By now, many employers have chosen to offer employees a high-deductible health plan (HDHP) along with a Health Savings Account (HSA). One interesting issue that’s arisen is, at some organizations, employees have asked whether they can make pretax HSA contributions.
Doing so would enable them to save on income taxes every pay period rather than wait to enjoy those savings when they file their tax returns. In addition, both employees and employers could save on their respective shares of Federal Insurance Contributions Act (FICA) (Social Security and Medicare) taxes.
The question is, can an employer simply set up pretax payroll deductions for employees without having a Section 125 cafeteria plan in place?
Constructive Receipt Doctrine
The answer is a resounding “no.” Employees can’t make pretax HSA contributions unless the employer offers a Section 125 cafeteria plan because of the constructive receipt doctrine, which applies whenever an employee is offered a choice between a:
- Nontaxable benefit, such as HSA contributions, and
- Taxable benefit, such as cash or regular pay
Constructive receipt treats employees 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 incomes. Section 125 provides an exception to this doctrine if the choice between nontaxable benefits and taxable cash or regular pay is offered under a cafeteria plan.
Section 125 Requirements
HSA contributions made through a cafeteria plan are excludable from employees’ gross incomes. The contributions won’t be subject to federal income tax withholding or FICA, Federal Unemployment Tax Act (FUTA), or Railroad Retirement Tax Act (RRTA) taxes. State or local withholding requirements may vary.
Section 125 imposes various legal requirements on cafeteria plans. For example, the plan must:
- Be set forth in writing
- Describe who’s eligible to participate
- Specify the available benefits, such as pretax HSA contributions
- Allow participants to change their HSA contribution elections at least monthly and upon loss of HSA eligibility
- Satisfy certain nondiscrimination requirements
If an employer 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 applicable withholding requirements. And the employer will still be responsible for paying the employment taxes. Employees could 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 can be held liable for unpaid employment taxes, interest, and penalties. There’s even a risk of criminal prosecution for knowingly failing to report and pay the taxes. Contact our firm for help assessing the advantages, risks, and costs of any employee benefits you’re considering.