Comprehensive commentary by attorney John J. McFadden, co-author of Tools and Techniques of Employee Benefit and Retirement Planning . 

Here's John's very practical and comprehensive commentary on HSAs!  I think you'll agree that this information is a great way to start the new year!

EXECUTIVE SUMMARY:

Health Savings Accounts (HSAs) are an extension and expansion of the existing Archer Medical Savings Accounts (MSAs) which expire after 2003 for new MSAs (existing MSAs are grandfathered).  

HSAs are intended to provide a tax exemption for amounts accumulated to pay health care expenditures. 

The two major features are

FACTS:

In 1996 Congress enacted a pilot program for a new approach to providing tax benefits for health care expenses called the Medical Savings Account (MSA). This was also called an Archer MSA after one of the sponsors. 

The MSA program was extended through 2003.  It was limited to small businesses (50 or fewer employers) and the program was to be closed once 750,000 taxpayers were covered. 

The results of this program were inconclusive and coverage never reached the 750,000 limit.  However, the Congressional sponsors were committed to the concept and as part of the recent Medicare Prescription Drug Act of 2003, the idea behind Archer MSAs was expanded and made permanent in the form of the Health Savings Account or HSA.   No new Archer MSAs can be adopted after 2003, but existing ones are grandfathered.  The new HSA provisions are summarized here.

ELIGIBILITY FOR  COVERAGE:

The only requirement for eligibility is that the individual must be covered under a high-deductible health plan.  There is no restriction to small businesses, and in fact, HSAs do not have to be linked to a business at all, and can be adopted by any individual who qualifies.

A high deductible health plan is a plan (it can be insured or noninsured) that has

The individual covered under a high deductible plan is not eligible if he is also covered under a non-high deductible plan. For example, an individual is not eligible for HSA coverage if his spouse has a non-high deductible plan that covers him. 

The individual can be eligible for an HSA even though covered by certain types of  “permitted insurance” that don’t have high deductibles; these include coverage for accidents, disability, dental care, vision care, long-term care, workers’ compensation, hospitalization insurance paying a certain sum per day of hospitalization, and insurance for a specified disease or illness. 

Also, a plan including low deductible or first-dollar coverage for “preventive care” (not yet spelled out by the IRS) can qualify as a high-deductible plan.  Certain network plans are eligible as high deductible plans even though out-of-pocket limits for out-of-network coverage are higher than the $5,000/$10,000 limits.

WHO IS ELIGIBLE – AND WHO IS NOT?

An individual covered under Medicare is not eligible for an HSA. Thus, HSA contributions generally must cease after the attainment of age 65.

An individual who may be claimed as a dependent on another person’s tax return is not eligible for an HSA.

An HSA plan can be adopted by an employer for employees, or an individual may adopt it on his own.  If an employer adopts an HSA for employees, there does not seem to be any requirement for coverage of any minimum percentage of employees or prohibition against a plan that covers only highly-compensated employees.  However, there is a “comparability” requirement for employer contributions, discussed below.

CONTRIBUTION LIMITATIONS:

The maximum contribution to an HSA is a monthly limit.  For coverage during the full year 2004, the annual monthly limits add up to $2,600 for an individual and $5,150 for a family. 

DANGER:  The aggregate annual contribution limit is technically the lesser of (a) the above dollar amount or (b) the high-deductible plan’s annual deductible!   So for the maximum financial planning benefit, it would be best to have a deductible at least equal to the maximum contribution amount.
 
The contribution limit is a per-individual (or family) limit, and all HSAs covering the individual are aggregated for this purpose. 

There is a “catch-up” addition of $500 (for 2004) for individuals aged 55 or older.  The catch-up is scheduled to increase by $100 each year until it reaches $1000 in 2009. 

If a spouse participates in an individual’s plan, the basic limit is equal to the family limit, and each spouse aged 55 or over is eligible for a separate catch-up (that is, $5,150 plus $500 plus $500 for 2004--$6,150 total). 

No contributions (regular or catch-up) can be made after the individual reaches age 65 and becomes eligible for Medicare.  Excess contributions are treated similarly to excess IRA contributions.

WHO CAN MAKE CONTRIBUTIONS – AND HOW:

Contributions can be made

(1) directly by an individual;

(2)  through salary reductions under an employer cafeteria (Section 125) plan; or

(3)  directly by employers.

TAX, FICA , AND FUTA  TREATMENT:

Contributions made by an individual are deductible “above the line” (that is, regardless of whether the individual itemizes deductions).  (The individual can’t double-dip by taking an itemized medical expense deduction for contributions or benefit payments.) 

Contributions by the employer (types 2 and 3) are deductible by the employer, not taxable to the employee, and not subject to FICA and FUTA taxes (social security and federal unemployment).

