The Internal Revenue Service has issued a series of guidance this year regarding health savings accounts ("HSAs"), which were created as of January 1, 2004 by the new Medicare prescription drug law that was enacted last December. The IRS issued the guidance to make it easy to operate HSAs in accordance with the law and to encourage both employers and individuals to contribute to HSAs. The new law is intended to assist employers in designing their health plans on a more cost effective basis and to provide tax incentives to individuals to accumulate funds to pay future medical costs. HSAs should be seriously considered by both employers as well as individuals who are looking for ways to reduce their health care costs.
What Is An HSA?
An HSA is a tax-exempt account, similar to an IRA, which is established for the purpose of paying medical expenses of the account owner who, during the time for which contributions are made to the HSA, is covered under a high-deductible health plan ("HDHP"). Although an HSA can be established at any financial institution, many institutions do not offer them yet because they are so new. An HSA can invest in anything an IRA can invest in (e.g., stocks, mutual funds, certificates of deposit, etc.).
Who Can Establish An HSA?
Any individual can establish an HSA provided the individual: (1) is covered under an HDHP; (2) is not covered by any other health plan that is not an HDHP (except for certain types of plans that provide limited types of coverage, such as specific injury insurance, disability, dental, vision care and long-term care); (3) is not entitled to benefits under Medicare; and (4) is not claimed as a dependent on another person's tax return. Under certain circumstances, an individual who is covered under a health flexible spending account ("FSA") or health reimbursement account can also establish an HSA.
What Is A High Deductible Health Plan?
An HDHP is a health plan with a minimum annual deductible of at least $1,000 for single coverage and $2,000 for family coverage and a maximum out-of-pocket limit of $5,000 for single coverage and $10,000 for family coverage. However, a HDHP can have first dollar coverage (i.e., no deductible) for "preventive" care and also provide for higher out-of-pocket expenses (i.e., copays and co-insurance) for non-network services.
Are Prescription Drugs Subject To The Minimum Annual Deductible Under An HDHP?
Yes. An individual is not eligible to have an HSA if he or she is covered by an HDHP or separate prescription drug plan that provides prescription drug benefits before the HDHP's minimum deductible has been met. However, the IRS has issued transition relief to permit individuals to be eligible for an HSA until December 31, 2005, if they are covered by an HDHP that does not provide prescription drug benefits and by a separate plan or rider that provides prescription drug benefits before the minimum annual deductible of the HDHP is met.
What Types Of Preventive Care Can Be Offered Under An HDHP?
The IRS permits an HDHP to provide coverage, without regard to the HDHP's deductible, for periodic health evaluations, including tests and diagnostic procedures ordered in connection with routine examinations; routine pre-natal and well-child care; child and adult immunization; tobacco cessation programs; obesity weight-loss programs and screening services for various diseases and conditions, including cancer, heart and vascular diseases, infectious diseases, mental health conditions and substance abuse, metabolic nutritional and endocrine condition screening, muscular skeletal disorder screening, obstetric and gynecologic condition screening, pediatric condition screening, and vision and hearing disorder screening. However, preventive care does not include treatment for an existing illness, injury or condition.
What Are The HSA Contribution Rules And The Tax Treatment Of Such Contributions?
Contributions to an HSA may be made by either an employer or an individual, or both. Contributions can also be made, free of income and employment taxes, through an employer-sponsored cafeteria plan.
Contributions made by an individual are fully deductible to the individual, without regard to income limits.
Contributions made by the employer are tax deductible to the employer, are not taxable to an employee, and are not subject to employment taxes (i.e., FICA and FUTA).
Contributions can also be made by others to an HSA on behalf of an individual and deducted by that individual.
The maximum annual amount that can be contributed to an HSA on behalf of an individual is:
1. For individuals with self-only coverage, the lesser of 100% of the annual deductible under the HDHP, but not more than $2,600.
2. For individuals with family coverage, the lesser of 100% of the annual deductible under the HDHP, but not more than $5,150.
The maximum contribution limits will be indexed annually for cost-of-living adjustments.
Individuals who are age 55 and older may make additional "catch-up" contributions to an HSA up to $500 in 2004, $600 in 2005, $700 in 2006, $800 in 2007, $900 in 2008, $1,000 in 2009 and thereafter.
