If an employer wants to offer employees pretax payroll deferrals to their health savings accounts, the employer needs tofirst create a Section 125 plan or cafeteria plan that allowsHSA deferrals.

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A cafeteria plan is the only way for employers to offeremployees a choice between taxable and nontaxable benefits,“without the choice causing the benefits to become taxable,” theIRS says. “A plan offering only a choice between taxable benefitsis not a Section 125 plan.”

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Here are five things to know about HSAs and Section 125plans.

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1. A Section 125 plan is just one of several ways foremployers to help employees with funding their HSAs.

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Employers offering HDHPs face the choice of whether and how tohelp their employees with the funding of the employees' HSAs. Theoptions include the following:

  • Option 1 – Employee after-tax contributions.Employers are not required to help with the employees' HSAs and maychoose not to. In this case, employees may open HSAs on their ownand receive the tax deduction on their personal income tax return.This option allows for income tax savings, but not payroll taxes. Avariation on this option is for employers to allow for post-taxpayroll deferral (basically, direct deposit of payroll funds intoan HSA without treating the deposit any differently than otherpayroll which may also be directly deposited into an employee'spersonal checking account).

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    This does not change the tax or legal situation, but it doesprovide convenience for employees and will likely increase HSAparticipation and satisfaction.

  • Option 2 – Employee pretax payroll deferral.Employers can help employees fund their HSAs by allowing for HSAcontributions via payroll deferral. This is inexpensive and can beaccomplished by adding a Section 125 cafeteria plan with HSAdeferrals as an option. Employers benefit by not having to paypayroll taxes on the employees' HSA contributions. Employees savepayroll taxes as well. Plus, HSA contributions are not counted asincome for federal, and in most cases, state income taxes. Settingup automatic payments generally simplifies and improves employeesavings.

  • Option 3 – Employer-funded contributions.Employers may make contributions to their employees' HSAs without aSection 125 plan if the contributions are made directly. Thecontributions must be “comparable,” basically made fairly (with alot of rules to follow). This type of contribution is taxdeductible by the employer and not taxable to the employee (notsubject to payroll taxes or federal income taxes and in most cases,not subject to state income taxes either).

  • Option 4 – Employer and employee pretaxfunding. Employers can combine options 2 and 3, where theemployer makes a contribution to the employees' HSAs and theemployer allows employees to participate in a Section 125 plan andenabling them to defer a portion of their pay pretax into an HSA.This is a preferred approach for a successful HDHP and HSA program,as it ensures that employees get some money into their HSA throughthe employer contribution and allows for the best tax treatment toallow for employees to contribute more on their own through payrolldeferral.

  • Options for more tax savings. Some employers gobeyond these options to increase tax savings even more. Although anumber of strategies exist to increase tax savings, using alimited-purpose FSA (or HRA) is a common one. Generally, FSAs arenot allowed with HSAs; however, an exception exists forlimited-purpose FSAs. Limited-purpose FSAs are FSAs limited topayments for preventive care, vision and dental care. This providesmore tax savings and employees use the FSA to pay for thelimited-purpose expenses (dental and vision) and save the HSA forother qualified medical expenses.

HRAs can also be used creatively in connection with HSAprograms. The HRA cannot be a general account for reimbursement ofqualified medical expenses, but careful planning can allow for alimited-purpose HRA, a postdeductible HRA, or other special typesof HRAs.

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2. There are several benefits for an employer using aSection 125 plan combined with an HSA.

  • Employees can make HSA contributions through payroll deferral ona pretax basis.

  • Employees may pay for their share of insurance premiums on apretax basis.

  • Employers and employees save payroll taxes (7.65 percent each onFICA and FUTA for contributions).

  • Employers avoid the “comparability” rules for HSA contributionsalthough employers are subject to the Section 125 plan rules.

3. The employer is responsible for administering theSection 125 plan.

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For payroll deferral into an HSA through a Section 125 plan, theemployer must reduce the employees' pay by the amount of thedeferral and contribute that money directly into the employees'HSA.

