Limited-Purpose Health FSA

A limited-purpose health FSA is an employer-sponsored flexible spending arrangement whose written plan document restricts what it may reimburse, so that being covered by it does not disqualify the employee from contributing to a health savings account. Everything else about it is an ordinary health flexible spending account: the employee elects an annual amount before the plan year, the money comes out of pay before tax, the whole election is available from the first day, and what is not spent is forfeited.

The restriction is the entire point, and it exists because of an eligibility test. Internal Revenue Code section 223(c)(1)(A) makes someone an eligible individual for a month only if they are covered by a high deductible health plan and are not, while covered by it, covered by any other health plan that is not a high deductible plan and that "provides coverage for any benefit which is covered under the high deductible health plan." A general-purpose health flexible spending account reimburses exactly those benefits, so it counts as disqualifying coverage. Narrow what the arrangement is permitted to reimburse and the conflict disappears, which is what a limited-purpose design does.

What the envelope actually is. Revenue Ruling 2004-45 describes a limited-purpose health FSA as one "that pays or reimburses benefits for 'permitted coverage' (but not through insurance or for long-term care services)," and adds that "the limited-purpose health FSA or HRA may pay or reimburse preventive care benefits. The individual is an eligible individual for the purpose of making contributions to an HSA because these benefits may be provided whether or not the HDHP deductible has been satisfied." Permitted coverage is the list disregarded by section 223(c)(1)(B)(ii): "coverage (whether through insurance or otherwise) for accidents, disability, dental care, vision care, long-term care, or telehealth and other remote care." Publication 969 states the same boundary from the other direction, saying these arrangements "can pay or reimburse the items listed earlier under Other health coverage except long-term care" and can also reimburse preventive care.

So the categories a limited-purpose health FSA may lawfully cover are wider than the two everybody names: accidents, disability, dental, vision, and telehealth and other remote care, plus preventive care, with long-term care carved out. The long-term care exclusion is not an oversight; section 125(f)(2) separately provides that a cafeteria plan's "qualified benefit" does not include "any product which is advertised, marketed, or offered as long-term care insurance."

Why almost every plan is dental and vision anyway. Revenue Ruling 2004-45's own facts describe arrangements that pay "only vision and dental expenses," plus preventive care, and that is what employers have built. Those two categories are the ones employees spend on predictably and in amounts worth electing, and confining the plan to them makes administration and substantiation simple. The distinction matters when you are reading your own plan document rather than a summary: what your account will reimburse is whatever the document says, and the document is generally narrower than the law allows.

The post-deductible sibling, and the combination. The same revenue ruling blesses a second design: "a post-deductible health FSA or HRA that does not pay or reimburse any medical expense incurred before the minimum annual deductible under section 223(c)(2)(A)(i) is satisfied." That arrangement can reimburse ordinary medical expenses, but only after the statutory minimum deductible has been met. The ruling adds that the arrangement's own deductible "need not be the same as the deductible for the HDHP, but in no event may the HDHP or other coverage provide benefits before" that statutory minimum is satisfied. The two designs can be combined: the ruling says expressly that "if an employer offers a combined post-deductible health FSA and a limited-purpose health FSA, this would not disqualify an otherwise eligible individual from contributing to an HSA."

The timing rule that catches people switching plans. Health savings account eligibility is tested month by month, so a general-purpose health flexible spending account is disqualifying for every month it is in force, not merely for the months claims are paid. That includes a grace period running into the new year, with one escape written into the statute: section 223(c)(1)(B)(iii) disregards "coverage under a health flexible spending arrangement during any period immediately following the end of a plan year of such arrangement" during which unused amounts may still be used, if "the balance in such arrangement at the end of such plan year is zero" or the individual makes a qualified health savings account distribution of the remaining balance. Someone moving from a general-purpose account to a high deductible plan with an HSA should therefore care about the balance on the last day of the plan year, not just the plan year's end date. A carryover works the same way: money carried into a new plan year in a general-purpose account is coverage in the new year.

A spouse's election counts. The disqualifying coverage does not have to be yours. A general-purpose health flexible spending account held by a spouse that is able to reimburse your expenses breaks your eligibility, because the test asks what you are covered by rather than what you elected. Switching that account to a limited-purpose design solves the problem for both of you.

What does not change. The limited-purpose design narrows what the money can buy and nothing else. The employee salary reduction limit under section 125(i) is the same, currently $3,400; the whole annual election is available on day one; the election is locked for the year except in specified circumstances the plan chooses to permit; and unspent money is forfeited unless the plan offers a carryover, capped at $680, or a grace period, and never both.

1. The employer's plan document defines the restriction, naming the categories the account may reimburse. In most plans that is dental, vision and preventive care.

2. The employee elects an annual amount during open enrollment, exactly as with a general-purpose account, and it is withheld before federal income tax and payroll taxes.

3. The employee stays eligible for a health savings account, because the restricted account does not cover benefits the high deductible plan covers.

4. Claims are reimbursed from the flexible spending account for the permitted categories, and everything else is paid from the health savings account or out of pocket.

5. Unspent money is forfeited at year end, subject to whichever relief the plan offers, and eligibility for the following year turns on the balance on the last day of the plan year where a grace period runs.

A hypothetical, showing the saving. Owen expects $1,200 of orthodontia next year and elects that amount to his limited-purpose health FSA. Assume a 22 percent federal marginal rate and the 7.65 percent employee share of Social Security and Medicare tax, and ignore state income tax. The combined rate the election escapes is 22% + 7.65% = 29.65%, so the saving is $1,200 × 0.2965 = $355.80. He pays the orthodontist the same $1,200 either way; the difference is that $1,200 of his pay was never taxed. The rates are stipulated for the illustration and depend on his actual bracket and wage base position.

The same year, the part that is easy to get wrong. Owen also contributes to a health savings account. Had he elected the employer's general-purpose account instead, he would have been ineligible to contribute to the health savings account for every month that account was in force, including a grace period running into January and February unless his balance was zero on the last day of the plan year. The limited-purpose election is what lets him do both in the same year.

Pros

• It is the one flexible spending design that coexists with a health savings account, so an employee can use pre-tax money for dental and vision without giving up health savings account contributions.
• The whole annual election is available from the first day of the plan year, which turns a known expense early in the year into interest-free financing.
• Contributions escape federal income tax and payroll taxes, so the saving is larger than an income tax deduction of the same size.
• It can be combined with a post-deductible arrangement, which the governing revenue ruling blesses expressly.

Cons

• The restriction is real. Ordinary medical claims are not reimbursable from it, however much is sitting in the account.
• The plan document is usually narrower than the law allows, and there is no route to widen it as an individual.
• It carries the same forfeiture rule as any other health flexible spending account, and estimating a year of dental and vision spending is guesswork for anyone without a scheduled procedure.
• The election is locked for the year except in circumstances the plan chooses to permit.
• Switching from a general-purpose account still costs health savings account eligibility for the months the old account was in force, including a grace period unless the balance was zero at plan year end.
• Not every employer offers one, and no employee can create one.