by George G. Jones and Mark A. Luscombe
With the release of Notice 2002-45 and its companion Rev Rul 2002-41 in late June, the Internal Revenue Service has given employers the green light to establish tax-deductible and tax-free health reimbursement arrangements.
This form of self-directed medical benefit arrangement promises a "creative and effective response" to increasing health plan expenses by making employees more prudent consumers in the use of their health services while providing them with adequate coverage.
The linchpin of the new HRAs is its carryover feature in which each employee’s unused employer-contributed amount for the year can be added to an accumulating account and drawn down in a future year. Pitched as giving employees more choice and greater control over their health care coverage, the greatest benefit of the carryover feature may, in fact, be realized by employers who are hard strapped to provide the level of health benefits still generally expected of them.
For employers, the HRA offers a potential solution to curb the annual double-digit inflationary increases in the cost of group health insurance. The question seems to be not when a client should now adopt an HRA feature to its health plan coverage, but how fast.
Not new, but improved
Self-directed (a.k.a. consumer-directed) health plans are not new. Small employers have been able to set up medical savings accounts since 1997, but only strictly to supplement high-deductible medical insurance coverage. As a result, they have been woefully under-subscribed.
Traditional flexible spending accounts have been more popular, but also have their limitations. Maintained through pre-tax employee salary-reduction contributions to cover that portion of medical expenses not covered by medical insurance, FSAs require employee contributions and impose an annual "use it-or- lose it" rule. Funds from neither MSAs or FSAs may be used to pay medical insurance premiums. HRAs, in contrast, are considerably more versatile.
How HRAs work
An HRA with a carry-over feature may be offered on a tax-favored basis if the HRA:
- Is funded solely with employer contributions;
- Is used only to reimburse employees, former employees (including retirees) or their tax dependents for qualified medical care expenses; and,
- Is not funded by a salary-reduction election or other similar election under a cafeteria plan.
A qualifying HRA may reimburse up to the maximum dollar amount a coverage period, with any unused amount in an employee’s account carried forward to increase the maximum reimbursement dollar amount in subsequent periods.Reimbursement for insurance covering medical care expenses are allowable HRA reimbursements, including amounts paid for premiums for accident or health coverage. If any person has the right to receive cash or other benefit under the HRA other than the reimbursement of medical care expenses, currently or in a future year, the entire HRA is disqualified.
Under an HRA, the employee has no choice - over and above generally exerting marketplace pressure on the employer - either whether the employer will make contributions in any given year and how much that amount will be. The employer’s only real restriction is that contributions must not discriminate in favor certain employees.
Use-it or lose-it no more
An HRA that is properly drafted does away with the "use-it or lose-it" problem faced by employees using traditional FSAs. Because benefits can be carried over indefinitely, the only difficulty that arises occurs upon an employee’s retirement or termination. In either case, the IRS warns that any veiled attempt to avoid the rule through a retirement or severance "bonus" related to an employee’s maximum reimbursement amount remaining in an HRA at that time, the entire HRA is disqualified.
However, the IRS guidance allows this rule to be avoided simply by having a provision in an HRA that reimburses a former employee for medical care expenses up to an amount equal to the unused reimbursement amount remaining at retirement or other termination of employment.
Flexible plan designs
The IRS guidance is being applauded for allowing considerable flexibility in the way employers may fund HRAs, enabling them to make broader plan design decisions.
HRAs can be offered by an employer as a defined contribution health plan. The new IRS guidance permits employers to fund an HRA with the exact amount that they want to spend on their employees’ health care expenses and nothing more. Employers can contribute a set dollar amount, which employees can use either to reimburse specific substantiated health care expenses or to pay for part, or all, of the premiums for health insurance coverage - or some combination of both.
Although HRAs may be used to provide the only health benefits that are offered by employers, they also can be used as a supplement to high-deductible health plans that are provided at least in part by the employer. One popular health plan configuration pairs high deductible coverage, usually offered with a network of providers, with an HRA (also called a personal care account in these situations) into which the employer makes contributions for use by employees to pay medical expenses, including insurance premiums.
The health coverage can be insured or self-insured and the PCA either funded or unfunded. To be economically feasible, however, at least some portion of the policy part of the configuration usually is paid with pre-tax employee contributions.
