs from Certain FSAs and HRAs

As summarized in our December 21, 2006 Benefits Alert, the Tax Relief and Health Care Act of 2006 includes many significant improvements to health savings accounts ("HSAs"). Among other things, for the five-year period from 2006 through 2011, the Act permits rollovers to HSAs from health flexible spending accounts ("FSAs") with grace periods and from health reimbursement accounts ("HRAs"). Last week, the IRS issued Notice 2007-22, which clarifies the rules for rollovers from general purpose FSAs with grace periods and general purpose HRAs. The Notice also provides special transition relief for rollovers of amounts remaining at the end of 2006.

Rollover Rules

The Notice provides the following conditions that must be met for an employer to transfer funds on behalf of employees from general purpose FSAs with grace periods or general purpose HRAs, or both, to HSAs with favorable tax results:

By the end of the plan year, the employer must amend the FSA or HRA plan document to allow rollovers.

1. The employee must elect to have the employer make a rollover from the FSA or HRA to an HSA by the last day of the plan year. (This requirement prohibits employers from making automatic rollover elections for employees.)


2. The employee must not have previously elected to make a rollover of an FSA or HRA balance to the HSA. (In other words, the employer can allow the rollover option each year of the five-year period, but each employee can only take advantage of it one time.)

3. The employee must have coverage under a high deductible health plan as of the first day of the month during which the rollover occurs and must be otherwise HSA eligible. (An employee who receives the rollover must remain eligible for the HSA for at least 12 months after the rollover. Failure to do so will result in income tax and a 10% penalty on the rollover.)

4. The FSA or HRA cannot make reimbursements to the employee after the last day of the plan year.

5. The funds must be transferred by the employer to an HSA trustee by the March 15th following the end of the preceding plan year, but after the employee becomes HSA-eligible.

6. The amount of the rollover cannot exceed the balance of the FSA or HRA on September 21, 2006, or on the date of the rollover, whichever is smaller. (This requirement could create problems for employers who do not have FSA or HRA balances from September 21, 2006.)

7. After the rollover, there must be a zero balance in the FSA or HRA and the employee must not be a participant in a non-HSA compatible health plan. Alternatively, effective on or before the date of the rollover, the FSA or HRA must be converted to a HSA-compatible FSA or HRA. (The zero balance requirement, combined with the prohibition on making reimbursements to employees after the last day of the plan year, could create administrative issues for employers who have run-out periods for submitting claims.)

Transition Relief for Amounts Remaining at the End of 2006

The Notice provides special transition relief for rollovers of amounts remaining at the end of 2006. For these amounts, the rules for rollovers listed above apply, except that:

1. There is no requirement to "freeze" the year-end balance in the FSA or HRA.

2. The amendment, election, and transfer to the HSA trustee must be completed by March 15, 2007. (Given this timing requirement, the employer might want to set a date before March 15th by which employees must elect to roll over, so that the employer has time to transfer funds to the HSA trustee.)

Rationale for Limiting Guidance on Rollovers to General Purpose FSAs with Grace Periods and General Purpose HRAs

At this point, the IRS has limited its guidance to rollovers from general purpose FSAs with grace periods and general purpose HRAs. The IRS requires eligible FSAs to have grace periods because, without a grace period, the "use it or lose it" rule applies and there is no amount left at the end of the plan year to roll over. The IRS indicated in the Notice that rollovers are also allowed from limited purpose FSAs and HRAs, but did not address how these rollovers should be made.

Action Items

Employers who are interested in offering rollovers should first make sure that it is administratively feasible for them to do so (e.g., that they can resolve accounting issues with run-out periods and that they can obtain FSA and/or HRA account balances as of September 21, 2006). Employers who want to offer rollovers of amounts remaining at the end of 2006 must act quickly, as the March 15, 2007 deadline is approaching. Employers who plan to offer rollovers for the 2007 through 2011 plan years may want to wait to act, as the IRS may issue additional guidance on rollovers.