Are Health Savings Accounts Right For You and Your Employees?
The new Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (“Act”) permits eligible individuals to establish Health Savings Accounts (HSAs) starting January 1, 2004. HSAs are similar to Archer Medical Savings Accounts (“Archer MSAs”) as well as Individual Retirement Accounts (“IRAs”). They offer tax-sheltered savings like an IRA, and withdrawals for qualified medical expenses are tax-free. After a beneficiary attains the age of 65, withdrawals for anything other than qualified medical expenses (which continue to be tax-free) are treated the same as distributions from traditional IRAs.
Like an Archer MSA, an HSA is established for the benefit of an individual, is owned by the individual, and is portable. Therefore, an employee who establishes an HSA while working for one employer takes the account with him when he switches employers or leaves the workforce. Archer MSAs have not been used extensively because eligibility is limited to the self-employed and employees of small businesses.
The Act permits an employee to make pre-tax contributions to HSAs through a cafeteria plan as well as after-tax contributions outside a cafeteria plan which are deductible “above-the-line” when a covered beneficiary is covered under a high-deductible health plan. Employers may also contribute to HSAs, and such contributions are excluded from the employee’s gross income and deductible to the employer. HSA funds may be accumulated over the years or distributed on a tax-free basis to pay or reimburse qualified medical expenses.
Why Should Employers Care About HSAs?
HSAs may help reduce health care premium costs and give employees the ability to manage their own health care and health care costs.
HSAs are portable and owned by the individual; they go with the employee when the employee leaves. As such they can be viewed as a benefit, especially for those who do not have significant, current health problems.
Employees receive tax-free treatment on contributions, investment growth, and withdrawals for “qualified medical expenses.”
Employers do not have to determine whether HSA funds are used for “qualified medical expenses.” The determination is the employee’s responsibility.
HSAs will be more attractive to employees than Flexible Spending Accounts (“FSA”) which also allow employees to make pre-tax contributions to pay for medical expenses. FSA contributions do not earn interest, and employees must “use them or lose them.”
HSAs will be attractive to employees because they offer a variety of investment options, including savings accounts and mutual funds.
Unlike Archer MSAs, no limit on group size exists. HSAs are available to the self-employed as well as individuals covered under a large group plan.
Who May Establish an HSA?
An “eligible individual” can establish an HSA. An “eligible individual” means an individual who:
- Is covered under a high deductible health plan (“HDHP”) on the first day of the month in which contributions are made;
- Is not also covered by any other health plan that is not an HDHP (with certain limited exceptions);
- Is not entitled to benefits under Medicare (has not reached the age of 65); and
- May not be claimed as a dependent on another person’s tax return.
What Is a “High Deductible Health Plan”?
Definition: An HDHP is a health plan that satisfies certain requirements with respect to deductibles and out-of-pocket expenses.
Self-only coverage: An HDHP has an annual deductible of at least $1,000 and annual out-of-pocket expenses required to be paid (deductibles, co-payments and other amounts, but not premiums) not exceeding $5,000.
Family coverage: An HDHP has an annual deductible of at least $2,000 and annual out-of-pocket expenses required to be paid not exceeding $10,000. For family coverage, a plan is an HDHP only if, under the terms of the plan and without regard to which family members incur expenses, no amounts are payable from the HDHP until the family has incurred annual covered medical expenses in excess of the annual deductible.
Preventive care: A plan is not an HDHP merely because it has no deductible (or a small deductible) for preventive care. Except for preventive care, a plan may not provide benefits for any year until the deductible for that year is met.
Network plans: A network plan is a plan that generally provides more favorable benefits for services provided by its network of providers than for services provided outside of the network. In the case of a network plan, the out-of-pocket expense limits for services provided within the network are the only limits that count towards the maximum annual out-of-pocket expense limits allowed for an HDHP. Further, the annual contribution limit is determined by reference to the deductible for services within the network.
Other health coverage that makes an individual ineligible: Generally, an individual is ineligible for an HSA if the individual, while covered under an HDHP, is also covered under a health plan (as individual, spouse, or dependent) that is not an HDHP.
