Cadillac tax hurricane preparation: After-tax HSA contributions

To me, the ACA Cadillac tax is like a patient, powerful hurricane moving across the Atlantic. If it makes landfall, the impact will be dramatic. While some remain hopeful that it will drift off harmlessly into the North Atlantic, I prefer to chart its course, prepare accordingly, and remain cautiously optimistic that the storm track will change. As benefits professionals know, the latest forecast from Treasury’s Hurricane Hunter Aircraft came in February via IRS Notice 2015-16. While this notice isn’t guidance or even proposed guidance, if its forecast rings true, it’s not difficult to predict the impact to most employer-sponsored plans, beginning in 2018. For example, it’s likely that:

1. Flexible spending accounts and health reimbursement arrangements will go away.

2. Employer and pretax employee contributions to health savings accounts will end.

3. Most employers will eventually need to drop all health plans except for qualified high deductible health plans.

For my employer-clients that already offer HDHPs, in addition to eliminating any employer HSA contributions, another mitigation strategy we’re discussing is discontinuing pretax employee HSA contributions via the Section 125 plan and allowing employee contributions to continue on an after-tax basis. Generally, this strategy would:

1. Allow HSA-eligible employees to continue contributing via payroll to their HSAs on an after-tax basis.

2. Retain the income-tax advantages of the HSA for the HSA-eligible employees. That is, they could deduct their HSA contributions on their IRS Form 1040s.

3. End the payroll tax advantages of the HSA for both the employee and the employer.

Our ensuing discussions have led to many astute questions, so I asked my colleague Bill Smith from our national tax office to address those of the highest concern:

Q:  Many of our highly compensated employees contribute the maximum allowable amount to their HSAs. Is there any limitation on the deductibility of these contributions?

A: Generally, individuals can deduct unreimbursed medical expenses on Schedule A of Form 1040. Those expenses, however, must exceed 10% of a taxpayer’s adjusted gross income before they are deductible (7.5% for individuals or spouses born before Jan. 2, 1950). Qualifying contributions to an HSA, however, are deductible “above the line”; in other words, they are deducted from gross income to determine adjusted gross income. Therefore, they are not reported as medical expenses on Schedule A and as a result, are not limited by the 10%/7.5% floor, nor are they subject to any income phase-outs on itemized deductions. 

Q:  What is the general payroll tax impact for an employee with an income below the Social Security wage base? How about for an employee above the wage base?

A:  If the HSA contribution was historically pretax, any employee would avoid payroll taxes on the contribution. If it switches to post-tax, the amount contributed is treated as regular compensation income subject to the “normal” payroll tax rules. So if an employee is below the wage base, including the increased compensation caused by the taxation of the HSA contribution amount, the employee will be paying payroll taxes on that amount. If the employee has already paid the maximum amount of payroll taxes for the year, the change will not have any payroll tax impact.   

Q: How does the ACA 0.9 % Medicare tax withholding factor into all of this?

A: The employee’s portion of the Medicare component of FICA taxes is increased by an additional 0.9% (to 2.35%) for wages in excess of $200,000 ($250,000 in the case of a joint return, $125,000 in the case of a married taxpayer filing separately). For a joint return, the additional tax is imposed on the couple’s combined wages. Although the employer is generally required to withhold the employee's portion from the employee's wages, the employer is not obligated to withhold the additional Medicare tax unless (and until) the employee receives wages from the employer in excess of $200,000. For this purpose, the employer is permitted to disregard the amount of wages received by the employee's spouse. Thus, because an employee may receive wages from more than one employer or because the employee's spouse may receive wages, an employee may be subject to the additional tax without the tax being withheld from the employee's wages. The employee is responsible for any portion of the additional 0.9% tax that is not withheld.

For employees subject to the 0.9% Medicare tax, their HSA contributions will be included in the amount of wages subject to the tax.

Q: What is a good way to estimate the increase to an employer’s payroll taxes if HSA contributions cease flowing through the Section 125 plan?

A: That depends on how specific the employer wants to be. It would be possible to be very accurate in estimating the impact, but if an employer is only looking for a rough number, it could take its employees’ HSA contributions and multiply them by 7.65% (capped at total compensation of $118,500 for 2015), then add 0.9% for the contributions of employees paid more than $200,000 per year. 

Zack Pace is a senior vice president, benefits consulting, at CBIZ, Inc. He can be reached at ZPace@cbiz.com. Follow him on LinkedIn and Twitter at @zpace_benefits Bill Smith is the managing director, national tax office, at CBIZ MHM, LLC.

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