Adjusting HSA Contributions to Pass Nondiscrimination Testing

This column is an excerpt (Question 150) from a book to be published later this year to help guide account owners, employers, benefits managers, and administrators understand Health Savings Account compliance issues. The format consists of a common question, an explanation in easy-to-understand English (often with an appropriate example), and citation from government documents to support the answer. The book is designed to inform. It is not a legal document, and the contents should not be construed as legal advice.

Question: We just ran nondiscrimination testing on our Health Savings Account contributions, and we didn’t pass. What do we do now?

 Answer: The answer depends on whether you ran a preliminary test early in the year and again tested the plan at year-end, or just at year-end (which is the required timing).

A best practice is to test the plan at the beginning of the plan year. That way, if your program doesn’t pass, you can adjust employee elections to bring it into compliance. If your plan fails an early plan-year test, you may place a limit on contributions that certain key and highly compensated employees can make through the Cafeteria Plan (also called a Section 125 Plan to reflect the relevant section of the Internal Revenue Code).

 Example: You contribute $1,500 to employees with family coverage. You test the plan early in the year and find that highly compensated employees are contributing $7,050 (the $8,550 statutory maximum in 2025 less the company’s $1,500 contribution), whereas lower-paid employees are funding their accounts at much lower levels. You calculate the maximum pre-tax contribution that you can allow and meet the nondiscrimination standard. For example, allowing employees to contribute no more than $4,000 via salary deferral may bring your program back into compliance. If they want to deposit more, they can do so outside the Cafeteria Plan with personal, tax-deductible contributions.

 When a Health FSA or Dependent Care FSA plan fails the nondiscrimination testing and a similar adjustment is made, participants lose the ability to enjoy additional tax benefits. Not so for Health Savings Account owners. Although they may have to limit their salary deferrals through the Cafeteria Plan, they can make personal contributions to ensure that they deposit up to their maximum contribution. They can then deduct those personal contributions on their personal income tax returns. The only downside for them is that neither they nor the company can recoup the payroll (FICA) taxes paid on the money when earned. Remember, though, that the payroll tax is only $1.45 (each, employee and company) on incomes above $169,600 (2024 figure).

If you test the plan after the end of the plan year and discover that it didn’t pass, the correction is less clean. You must determine the maximum contribution through the Cafeteria Plan that would have kept the plan in compliance. You must then reclassify any additional contributions as taxable income. If you’ve already issued Form W-2 to employees, you must create and distribute a revised document to each affected employee to change the figure in Box 12 (see Question 142). Those employees can then reclassify the remainder of their pre-tax payroll contributions as a personal contribution and deduct that amount on their personal income tax returns.

Depending on timing, affected employees may have to refile the prior year’s return. That’s an inconvenience that serves as another reason to test the plan soon after the beginning of the plan year and adjust elections so that the plan is compliant.

Testing early in the year doesn’t provide perfect protection. If the participation changes during the year (new employees enroll and current enrollees leave the company, many workers adjust their contribution upward or downward, or the company acquires or divests a business unit), a plan that passed the test early in the year may end up failing by the end of the year. It may be wise to test several times during the year if your company has a large reduction in force or hiring spree or buys or sells a business.

Testing during the plan year to proactively address issues that lead to failure is optional. The end-of-year test is required.

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.

HSA Question of the Week is published every week, alternating every other Wednesday with HSA Wednesday Wisdom and every other Monday with HSA Monday Mythbuster.