Health Reimbursement Arrangement (HRA)

A health reimbursement arrangement is an employer-funded arrangement that reimburses an employee for medical care expenses without those reimbursements being taxed. IRS Notice 2002-45 gives the description everything else is built on. An HRA is an arrangement that "(1) is paid for solely by the employer and not provided pursuant to salary reduction election or otherwise under a § 125 cafeteria plan; (2) reimburses the employee for medical care expenses (as defined by § 213(d) of the Internal Revenue Code) incurred by the employee and the employee's spouse and dependents (as defined in § 152); and (3) provides reimbursements up to a maximum dollar amount for a coverage period and any unused portion of the maximum dollar amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods."

Two things follow from that first clause. Because the employer alone funds it, an HRA is not a way for an employee to pay medical bills with pre-tax salary; that is what a health flexible spending account inside a cafeteria plan does. And because the money is never the employee's, an HRA is a bookkeeping promise rather than an account. People routinely call it a health reimbursement account, and the tax law says arrangement, for the same reason it says individual retirement arrangement: the word describes a contractual promise, not a pot of money with the employee's name on it.

An HRA is a group health plan, and that single fact drives most of its design. The regulation at 26 C.F.R. 54.9815-2711(d)(6)(i) defines an account-based group health plan as "an employer-provided group health plan that provides reimbursements of medical care expenses with the reimbursement subject to a maximum fixed dollar amount for a period," and says in terms that "an HRA is a type of account-based group health plan." Being a group health plan means the Affordable Care Act's market reforms apply, including the bar on annual dollar limits for essential health benefits and the requirement to cover preventive services without cost sharing. An arrangement that pays a fixed dollar amount cannot satisfy those requirements by itself, which is why an HRA generally has to be integrated with other coverage that does. There are two integration routes: with the employer's own group health plan, which is the traditional design, or with individual health insurance coverage or Medicare, which is the individual coverage HRA.

The same regulation draws the boundary for the whole family. After defining the category it adds: "an account-based group health plan does not include a qualified small employer health reimbursement arrangement, as defined in section 9831(d)(2)." The statute is blunter still, providing at section 9831(d)(1) that "the term 'group health plan' shall not include any qualified small employer health reimbursement arrangement." So an ordinary HRA and an individual coverage HRA are group health plans, and a QSEHRA is expressly not one. Almost every difference between them, which market reforms apply, whether integration with other coverage is required, and whether Congress had to cap the arrangement in dollars, falls out of that line.

Four species, and where each is defined. The traditional integrated HRA is the arrangement Notice 2002-45 describes, sitting alongside the employer's own group health plan, with no statutory dollar cap. The individual coverage HRA at 26 C.F.R. 54.9802-4 is integrated instead with the employee's own individual coverage or with Medicare, and likewise has no statutory cap. The qualified small employer health reimbursement arrangement at Internal Revenue Code section 9831(d) is the one that is not a group health plan at all, and it is capped in dollars by statute with the cap indexed each year. And an excepted benefit HRA, defined at 26 C.F.R. 54.9831-1(c)(3)(viii), is a narrower arrangement treated as a limited excepted benefit rather than as coverage, which is a separate subject this site does not yet cover.

What an HRA may and may not reimburse. Notice 2002-45 restricts benefits to expenses for medical care as defined in section 213(d), each of which must be substantiated. It may not reimburse an expense that was deducted under section 213 in a prior year, nor one incurred before the HRA existed or before the employee enrolled. It may reimburse premiums for accident or health coverage, including for current employees, retirees and COBRA qualified beneficiaries, which is why an HRA is a natural vehicle for retiree health benefits. And the notice is strict about cash: an HRA does not qualify for the income exclusion "if any person has the right to receive cash or any other taxable or non-taxable benefit under the arrangement other than the reimbursement of medical care expenses," and where that right exists every distribution to everyone becomes taxable, including the ones that did reimburse real medical bills.