An individual is not permitted to make contributions to an HSA once he or she becomes eligible for Medicare (normally at age 65).
What Are The Rules That Govern Employer Contributions To An Employee's HSA?
Employer contributions are subject to the same contribution limits that are applicable to an individual who contributes to his or her own HSA. Contributions to an HSA by both an employee and an employer are combined for purposes of the overall contribution limits. If an employer chooses to make contributions to an employee's HSA, the employer must make "comparable" contributions on behalf of all employees participating in an HSA. Contributions are considered to be comparable if they are either the same dollar amount or the same percentage of the annual deductible under the HDHP that covers the employee. The comparability rule is tested separately with respect to part-time employees who customarily work 30 hours or less per week. Cafeteria plans are not subject to the comparability rule (but cafeteria plans are subject to a separate set of nondiscrimination rules, regardless of whether they include HSAs).
What Are The Rules That Apply To Distributions From An HSA?
Distributions are non-taxable if they are made for qualified medical expenses, including over-the-counter medications. Distributions cannot be used to pay for other health insurance coverage, except for:
COBRA continuation coverage;
health coverage while receiving unemployment compensation; and
premiums paid for Medicare and employer-sponsored retiree medical coverage (not including any Medigap premiums) while an individual is eligible for Medicare.
Distributions from an HSA that are not used to pay for qualified medical expenses are taxable income and are subject to an additional 10% tax; however, the additional tax does not apply if the distribution occurs after the HSA account-holder dies, is disabled or becomes eligible for Medicare.
When Can Contributions Be Made To An HSA?
Contributions during the year can be made in one or more payments at any time prior to the time prescribed by law for filing the individual's federal income tax return for that year (not including extensions), but not before the beginning of that year. Although the maximum annual contribution is based upon the number of months during the year in which an individual is covered by an HDHP, the maximum annual contribution may be made on the first day of the year.
Who Determines Whether HSA Distributions Are Used For Qualified Medical Expenses?
Individuals who establish HSAs must make that determination and must maintain records of their medical expenses in order to prove that distributions have been made for qualified medical expenses. HSA trustees and custodians have no obligation to determine whether a distribution is used to pay qualified medical expenses.
What Are The Advantages Of An HSA?
HSAs are advantageous because:
distributions can be used to pay: (1) non-covered services under an individual health policy or group health plan; (2) COBRA premiums; (3) medical expenses after retirement; (4) Medicare premiums and medical expenses that are not covered by Medicare; and (5) long-term care expenses;
accounts are completely portable, regardless of whether the individual is employed or not, which employer the individual works for, which state an individual moves to, age or marital status changes or future medical coverage;
no "use it or lose it rules," like FSAs;
contributions can be made on a pre-tax basis through an employer-sponsored cafeteria plan;
accounts can grow tax-deferred through investment earnings, like an IRA;
premiums for HDHP coverage should be significantly cheaper than health insurance with usual deductibles.
Are HSAs Subject To ERISA?
The U.S. Department of Labor announced in a field assistance bulletin published on April 7, 2004, that HSAs will not constitute plans that are subject to the requirements of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), even if the employer makes contributions to employees' HSAs, provided that the establishment of the HSA is completely voluntary on the part of employees and the employer does not: (1) limit the ability of employees to move their HSA account to another financial institution; (2) impose conditions on the utilization of HSA funds beyond those permitted by law; (3) make or influence the investment decisions of employees with respect to funds contributed to an HSA; (4) represent that the HSA is an employee welfare benefit plan established or maintained by the employer; or (5) receive any payment or compensation in connection with the HSA.
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Employers who are considering the establishment of "consumer-directed" health plans to help contain or reduce costs for health coverage should consider the establishment of HSAs for employees in conjunction with an HDHP. Although the rules governing HSAs are far from settled, HSAs present a new opportunity for both employers and individuals to save on their health care costs in a tax-favored manner.
John J. Hunter is a Partner in the Philadelphia office of Stradley Ronon Stevens & Young, LLP where his practice focuses on employee benefits, deferred compensation arrangements and all aspects of ERISA. Mr. Hunter can be reached at (215) 564-8072.