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New IRS Guidance on Health Reimbursement Accounts

Over the last several years, "defined contribution health plans" have been in the news as a way for employers to reduce health plan costs. In many of these plans, an employer-funded "account" is established for each participant. The participant receives reimbursements from the account for medical expenses incurred, and any unused amount is carried over to the next year. Many benefits professionals hesitated to advocate the use of such plans because of concerns that the Internal Revenue Service would prohibit the carry over feature. The carry over feature is expressly prohibited in health care flexible spending accounts (FSAs). However, in June, the IRS issued guidance (Notice 2002-45 and Revenue Ruling 2002-41) on what it refers to as Health Reimbursement Accounts (HRAs), and explicitly permitted the carry forward of unused amounts to later years.

The IRS guidance provides that HRAs may: (1) only be funded by an employer and (2) only reimburse substantiated medical expenses incurred by employees, former employees, and their dependents, up to a dollar amount specified by the HRA, with unused amounts carried over to another plan year. Unused amounts may not be cashed out. If the arrangement qualifies as an HRA, the employer's contributions to the HRA, and the reimbursements from the HRA, will not be taxed to the participant.

Employer Funding. An HRA must be entirely employer funded. The employee is not permitted to make contributions to an HRA, either through salary reduction or otherwise.

Order of Payment. The existing rules on FSAs provided that a medical expense may not be reimbursed from an FSA if it may be reimbursed under any other health plan. However, under the new guidance, an HRA may provide that reimbursement under the HRA is available only after medical expenses exceeding the dollar amount of any health FSA have been paid, so long as that rule is adopted by the HRA before the FSA plan year begins. This means that a participant who is covered by both an FSA and an HRA may use the FSA first, and thereby maximize the carryover from the HRA, but only if the HRA documents are drafted properly.

Medical Expenses. An HRA may reimburse medical expenses incurred by employees, former employees, or their dependents. The medical expenses must be deductible under Internal Revenue Code Section 213. In addition to medical expenses, the HRA may make reimbursement for insurance and COBRA premiums. However, the HRA may not reimburse expenses incurred before the HRA was in existence, before the employee enrolled in the HRA, or if a deduction under Code Section 213 was previously taken.

Eligibility. Eligible persons include employees and former employees and their spouses and dependents. Therefore, former employees may continue to receive reimbursements for medical expenses incurred after termination of employment. HRAs are not available to self-employed individuals.

Employers may have multiple arrangements and structure them differently (e.g., provide a bigger benefit to certain employees) so long as the arrangements meet nondiscrimination requirements.

Carryover. There is no maximum amount that an employer is permitted to reimburse through an HRA. Unlike an FSA, an employee may carry over unused HRA amounts to later plan years. Also unlike FSAs, the HRA funding is not required to be available at all times. For example, if the employer "funds" the HRA at $100 per month, an employee would not have $1,200 available at the beginning of a plan year. Finally, expenses may be reimbursed in a different plan year than they are incurred.

Cash Out. No cash outs are permitted. The IRS guidance specifically provides that adjustments of compensation which take into account unused balances are impermissible either during or at the termination of employment (e.g., payment of an unused account balance characterized as severance). If a cash option is available, all distributions to all participants are taxable (and the employer would be liable for FICA and FUTA on the distributions), even if the distributions were, in fact, used to reimburse medical expenses.

Other Laws. HRAs are subject to COBRA. An individual who elects COBRA must continue to receive the maximum reimbursement amount at the time of the qualifying event, as well as any increase that is given to employees who are not on COBRA but are otherwise similarly situated.


September 30, 2002




Kellner, Robert C.
Mellin, Matthew P.