An individual can make contributions to an HSA for a family member who is eligible—for example, a son or daughter who needs some financial support.  The eligible son or daughter in this case would take the deduction for the HSA contribution.  However, as noted above, an individual who may be claimed as a dependent on another person’s tax return is not eligible for an HSA.
 

FUNDING:

HSA plans must be funded.  Funds are held with a qualified trustee or custodian, similar to IRAs.  The establishment of the fund requires no IRS permission or involvement of an employer.  Contributions must be in cash.  The HSA fund is not subject to income tax.  The fund may not be invested in life insurance contracts, but otherwise investments are not restricted.

The trustee or custodian of an HSA is not required to provide the high-deductible health insurance, but it is expected that marketers will sell the two products (insurance and investment account) in tandem to make the package more attractive.  Based on some experience with Archer MSAs, it is likely that investment firms will take the marketing lead on these plans, viewing them as a way to increase assets under management.
 

NO LIMIT ON PLAN ACCUMULATIONS:

Amounts in the account can accumulate without limit.  If they are not used each year for qualified medical expenses, they are not forfeited. Neither do unused amounts reduce the participant’s contribution limit in the future.  Whatever amount remains in the HSA account when the participant reaches age 65 is treated much like an IRA accumulation thereafter, except that it can be used tax-free to pay medical expenses in the future (see below).
 

PLAN BENEFITS:

Participants in HSAs can use the funds in their plans to pay for qualified medical expenses for themselves, their spouses, and dependents.  Distributions from the plan for this purpose are not taxable to the participants. 

“Qualified medical expense” means any expense eligible for an itemized medical expense deduction under Code Section 213(d).  This is a very broad category of expenses including some items that are almost never covered under health insurance, such as special schools for children with psychological conditions, or heated swimming pools for arthritics.  Cosmetic surgery, however, is not included. 

Of course, no more can be paid from the plan than the amount in the participant’s account.

NO TIME LIMITS ON WITHDRAWAL OF FUNDS:

A covered individual can withdraw funds from his HSA at any time. 
 

TAXATION OF WITHDRAWALS.

The distributions are tax-free to the extent used to pay for qualified medical expenses, even if the medical expenses are paid at a time when the individual is not eligible for HSA coverage, for example after he has reached age 65.

Distributions other than for qualified medical expenses are taxable and subject to a 10% penalty.  However, the 10% penalty does not apply if the distribution is made after the account beneficiary’s death, disability, or attainment of age 65.  

DOCUMENTATION:

Individuals (not plan trustees or employers) are responsible for proving that amounts are paid for qualified medical expenses and the IRS probably will provide a form for this purpose.


HOLE IN COVERAGE:

An HSA plan together with its companion high-deductible insurance plan could have a fairly significant “doughnut hole” in its coverage.  For example, if a family high-deductible insurance plan limits out-of-pocket expenses to the maximum of $10,000, there is a potential gap of $4,850 (assuming no carryovers from prior years in the HSA fund) that must be paid out-of-pocket with no tax benefit except presumably the possibility of an itemized deduction under Section 213.
 

DISCRIMINATION RULES:

HSAs are subject to the same nondiscrimination requirement that applies to Archer MSAs.  That is, if an employer makes a contribution to an employee’s plan, the contributions must be “comparable” for all ”comparable participating employees.”

This rule does not appear to require the plan to cover a nodiscriminatory group of employees; that is, coverage could be restricted only to a group of highly-compensated employees, so long as contributions within the group met the comparability standard. 

The question has been raised whether the Section 125 (cafeteria plan) nondiscrimination rules would apply if the HSA is part of a cafeteria plan.  This question was left open in the most recent IRS guidance on HSAs  (Notice 2004-2).  There is also some question whether the Section 105(h) rules could apply if the employer self-insures the high-deductible plan.  Future guidance is expected from the IRS and will, of course, be covered by LISI.

In assessing whether there is an “executive benefit loophole” in the HSA provisions, it is well to keep in mind that health insurance in general is not subject to nondiscrimination rules of any kind.  An employer can already provide health insurance only for executives, or provide better coverage for executives than for employees generally.  Such plans are limited only by the ability to find a carrier that will underwrite them. 

The HSA provisions as such do not appear to add much to this opportunity.  In addition, if an employer decides to adopt a high deductible-HSA plan in lieu of conventional insurance, it is likely that only the higher-paid employees will participate in the HSA feature if they must contribute to the HSA either directly or by salary reductions.

Most employees will not have enough discretionary income to make significant HSA contributions.  Thus the plan will in effect be largely for key employees.

ALTERNATIVES TO HSAs

Since HSAs add to -  rather than replace - other arrangements (even existing Archer MSAs are grandfathered rather than terminated), we’re left with an alphabet soup of possible health plans for employees, in addition to all the variations on conventional health insurance. 

