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Navigating FSA Grace Period and Carryover when Transitioning to an HSA

Health Savings Accounts are one of the most popular trends in the healthcare industry today.  More and more employers look to save money in an environment of increasing costs by offering their employees a lower-premium, high-deductible health care plan.  One of the key components in making a high-deductible plan attractive is the employees’ ability to contribute to a Health Savings Account.  Health Savings Accounts offer wonderful tax savings to those who contribute to them.  It is not surprising, therefore, that the Federal Government imposes rules that govern the use of HSAs.  Employers that oversee their employees’ transition from a traditional plan to a high-deductible plan must use caution to ensure that they do not run afoul of any HSA rules.  This is especially true if the employer offers a Flexible Spending Account to its employees and doubly true if the FSA plan offers a $500 carryover provision.

One of the key rules related to HSA eligibility is the “other insurance” rule.  This rule states that a participant is only eligible to contribute to a Health Savings Account if they are covered by a qualifying high-deductible healthcare plan and no “other (non-qualifying) insurance” plan.  A Flexible Spending Account qualifies as “other insurance” for the purposes of this rule.

Grace Period

There are two basic end-of-plan-year designs for an FSA.  The first design features a “grace period.”  An FSA grace period allows participants to continue using FSA funds from the prior plan year during a period of time in the new plan year.  This period is typically 75 days but can be shorter.  Even if the participant does not make a new FSA election during the new plan year—and why would they, they’re moving to an HSA—then leftover grace period dollars will affect their HSA eligibility.  Even if a single penny of FSA money is available on the first day of the grace period, the participant is not eligible to contribute to their HSA account until after the end of the grace period.  There are two ways to ensure that a participant transitioning from an FSA plan with a grace period to an HSA plan is eligible to contribute to the HSA as of the first day of the new plan year.  The first way is for the employee to exhaust all of their FSA funds prior to the end of the old plan year.  If funds are exhausted, there will be no funds remaining in the grace period to affect HSA eligibility.  The second way to ensure HSA eligibility from day one of the new plan year is for the participant to voluntarily forfeit any remaining FSA funds as of the last day of the old plan year.  Executing this second method will require careful coordination with the third-party administrator (TPA) of the FSA plan.  Employers will need to provide a list of employees to their TPA who wish to voluntarily forfeit their funds to the plan.


The second basic end-of-year plan design for an FSA allows participants to carry up to $500 into the new plan year.  Employers need to exercise extreme caution when transitioning their participants from this type of FSA plan to an HSA plan.  This is because the coverage period for an FSA plan is one full year.  Even if a single penny carries over from the old plan year to the new plan year without making adjustments, the participant will be ineligible to contribute to an HSA for the entirety of the next year.  There are three methods for ensuring HSA eligibility for participants making the transition.  The first, as with a plan with a grace period, is to exhaust the FSA funds prior to the last day of the old plan year.  The second, again, is for participants to voluntarily forfeit remaining FSA funds as of the last day of the old plan year.

A third method, which is unique to FSA plans with the carryover provision, is to have the funds carry forward into a Limited Purpose Flexible Spending Account.  An LFSA allows participants to pay for vision and dental expenses with LFSA funds and does not violate the “other insurance” rule.  It is possible to allow participants with remaining general FSA funds to carry those funds into an LFSA for the new plan year so that those participants are eligible to contribute to their new HSA as of the first day of the new plan year.  Implementing this procedure requires careful coordination with the FSA plan TPA.  Employers will need to provide the TPA with the list of employees who wish to carry the funds into an LFSA plan.  This method may also require an amendment to the Cafeteria Plan Document so that an LFSA account is added as an available benefit.

Coordinating the transition from a traditional plan with an FSA to a high-deductible plan with an HSA can be a complicated process.  The key to success is to know the rules and to coordinate carefully with the TPA administering the FSA and HSA plans.  National Benefit Services has been helping its clients navigate these kinds of situations for 30 years.  When it comes to bringing employees on to an HSA plan, we’ve got you covered.

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