Question: Can employers permit employees to front-load their HSA contributions through payroll to reach the statutory limit at the start of the year?
As discussed below, we recommend not permitting employees to front-load HSA contributions through payroll.
Employee Pre-Tax HSA Contributions Made Through Section 125 Cafeteria Plan
Employees make pre-tax HSA contribution elections through the employer’s Section 125 cafeteria plan. There is no other mechanism for employees to make these elections a pre-tax basis.
(Note that this is the reason why the vast majority of employer HSA contributions are subject to the Section 125 nondiscrimination rules, rather than the HSA-specific comparability rules under §4980G. See our prior post for more details: https://theabdteam.com/blog/hsa-nondiscrimination-rules/)
Section 125 Uniform Interval Rule Likely Prohibits HSA Front-Loading Through Payroll
The Section 125 cafeteria plan regulations that govern employee pre-tax contributions require that the interval for employee salary reductions be uniform for all participants. This means that you couldn’t have one employee paying contributions at a different interval than another (e.g., one contributes each pay period while another contributes once per month).
Allowing additional contributions for any pay period in that uniform interval likely violates that requirement. Although it’s not explicit in the regulations that salary reduction contributions be taken ratably, it would defeat the purpose of the uniform interval requirement to provide that employees may contribute different amounts at the set uniform interval. Therefore, most view front-loading contributions as not permitted under Section 125.
For example, take an employee who elects to contribute $6,900 to the HSA for 2018, and the company has 24 pay periods. The ratable contribution per semi-monthly pay period (the uniform interval) is $287.50. It cannot be $1,150 for the first six pay periods and $0 for the remaining 18 pay periods. Of course, these contributions can change if the employee makes an election change mid-year, but absent that situation the contributions would be taken ratably at $287.50 throughout the year.
Our recommendation is therefore that the employer should not permit employees to font-load their HSA contributions through payroll. The employer should instead implement the employee’s election ratably by taking the standard per-paycheck HSA contribution.
Reasonable Argument That Ratable Contribution Requirement Doesn’t Apply to HSA Contributions
There is a reasonable argument that the ratable contribution requirement described above does not apply to HSA contributions because employees are permitted to change their HSA election at least monthly.
The general rule for Section 125 cafeteria plan elections is that they are irrevocable for the plan year unless the employee experiences a permitted election change event. However, there is an exception to that rule for employee pre-tax HSA contribution elections. That exception provides that the cafeteria plan must permit employees to change their HSA contribution at least once per month for any reason (with no change in status or other event required).
Some argue that the requirement to take contributions ratably throughout the year should not apply to HSA contributions because employees can increase or decrease their HSA elections at any point and for any reason. In other words, that argument would permit contributions in excess of the per pay period average because employees could change their contribution amount at any point. Although we do not agree, we consider that to be only a mildly aggressive position.
Potential Downside of HSA Front-Loading
Employers that do permit HSA front-loading through payroll create the potential that an employee will make excess HSA contributions. Although this is purely an individual income tax issue for the employee, employers frequently become entangled in excess contribution situations because the employee will look first the employer for advice and guidance.
This potential issue arises for an employee who front-loads an HSA early in the year but does not remain HSA eligible for the full year (e.g., because of a termination in employment or other permitted election change event that results in the employee losing HDHP coverage). In that scenario, the employee may have exceeded the reduced proportional HSA limit based on the number of months of HSA eligibility in the year. That would require the employee to make a corrective distribution directly with the HSA custodian by his or her tax filing due date (generally April 15 unless filing for an extension) to avoid a 6% excise tax on the excess contribution.
For more details on the proportional HSA contribution limit, as well as a special exception known as the last-month rule, see our previous post here: https://theabdteam.com/blog/hsa-last-month-rule/.
Preferred Alternative: HSA Contributions Outside of Payroll
We recommend that employers do not permit HSA front-loading, but instead advise that employees can make contributions directly to the HSA custodian outside of payroll. This form of front-loading with after-tax dollars bypasses the employer and its Section 125 cafeteria plan.
Employees can always front-load as much as they want by making direct HSA contributions outside of payroll without losing the income tax advantage. The employee can take an above-the-line deduction on the individual tax return for any direct HSA contributions with after-tax dollars and receive the same income tax treatment as a pre-tax contribution through the cafeteria plan. (Note that the new 2018 Form 1040 moves the HSA above-the-line deduction, as well as many other common deductions, to Schedule 1.)
