The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 established a new type of tax-favored individual account health plan, known as a health savings account (HSA), effective for tax years beginning on or after December 31, 2003. The new HSAs are much like IRAs or Archer Medical Savings Accounts (MSAs) because they are funded, portable and belong to the individual. Recently issued IRS guidance clarifies the statutory rules, but imposes some significant restrictions on HSA plan design. Only time will tell if HSAs will revolutionize the delivery of health care in the United States or merely serve as tax-savings vehicles.
What Is an HSA?
An HSA is a tax-exempt trust or custodial account established to pay any qualified medical expenses of the account holder and his or her tax dependents. An HSA must be trusteed by a bank, insurance company or other non-bank trustee approved by the IRS. In order to establish and contribute to an HSA, an individual must be covered by a high deductible health plan (HDHP) and not covered under any other type of health plan with certain exceptions.
What Are HDHPs?
An HDHP is an insured or self-insured health plan with a minimum annual deductible of at least $1,000 for single coverage or $2,000 for family coverage. In addition, the maximum out-of-pocket limit under the HDHP cannot exceed $5,000 for single coverage or $10,000 for family coverage. A health plan will qualify as an HDHP if the plan imposes no deductible for preventive care or if the plan contains a network feature with higher deductible and out-of-pocket limits for out-of-network services.
An individual cannot contribute to an HSA if the individual is covered (as an individual, a spouse or a dependent) under a health plan that is not an HDHP and provides coverage for benefits covered under the HDHP. So an individual covered by a prescription drug carve-out or a typical health care flexible spending arrangement (FSA) (or covered by a spouse’s health FSA) will generally not be eligible to contribute to an HSA. But an individual can have certain types of health plan or insurance coverage and still be eligible to contribute to an HSA. For example, an individual with coverage for disability, accidents, dental care, vision care or long-term care will not be disqualified from contributing to an HSA. Other types of permitted insurance coverage include workers’ compensation, automobile insurance, specific disease insurance, such as cancer insurance, and per diem hospitalization insurance.
Contributions to an HSA
Subject to specified limits, contributions to an HSA are excluded from income and wages if made by an employer and/or deductible above the line if made by an individual. Employees may also contribute to an HSA on a pre-tax basis through an employer-sponsored cafeteria plan. Unlike Archer MSAs, both employers and employees may contribute to an HSA in a given year, subject to the applicable contribution limits.
The maximum annual contribution to an HSA for 2004 is the lesser of the HDHP’s annual deductible or $2,600 for single coverage and $5,150 for family coverage.
If an individual reaches age 55 before the end of the year, the maximum annual contribution increases by specified amounts, starting at $500 in 2004 and increasing to $1,000 in 2009.
If an individual becomes covered under an HDHP in the middle of the year, his or her annual limit is determined by dividing the maximum annual contribution by the number of full months of eligibility.
Contributions cannot be made for individuals who are eligible for Medicare or who may be claimed as a dependent on another person’s tax return. Contributions to an HSA in excess of the statutory limits are subject to a 6 percent excise tax, unless the excess amount is distributed to the individual.
If an employer contributes to HSAs for its employees, the employer must make comparable contributions on behalf of all employees with comparable coverage (i.e., single or family coverage) during the same period. Contributions are considered comparable if they are either the same dollar amount or the same percentage of the deductible. The comparability rule does not apply to HSA contributions made through a cafeteria plan. Employer contributions that fail to satisfy the comparability requirement are subject to a 35 percent excise tax.
Distributions from an HSA
Distributions may be made from an HSA at any time. If they are used to pay qualified medical expenses, they are excluded from an individual’s gross income. A “qualified medical expense” includes any amount paid for medical care, including certain non-prescription drugs. Generally, distributions from an HSA cannot be used to pay health insurance premiums. However, certain health insurance premiums are treated as qualified medical expenses, including COBRA premiums, long-term care insurance premiums, health plan premiums paid while an individual is receiving unemployment compensation and premiums paid while an individual is eligible for Medicare (including retiree health plan contributions, but excluding Medicare supplemental coverage).
