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 Treasury and IRS Issue Guidance on FSA Grace Period and HSA Eligibility


11/22/2005

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Today the Treasury and the IRS issued Notice 2005-86 which clarifies the interaction of the 2-1/2 month Flexible Spending Arrangement (FSA) grace period (established earlier this year by Notice 2005-42) and eligibility to contribute to Health Savings Accounts (HSAs).  The guidance clarifies that coverage by the FSA grace period disqualifies an individual to contribute to an HSA during the grace period.  However, the notice also provides guidance on how an FSA can be amended to enable a covered individual to contribute to an HSA during the grace period.  The guidance also clarifies a number of technical questions concerning the grace period.

An individual eligible to contribute to an HSA must be covered by a high deductible health plan (HDHP) and generally no other non-HDHP coverage, including health FSA coverage.  Consequently, an individual who has his or her health FSA coverage extended by the grace period is ineligible to contribute to an HSA, even where the health FSA has reached its annual benefit limit.   However, the guidance provides that, if the employer amends the FSA to be HSA-compatible during the grace period for all participants, individuals would not be disqualified from contributing to an HSA during the grace period.  In addition to this general rule, the notice provides a special transition rule for coverage years ending before June 5, 2006 .  For those years, an otherwise eligible individual may contribute to an HSA during coverage by a health FSA grace period if the individual's health FSA has no unused contributions or if the employer amends the cafeteria plan to provide that the grace period is not available to individuals electing HDHP coverage during the grace period.

Finally, the notice clarifies the following points about the grace period:

  • The grace period must be made available to all participants who are covered on the last day of the plan year, including participants whose coverage is extended to the last day through COBRA continuation coverage. 

  • The grace period must remain in effect for the entire period even though the participant terminates employment prior to the end of the grace period.

  • Employers may limit the application of the grace period to only certain benefits (e.g.,  a plan offering a health FSA and a dependent care FSA could limit the grace period to the health FSA). 

  • The maximum grace period is until the 15th day of the third calendar month after the end of the plan year, but a shorter period may be adopted as a grace period.

A copy of Notice 2005-86 is attached.

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