The only difference with direct HSA contributions is that you don’t receive the payroll tax exemption that you would receive for pre-tax contributions made through the cafeteria plan. The FICA tax rates are 6.2% for Social Security, 1.45% for Medicare. That payroll tax exemption is more meaningful for employees who do not exceed the FICA wage base for the 6.2% Social Security tax ($128,400 in 2018). Those who exceed the wage base will only be losing the 1.45% Medicare tax exemption (and potentially the ACA’s 0.9% additional Medicare tax at certain income levels).
For more information on this issue and everything else HSA, see our ABD Office Hours Go All the Way With HSA.
Prop. Treas. Reg. §1.125-1(a)(3)(j):
(3) Qualified benefit. Except as otherwise provided in section 125(f) and paragraph (q) of this section, the term qualified benefit means any benefit attributable to employer contributions to the extent that such benefit is not currently taxable to the employee by reason of an express provision of the Internal Revenue Code (Code) and which does not defer compensation (except as provided in paragraph (o) of this section). The following benefits are qualified benefits that may be offered under a cafeteria plan and are excludible from employees’ gross income when provided in accordance with the applicable provisions of the Code—
(A) Group-term life insurance on the life of an employee in an amount that is less than or equal to the $50,000 excludible from gross income under section 79(a), but not combined with any permanent benefit within the meaning of §1.79-0;
(B) An accident and health plan excludible from gross income under section 105 or 106, including self-insured medical reimbursement plans (such as health FSAs described in §1.125-5);
(C) Premiums for COBRA continuation coverage (if excludible under section 106) under the accident and health plan of the employer sponsoring the cafeteria plan or premiums for COBRA continuation coverage of an employee of the employer sponsoring the cafeteria plan under an accident and health plan sponsored by a different employer;
(D) An accidental death and dismemberment insurance policy (section 106);
(E) Long-term or short-term disability coverage (section 106);
(F) Dependent care assistance program (section 129);
(G) Adoption assistance (section 137);
(H) A qualified cash or deferred arrangement that is part of a profit-sharing plan or stock bonus plan, as described in paragraph (o)(3) of this section (section 401(k));
(I) Certain plans maintained by educational organizations (section 125(d)(2)(C) and paragraph (o)(3)(iii) of this section); and
(J) Contributions to Health Savings Accounts (HSAs) (sections 223 and 125(d)(2)(D)).
Prop. Treas. Reg. §1.125-5(g)(2):
(2) Interval for employees’ salary reduction contributions. The cafeteria plan is permitted to specify any interval for employees’ salary reduction contributions. The interval specified in the plan must be uniform for all participants.
Prop. Treas. Reg. §1.125-2(c)(1)(ii):
(c) Election rules for salary reduction contributions to HSAs.
(1) Prospective elections and changes in salary reduction elections allowed. Contributions may be made to an HSA through a cafeteria plan. A cafeteria plan offering HSA contributions through salary reduction may permit employees to make prospective salary reduction elections or change or revoke salary reduction elections for HSA contributions (for example, to increase or decrease salary reduction elections for HSA contributions) at any time during the plan year, effective before salary becomes currently available. If a cafeteria plan offers HSA contributions as a qualified benefit, the plan must—
(i) Specifically describe the HSA contribution benefit;
(ii) Allow a participant to prospectively change his or her salary reduction election for HSA contributions on a monthly basis (or more frequently); and
(iii) Allow a participant who becomes ineligible to make HSA contributions to prospectively revoke his or her salary reduction election for HSA contributions.
(2) Example. The following example illustrates the rules in this paragraph (c):
Example. Prospective HSA salary reduction elections.
(i) A cafeteria plan with a calendar plan year allows employees to make salary reduction elections for HSA contributions through the plan. The cafeteria plan permits employees to prospectively make, change or revoke salary contribution elections for HSA contributions, limited to one election, change or revocation per month.
(ii) Employee M participates in the cafeteria plan. Before salary becomes currently available to M, M makes the following elections. On January 2, 2009, M elects to contribute $100 for each pay period to an HSA, effective January 3, 2009. On March 15, 2009, M elects to reduce the HSA contribution to $35 per pay period, effective April 1, 2009. On May 1, 2009, M elects to discontinue all HSA contributions, effective May 15, 2009. The cafeteria plan implements all of Employee M’s elections,
(iii) The cafeteria plan’s operation is consistent with the section 125 election, change and revocation rules for HSA contributions.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).