FSAs and HSAs may get run over by Cadillac Tax
Even though Congress is trying to repeal the “Cadillac Tax” (the Affordable Care Act’s 40 percent nondeductible penalty on employer-based healthcare that exceeds specified annual costs), employers still need to be looking ahead to the 2018 effective date of the Cadillac Tax when considering their long-term health plan design strategy. One aspect of the Cadillac Tax flying under many employers’ radar is the fact that employer contributions and pre-tax employee contributions to medical flexible spending accounts (FSAs) and health savings accounts (HSAs) are included when calculating the value of coverage made available to an employee. This means that the amount of employer contributions an employee receives and the amount of pre-tax employee contributions an employee elects to make to an FSA are included when calculating the value of coverage received by the employee. Similarly, the amount of employer contributions an employee receives and the amount of pre-tax employee contributions an employee elects to make to an HSA are included when calculating the value of an HSA-qualified health plan in which the employee is enrolled.
The benefit of FSAs was already reduced for many employees after the ACA imposed an annual limit on maximum FSA contributions ($2,550 for 2015). Before the ACA, the annual limit on FSA contributions was determined only by the employer’s appetite for the risk exposure resulting from the FSA requirement that the full amount of an employee’s annual FSA election had to be available as of the first day of the plan year. Now that FSA contributions will be included when calculating the Cadillac Tax, the expectation is that many employers will reduce the annual maximum FSA contributions below the IRS limit, or eliminate their FSAs completely, to avoid paying the Cadillac Tax on employees’ FSA contributions. Because FSAs give employees the ability to pay for medical expenses on a pre-tax basis when the employee would not be eligible to deduct those medical expenses as an itemized deduction (because the employee’s medical expenses don’t exceed 10 percent of the employee’s adjusted gross income), employers’ reduction or elimination of their FSAs will increase the payroll and income tax burden on most employees.
Fortunately, after-tax employee contributions to HSAs will not be included for purposes of the Cadillac Tax, so employers currently allowing employees to make payroll deduction contributions to HSAs could simply change those contributions from pre-tax to after-tax; employees can also elect to make after-tax HSA contributions on their own. Employees making after-tax HSA contributions can still take an “above the line” deduction on their individual federal income tax returns for those HSA contributions, regardless of their income. However, unlike pre-tax HSA contributions, employees will be subject to FICA taxes on their after-tax contributions. And, if the employer does not offer payroll deduction for after-tax HSA contributions, some employees may lack the fiscal discipline to make after-tax HSA contributions on their own.
Inclusion of pre-tax FSA and HSA contributions in the Cadillac Tax calculation is specified in Section 4980I of the Internal Revenue Code, so legislative action will be necessary to remove those contributions from the calculation if the Cadillac Tax is not repealed entirely. Employers need to keep an eye on Congress’s actions in this area when planning for addressing the Cadillac Tax in 2018 and beyond.