Other health coverage that does not affect individual eligibility: The following types of insurance are called “permitted insurance” and do not affect individual eligibility: coverage under insurance for workers’ compensation, tort liabilities, liabilities relating to ownership or use of property, as well as insurance for a specified disease or illness, and insurance that pays a fixed amount per day (or other period) of hospitalization. Accident, disability, dental care, vision care and long-term care insurance coverage likewise does not affect individual eligibility.
Self-insured medical reimbursement plans: A self-insured medical reimbursement plan sponsored by an employer can be an HDHP.
How Does an Individual Establish an HSA?
An eligible individual can establish an HSA with a qualified HSA trustee or custodian in much the same way an individual establishes an IRA or Archer MSA. Any insurance company or bank can be a trustee or custodian. An eligible individual may establish an HSA with or without the involvement of the employer. The HSA can be established through a qualified trustee or custodian who is different from the HDHP provider. The trustee or custodian may require proof or certification that the account beneficiary is an eligible individual, including that the individual is covered by a health plan that meets all of the requirements of an HDHP.
How Are Contributions to an HSA Made?
Who makes contributions: Any eligible individual may contribute to an HSA. For an HSA established by an employee, the employee, the employee’s employer or both may contribute to the HSA of the employee in a given year. Family members may also make contributions to an HSA on behalf of another family member as long as the other family member is an eligible individual.
How much can be contributed: The maximum annual contribution is the sum of the limits determined separately for each month, based on status, eligibility and health plan coverage as of the first day of the month. For 2004, the maximum monthly contribution for eligible individuals with self-only coverage under an HDHP is 1/12 of the lesser of 100% of the annual deductible under the HDHP or $2,600. For eligible individuals with family coverage, the maximum monthly contribution is 1/12 of the lesser of 100% of the annual deductible under the HDHP or $5,150. All contributions made by or on behalf of an eligible individual are aggregated for purposes of applying the limit. The annual limit is decreased by the aggregate contributions to an Archer MSA. Unlike Archer MSAs, contributions may be made by or on behalf of eligible individuals even if the individuals have no compensation or if the contributions exceed their compensation. If an individual has more than one HSA, the aggregate annual contributions to all the HSAs are subject to the limit.
Catch-up contributions for individuals between the ages of 55 and 65: For individuals (and their spouses covered under the HDHP) between ages 55 and 65, the HSA contribution limit is increased by $500 in calendar year 2004. This catch-up amount will increase in $100 increments annually until it reaches $1,000 in calendar year 2009. The catch-up contribution is also computed on a monthly basis. After an individual has attained age 65 (the Medicare eligibility age), contributions, including catch-up contributions, cannot be made to an individual’s HSA.
Contribution limit for one or both spouses that have family coverage: In the case of married individuals, if either spouse has family coverage, both are treated as having family coverage. If each spouse has family coverage under a separate health plan, both spouses are treated as covered under the plan with the lowest deductible. The contribution limit for the spouses is the lowest deductible amount, divided equally between the spouses unless they agree on a different division.
Form of contributions: Contributions to an HSA must be made in cash.
Tax treatment of contributions by individuals: Contributions are deductible by the eligible individual in determining gross income (“above the line”). The contributions are deductible whether or not the eligible individual itemizes deductions. Contributions made by a family member on behalf of an eligible individual are deductible by the eligible individual in computing adjusted gross income, whether or not the eligible individual itemizes deductions.
Tax treatment of employer contributions: In the case of an employee who is an eligible individual, employer contributions to the employee’s HSA are treated as employer-provided coverage for medical expenses under an accident or health plan and are excludable from the employee’s gross income. The employer contributions are not subject to withholding from wages for income tax or subject to FICA, FUTA or the Railroad Retirement Act. Contributions to an employee’s HSA through a cafeteria plan are treated as employer contributions. The employee cannot deduct employer contributions on his federal income tax return as HSA contributions or as medical expense deductions.
Tax treatment of an HSA: An HSA is generally exempt from tax like an IRA or Archer MSA unless is ceases to be an HSA. Earnings on amounts in an HSA are not includable in gross income while held in the HSA.