There’s no space here for describing them all in detail (see Tools and Techniques of Employee Benefit and Retirement Planning (800 543 0874) for detailed discussions) but the following chart should help in gaining some perspective on the options now available to the employer.

COMMENT:

PROS:

HSAs could provide employers a way to save health insurance costs or offer an exit strategy for high cost plans. 

They also have potential value for self-employed individuals and their families, or as an alternative to conventional individual health insurance plans for those not covered under employer plans. 

HSAs do offer some tax-saving opportunities to individuals who are eligible for them or can arrange eligibility by having a high-deductible plan.  If an individual is eligible for an HSA and has enough discretionary income to make contributions, it appears that there is little reason not to set up the HSA and make contributions. 

Funds are not forfeited for non-use as in FSA-type cafeteria arrangements, and excess funds will simply accumulate as an extra retirement fund. 

There is no actual requirement that these funds be used to pay the participant’s medical expenses. An annual contribution of $5,000 will grow to more than $400,000 after 30 years at 6%; this is nothing to sneeze at. 

The 10% penalty for early distributions has fewer exceptions that that for IRAs, however, so the HSA fund is not quite as flexible as an IRA.  However, a participant in an employer’s qualified plan can contribute to an HSA (but not an IRA) regardless of his income.

CONS:

HSAs do not appear to add much to the techniques available for providing  benefit plans tailored to selected executives, but this is not entirely clear at this time.  HSAs also do not seem likely to substantially extend health insurance coverage to people who are currently uncovered.

At this point, nobody can predict the effect of the new HSA provision on the overall health-care market.  The pilot program represented by the old Archer MSA provisions from 1996 to 2003 was inconclusive. Its limit of 750,000 covered individuals was not nearly met, and the impact was unclear.

Although employers have an opportunity to save money on health insurance by adopting high deductible plans along with HSAs, the downside is that lower-income employees are likely to see this change as a drastic cut in benefits, and they may not feel they have enough discretionary income to make adequate contributions to the HSA ($400-plus monthly for a family). 

This is exacerbated by the fact that taxpayers in lower brackets get less tax benefit from the tax deduction/exclusion of the HSA contributions (the benefit may be zero for the very lowest-paid who pay no income taxes).  Also, the possible doughnut-hole in coverage discussed above will have its primary impact on families who use up most of their HSA accounts each year.  Thus, the amount of health costs that must be funded by the general public may increase as these employees utilize emergency rooms and other publicly-subsidized facilities.

In addition, health-insurance economists have argued that if an employer offers an HSA/high-deductible plan as an option to regular health insurance, there will be “adverse selection,” since younger, healthier, and higher-income employees will choose the HSA, resulting in skyrocketing premiums for the regular insurance covering the older and sicker members of the group and the eventual disappearance of such coverage. 

On the plus side is the hope expressed by the proponents of HSAs that if people use what they see as their own money for health care expenditures, they will shop wisely and the free market will optimize health care costs.  We don’t know whether this will happen or whether, as pessimists would predict, people will put off going to the doctor until their condition requires really costly medical intervention.

EDITOR'S NOTE:

"Qualified medical care" includes expenses and premiums for long-term care insurance.  Annual tax deductions for such premium payments are currently limited as follows (IRC Section 213(d)(10)): 

Individuals ages

40 or less are limited to $200;

50 or less are limited to $375;

60 or less are limited to $750;

70 or less are limited to $2,000; and

Older than 70 are limited to $2,500. 

AALU (Association for Advanced Life Underwriting) concluded that such premium payments are similarly so limited for HSA purposes based on an intricate set of cross-references imbedded primarily in Revenue Code sections 213(d), 223(d), 7702(a)(4) and 7702B(b) and (c) and on informal discussions with Treasury Department officials.   

This limitation may effectively

    (i)     delay use of HSA distributions for long-term care insurance premiums, or,

    (ii)  slow down the acceptance of long-term care insurance by HSA owners. 

AALU gave this example: 

"Individuals currently eligible for Medicare may not establish an HSA, but persons not so eligible (i.e., under age 65) may establish an HSA and may continue to use HSA distributions to pay for qualified medical expenses until death (i.e., individuals who become Medicare-eligible after establishing an HSA may continue to use HSA amounts that have built up over the years.) 

Generally, younger individuals are less likely to purchase long-term care insurance, and older individuals who are close to Medicare-eligibility (e.g., in their 50s and early 60s) have limited years to build up their HSA account balances in order to pay for the cost of such premiums. 

Younger persons who need immediate long-term care services will have little opportunity to increase their usage of long-term care premiums through HSAs." 

Bottom Line:  Although the new rules permit HSA distributions to be used to pay for long-term care insurance premiums, such use may be inhibited by these same rules. 

CONCLUSION:

Health care economics is anybody’s bet these days, but there could be some real opportunities for individual tax savings through HSAs.

Latest HSA update 3/30/2004