QUESTION: Our company offers a high-deductible health plan (HDHP), and many participants contribute to their own HSAs. Several have asked about making HSA contributions on a pre-tax basis so they can receive income tax savings every payroll period (instead of waiting until they file their tax returns) and avoid paying FICA taxes on those contributions. Our company could also save its share of FICA taxes on the contributions. Do we need a Code § 125 cafeteria plan to do this, or can we just set up pre-tax payroll deductions for our employees without a cafeteria plan?
ANSWER: Your employees cannot make pre-tax HSA contributions unless your company offers a Code § 125 cafeteria plan. That’s because of the constructive receipt doctrine, which applies whenever an employee is offered a choice between a nontaxable benefit (e.g., HSA contributions) and a taxable benefit (e.g., cash or regular pay). Constructive receipt treats employees, for tax purposes, as having elected the taxable benefit, regardless of their actual choice. (In other words, the taxable benefit that employees could have elected would have to be included in their gross income.) Code § 125 provides an exception to that doctrine if the choice between nontaxable benefits and taxable cash or regular pay is offered under a cafeteria plan.
HSA contributions made through a cafeteria plan are excludable from employees’ gross income and will not be subject to federal income tax withholding or FICA (Social Security and Medicare), FUTA (federal unemployment), or RRTA (Railroad Retirement Tax Act) taxes. (You’ll need to check on state or local withholding requirements.) Code § 125 imposes various legal requirements on cafeteria plans. For example, the plan must (1) be in writing; (2) describe who is eligible to participate; (3) specify the available benefits (such as pre-tax HSA contributions); (4) allow participants to change their HSA contribution elections at least monthly (and upon loss of HSA eligibility); and (5) satisfy certain nondiscrimination requirements.
If your company processes payroll deductions for employees’ HSA contributions without setting up a cafeteria plan, it will have to treat those contributions as taxable compensation subject to all applicable withholding requirements, and it will still be responsible for paying the employment taxes. (Employees can still take an above-the-line deduction on their individual tax returns for their HSA contributions.) Employers that fail to treat payroll deductions made without a cafeteria plan as taxable compensation will be liable not only for unpaid employment taxes, but also interest and penalties. There is also the risk of criminal prosecution for a knowing failure to report and pay the taxes.
For more information, see EBIA’s Consumer-Driven Health Care manual at Section XVIII.B (“HSAs Offered Through Cafeteria Plans”). See also EBIA’s Cafeteria Plans manual at Sections III (“Why Have a Cafeteria Plan?”), VII (“Overview of Cafeteria Plan Legal Requirements”), and XVI.K (“Special Considerations for HSAs Offered Through Cafeteria Plans”).