When contributions may be made: Contributions for the taxable year can be made in one or more payments, at the convenience of the individual or employer, at any time prior to the time prescribed by law for filing the individual’s federal income tax return without extensions (generally April 15). Although the annual contribution is determined monthly, the maximum contribution may be made on the first day of the year.
Excess contributions: Contributions by individuals to HSAs are not deductible to the extent they exceed the applicable limit. Contributions by an employer to an HSA for an employee are included in the gross income of the employee to the extent that they exceed the applicable limits or if they are made on behalf of an employee who is not an eligible individual. An excise tax of 6% for each taxable year is imposed on the account beneficiary for excess individual and employer contributions. If the net income attributable to the excess contribution is paid to the account beneficiary before the last day prescribed by law (including extensions) for filing the account beneficiary’s federal income tax return, then such net income attributable to the excess contributions is included in the account beneficiary’s gross income, but the excise tax is not imposed and the distribution of the excess contributions is not taxed.
Rollover contributions: Rollover contributions from Archer MSAs and other HSAs into an HSA are permitted. Rollover contributions need not be in cash, but are subject to the annual contribution limits. Rollovers from IRAs, health reimbursement arrangements (HRAs) or from FSAs to an HSA are not permitted.
How Are Distributions From HSAs Treated?
When distributions may be received: An individual can receive distributions at any time.
How distributions are taxed: Distributions from an HSA used exclusively to pay for qualified medical expenses of the account beneficiary, his or her spouse, or dependents are excludable from gross income. This is true generally even if the individual is not currently eligible for contributions to the HSA. Amounts not used exclusively to pay for qualified medical expenses of the account beneficiary, spouse or dependent are includable in gross income, and are subject to an additional 10% tax, except in the case of distributions made after the account beneficiary’s death, disability or attaining age 65. If the account beneficiary is no longer an eligible individual (i.e., the individual is over age 65), distributions used to pay for qualified medical expenses continue to be excludable from gross income.
Qualified Medical Expenses: “Qualified medical expenses” are expenses paid by the account beneficiary, his or her spouse or dependents for medical care as defined in section 213(d) such as those costs to diagnose, cure, treat or prevent disease which may include nonprescription drugs and over-the-counter drugs, but only to the extent the expenses are not covered by insurance or otherwise. The qualified medical expenses must be incurred only after the HSA has been established. Health insurance premiums are not qualified medical expenses except for the following: qualified long-term care insurance, COBRA health care continuation coverage, and health care coverage while an individual is receiving unemployment compensation. For individuals over age 65, premiums for Medicare Part A or B, Medicare HMO and the employee share of premiums for employer-sponsored health insurance, including premiums for employer-sponsored retiree health insurance can be paid from an HSA. Premiums for Medigap policies are not qualified medical expenses.
Who determines whether distributions are used exclusively for qualified medical expenses: Employers, trustees and custodians are not required to determine whether HSA distributions are used for qualified medical expenses. Individuals who establish HSAs make that determination and should maintain records of their medical expenses sufficient to show that the distributions have been made exclusively for qualified medical expenses and are therefore excludable from gross income.
What happens upon death: Upon death, any balance remaining in the account beneficiary’s HSA becomes the property of the individual named in the HSA instrument as the beneficiary of the account. If the surviving spouse is the named beneficiary, the HSA becomes the spouse’s HSA. The surviving spouse is subject to income tax to the extent distributions from the HSA are not used for qualified medical expenses. If the beneficiary is someone other than the surviving spouse, the HSA ceases to be an HSA as of the date of the account beneficiary’s death.
Are There Any Other Special Rules With Respect to HSAs?
Discrimination rules for employers: If an employer makes HSA contributions, the employer must make available comparable contributions on behalf of all “comparable participating employees,” those with comparable coverage, during the same period. Contributions are considered comparable if they are either the same amount or same percentage of the deductible under the HDHP. If employer contributions do not satisfy the comparability rule during a period, the employer is subject to an excise tax equal to 35% of the aggregate amount contributed by the employer to HSAs for that period.
Cafeteria plan: Both an HSA and an HDHP may be offered as options under a cafeteria plan. An employee may elect to have amounts contributed as employer contributions to an HSA and HDHP on a salary-reduction basis.
COBRA: HSAs are not subject to COBRA continuation coverage.