Distributions not used to pay qualified medical expenses are taxable and subject to an additional 10 percent penalty tax. The penalty tax does not apply if the individual dies, becomes disabled or is eligible for Medicare. Distributions from an HSA are not included in income or subject to the penalty tax if rolled over to another HSA within 60 days. An HSA may also accept rollover distributions from another HSA or from an Archer MSA, but not from an IRA, a health reimbursement arrangement (HRA) or a health care FSA. Special rules apply to distributions from an HSA upon an individual’s death or divorce.
Earnings on the amounts contributed to an HSA grow tax-free and do not have to be distributed upon termination of employment or death. As a result, individuals who are able to make contributions to an HSA without taking distributions may accumulate substantial amounts to pay for post-retirement medical benefits or simply to defer the taxation of income.
Impact of Other Laws on HSAs
While HSAs are exempt from the COBRA provisions in the tax code, an employer-funded HSA may be subject to the COBRA provisions in the Employee Retirement Income Security Act (ERISA). In addition, it is likely that an employer-funded HSA or one offered through a cafeteria plan is a group health plan for purposes of ERISA and the Health Insurance Portability and Accountability Act (HIPAA), thereby subjecting the HSA to ERISA’s reporting, disclosure and fiduciary requirements and HIPAA’s nondiscrimination, portability and administrative simplification requirements. It is also unclear how the cafeteria plan rules will apply to HSAs funded through cafeteria plans. More guidance is needed from the U.S. Department of Labor and the IRS on these issues.
To its great credit, the IRS has moved quickly to provide guidance on HSAs. General guidance issued in December 2003 clarified the statutory provisions, and solicited public comments on a variety of open issues. More specific guidance issued in March 2004 provides a safe harbor definition of preventive care that includes, but isn’t limited to, periodic health evaluations and related tests, routine prenatal and well-child care, child and adult immunizations, tobacco cessation and weight loss programs, and a variety of screening services. The IRS also indicated that preventive care doesn’t include services or benefits intended to treat an existing illness, injury or condition. State benefit mandates that fail to satisfy this requirement won’t be treated as preventive care, making it difficult for insurance carriers to offer fully insured HDHPs in certain States.
The March guidance also clarifies that individuals are not eligible to make HSA contributions if simultaneously covered by an HDHP that doesn’t cover prescription drugs and a separate prescription drug plan (or rider) that is not an HDHP. But the guidance also provides generous transition relief, indicating that these individuals won’t be precluded from making HSA contributions until January 1, 2006. Finally, the March guidance also includes a special rule permitting HSAs established on or before April 15, 2005 to reimburse medical expenses incurred prior to that date.
Additional IRS guidance is expected by June 2004 which will address, among other things, whether individuals are eligible to make HSA contributions if simultaneously covered by a Health FSA or an HRA, and whether employers may comply with the comparable contribution requirements if they make matching contributions or age-based contributions to employee HSAs.
Implications for Employers
HSAs will be an intriguing option for employers that have adopted or are considering adopting consumer-choice health plans. Many of these plans already rely on the combination of a high-deductible plan and an individual health account, typically an HRA financed exclusively by an employer. While some employers may not want to pre-fund a nonforfeitable account that an employee can take upon termination of employment, other employers may find HSAs to be a solution for their retiree medical dilemmas.
HSAs offer an interesting opportunity to create an alternative type of individual account--one that is truly portable, includes carryover features and need not be tied to employment. The ability to offer HSAs as a nontaxable benefit under a cafeteria plan will also present employers with potential FICA tax savings opportunities. But the initial IRS guidance suggests that employers may face certain difficulties in integrating the new HSA model with existing consumer-choice designs that rely on HRAs. Employers will want to review their health care strategies and consider whether HSAs are the right choice for them.