Who may be covered, and who may not. Reimbursements are excludable for current and former employees, including retirees, their spouses and dependents, and the spouses and dependents of deceased employees. The notice then closes a door small-business owners walk into constantly: "the term 'employee' does not include a self-employed individual as defined in § 401(c)." A sole proprietor and a partner are self-employed individuals under that section, so an HRA cannot give them tax-free reimbursements on their own account. An owner working through an S corporation lands in the same place by a different route: section 1372 provides that for employee fringe benefit purposes the S corporation is treated as a partnership and any shareholder owning more than 2 percent of its stock is treated as a partner.

A vocabulary trap worth naming. Notice 2002-45 also says that where the maximum reimbursement reasonably available is not substantially in excess of the value of the coverage, an HRA is a flexible spending arrangement as defined in section 106(c)(2). That is a different statutory phrase from the health flexible spending account most people mean, which is a salary-reduction benefit inside a cafeteria plan under section 125. The two share a name and almost nothing else: one is funded by the employer and can carry forward, the other is funded by the employee's own salary and is subject to the use-it-or-lose-it rule.

1. The employer adopts a written plan setting the maximum reimbursement for a coverage period, who is eligible, and which medical care expenses the arrangement will pay.

2. The employer decides how the HRA is integrated. With its own group health plan, or with individual coverage or Medicare as an individual coverage HRA. A small employer with no group plan may instead adopt a QSEHRA, which is a different statutory creature.

3. The employee incurs a medical care expense and submits it with substantiation. Nothing is deducted from their pay at any point.

4. The arrangement reimburses up to the remaining maximum, tax-free to the employee and deductible to the employer.

5. Unused amounts carry forward if the plan provides for it, increasing the maximum available in the next coverage period. There is no forfeiture at year end of the kind a health flexible spending account imposes.

6. Employment ends and the promise generally ends with it, unless the plan continues access or COBRA continuation coverage applies to the arrangement.

A hypothetical showing why carryover changes the arithmetic. Ana's employer funds an HRA with $2,000 a year, alongside a group plan with a $3,000 deductible.

In year one Ana has $1,200 of covered expenses. The HRA reimburses all of it, and 2,000 − 1,200 = $800 carries forward. Her available maximum for year two is therefore 800 + 2,000 = $2,800.

In year two she has a procedure and meets the full $3,000 deductible. The HRA pays $2,800 of it and she pays 3,000 − 2,800 = $200 herself. Under a health flexible spending account of the same size with no carryover, the unspent $800 from year one would have been forfeited and she would have paid $1,000 in year two instead. A health FSA carryover, where a plan offers one at all, is capped at a small annual limit and cannot be combined with a grace period; an HRA's carryover has no statutory ceiling. The figures are illustrative; the carryover is the feature.

Pros

• Costs the employee nothing. Every dollar is employer money, so there is no salary reduction to elect and nothing to lose by guessing wrong.
• Unused amounts can carry forward, which removes the forecasting problem that makes a health flexible spending account uncomfortable.
• Reimbursements are excluded from income under sections 105 and 106 and are deductible to the employer, so the tax treatment is efficient on both sides.
• The employer controls its exposure, because the arrangement pays a stated maximum rather than an open-ended share of claims.
• It can reimburse premiums as well as care, which makes it flexible enough to support retirees and individual-market coverage.

Cons

• The employee owns nothing. There is no account, nothing vests, and an unused balance generally stays with the employer at separation.
• It cannot stand alone. As a group health plan it has to be integrated with other coverage, which constrains how an employer may use it.
• Reimbursement requires substantiation of each expense, which is real administrative work for a small employer.
• Self-employed individuals, including partners and more-than-2-percent S corporation shareholders, cannot be covered on a tax-favored basis.
• Allowing any right to cash under the arrangement destroys the exclusion for everyone in it, not just for the person with the right.