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The employer may do this administration itself or it may use apayroll service or another type of third-party administrator. Inany case, the cost of the Section 125 plan itself and the ongoingadministration are generally small and offset, if not entirelyeliminated, by employer savings through reduced payroll taxes.

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Another administrative element is the collection of Section125/HSA payroll deferral election forms from employees. Employersthat have offered Section 125 plans prior to introducing an HSAprogram are familiar with this process.

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Unlike other Section 125 plan deferral elections, which onlyallow annual changes, the law allows for changes to the HSAdeferral election as frequently as monthly.

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Although frequent changes to the elections create a smalladministrative burden on the employer, the benefit to employees issignificant. Employers are not required to offer changes morefrequently than annually.

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The full extent of the administrative rules for Section 125plans is beyond the scope of this discussion.

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4. Contributions to HSAs under Section 125 plans aresubject to nondiscrimination rules.

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A cafeteria plan must meet nondiscrimination rules. The rulesare designed to ensure that the plan is not discriminatory in favorof highly compensated or key employees.

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For example, contributions under a cafeteria plan to employeeHSAs cannot be greater for higher-paid employees than they are forlower-paid employees. Contributions that favor lower-paid employeesare not prohibited.

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The cafeteria plan must not: (1) discriminate in favor of highlycompensated employees as to the ability to participate (eligibilitytest), (2) discriminate in favor of HCEs as to contributions orbenefits paid (contributions and benefits test), and (3)discriminate in favor of HCEs as measured through a concentrationtest that looks at the contributions made by key employees (keyemployee concentration test). Violations generally do not result inplan disqualification, but instead may cause the value of thebenefit to become taxable for the highly compensated employees orkey employees.

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The nondiscrimination rules predate the creation of HSAs and howthe rules apply to HSA contributions is an area where additionalgovernment guidance would be welcome.

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5. An employer needs a Section 125 plan to allow for HSAcontributions through payroll deferral.

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Can an employer allow for HSA contributions through payrolldeferral without a Section 125 plan? No, not if the goal is to savepayroll taxes. Employers can offer HSA payroll deferral on anafter-tax basis without concern over the comparability rules or theSection 125 plan rules. Amounts contributed under this method aretreated as income to the employee and are deductible on theemployee's personal income tax return. The lack of any special taxtreatment for this approach makes it unattractive for mostemployers and with just a small additional investment of money andtime, a Section 125 plan could be added allowing for pretaxdeferrals.

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Here is an example: Waving Flags, Inc. does not offer healthinsurance or a Section 125 plan to its employees. Waving Flags doesprovide direct deposit services to its employees that provide itwith their personal checking account number and bank routingnumber. Maggie, an employee of Waving Flags, Inc., approaches thehuman resources person and asks to have her direct deposit splitinto two payment streams with $100 per month being directlydeposited to her HSA and the balance of her pay being depositedinto her personal checking account. She provides Waving Flags theappropriate account and routing numbers and signs the properelection forms.

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Waving Flags is not subject to the Section 125 nondiscriminationrules for pretax payroll deferral, nor is Waving Flags subject tothe HSA comparability rules. Waving Flags is simply paying Maggieby making a direct deposit into her HSA. The $1,200 Maggie electsto have directly deposited to her HSA in this manner will bereflected in Box 1 of her IRS Form W-2 from Waving Flags asordinary income. She will be subject to payroll taxes on theamount. She can claim an HSA deduction on line 25 of her IRS Form1040 when she files her tax return.

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Maggie benefits from this approach by setting up an automaticcontribution to her HSA, which often improves the commitment tosavings. Most HSA custodians will offer a similar system that HSAowners can set up on their own by having their HSA custodianautomatically draw a certain amount from a personal checkingaccount at periodic intervals. Employer involvement is notnecessary. Individuals with online banking tools available to themmay be able to set it from their personal checking account as wellto push money periodically to an HSA.

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