Coordination with cafeteria plans
An HRA cannot be funded within a cafeteria plan, since funding through salary-reduction arrangements are expressly prohibited. Nevertheless, employers can coordinate cafeteria plan benefits with HRAs in a manner that provides an attractive, yet IRS-sanctioned package.
One such sanctioned arrangement permits an employer to offer employees a choice between employer-provided coverage under an HRA and coverage under an HMO. With no cash or other taxable benefits made available though this arrangement in either case, the choice will not be considered an election under a cafeteria plan.
Another sanctioned arrangement permits an employer to provide an HRA only in conjunction with an accident or health plan provided under a cafeteria plan’s salary reduction election. Provided that the salary reduction is not used in any part to pay for the HRA itself (i.e., it does not exceed the cost of coverage under the specified accident or health plan), it will not taint qualification of the HRA.
This latter requirement, however, will be applied strictly to prohibit any arrangement under which even indirect use of salary reduction is used to fund the HRA. For example, the maximum allowable salary reduction may not be exceeded but, nevertheless, disqualifies the arrangement as an HRA if the employee is also given the choice of a higher salary-reduction funded health plan coverage that also provides a higher HRA maximum reimbursement amount.
One prohibited relationship between a salary-reduction health plan and an HRA, however, may not be so obvious. If the employee is given the choice to pay for health plan premiums through a salary-reduction arrangement or through the use of HRA amounts, the IRS, in its guidance, stated that the reimbursement arrangement will be considered to be indirectly funded pursuant to salary reduction and will disqualify the HRA.
Coordination with FSAs
While an HRA can be an FSA, most FSAs are not HRAs. Under the general rules applicable to both, if coverage is provided under both an HRA and a traditional Section 125 health FSA for the same medical care expenses, amounts that are available under an HRA must be exhausted before reimbursement may be made from the FSA, increasing the danger of losing it by not using it for amounts in the FSA. An approved way around this rule, however, is for the HRA in the employer’s discretion to specify that coverage under the HRA is available only after expenses exceeding the dollar amount of the FSA have been paid. This not only avoids the disqualification problem, but also enhances the likelihood that the FSA money will be used for necessary medical expenses rather than for marginally effective tests and procedures purchased during a year-end frenzy to spend down the account.
Some experts see the use of debit cards that coordinate FSAs and HRAs as the next new thing to arise after the latest IRS guidance. With the need to tie together the administration of HRA and other plans, such as FSAs, the use of electronic and debit card systems by employers could help employers achieve coordinated substantiation procedures and create a smooth transition between accounts.
Not all is certain in using HRAs at this time. The IRS Notice admits that certain statutory provisions have not been addressed, including:
- The deduction limits for employer contributions to welfare benefit funds under 419, 419A and 404;
- The nondiscrimination rules under the Health Insurance Portability and Accountability Act of 1996;
- The certificates of creditable coverage rules under HIPAA;
- Plan designs that cap certain carryforwards, provide for forfeitures and specify the method for allocating interest; and,
- The welfare benefit plan rules under ERISA.
Clients who bump up against one or more of these questions may want to postpone integrating an HRA into their health care package until the IRS chooses to resolve them.Conclusion
The IRS has considerable latitude in interpreting these arrangements and it is hoped that it continues to be as encouraging as Rev Rul 2002-41 has been for their use. For most employers, favorable tax treatment for their contributions is essential to the success of sponsoring an HRA. The IRS has now approved coordination of FSAs and HRAs to maximize tax-free and pre-tax benefits from employee and employer contributions.
Proposals in Congress, such as the Flexible Spend Account Enhancement Act, in which workers would be permitted to carry forward as much $500 of their unspent FSA dollars, or to withdraw them as taxable income or contribute them to their 401(k) plans, indicate that such coordination will only grow in the future as employers try to find the most palatable way to deal with health care costs that have continued to rise.
HRAs clearly force plan participants to become more engaged in decisions related to health care costs. Both employers and employees seem to win ... at least for now. Ironically, however, HRAs may eventually prove to be a net loss to employees. If HRAs prove successful, some employers may be persuaded only to sponsor HRAs and drop group health coverage. As they say, time will tell.
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