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 guidance from the Internal Revenue Service (IRS) and U.S. Department of Labor (DOL) 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?
For 2004, 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. The minimum annual deductibles and maximum out-of-pocket limits will be increased each year by cost-of-living adjustments.
Disqualifying Health Coverage
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 typical health care flexible spending arrangement (FSA) or health reimbursement arrangement (HRA) (or covered by a spouse’s health FSA or HRA) will generally not be eligible to contribute to an HSA. The IRS guidance 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.
Permitted Health Coverage
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 preventive care, 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. The IRS guidance 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 guidance also indicates 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 IRS guidance also clarifies that certain types of health plan coverage will not disqualify an individual from contributing to an HSA. For example, an individual who is covered by a health FSA or HRA that only reimburses permitted coverage, such as preventive care benefits or dental or vision expenses is eligible to contribute to an HSA. In addition, an individual who is covered by an HRA or health FSA that reimburses expenses only after the statutory minimum annual deductibles are satisfied is eligible to contribute to an HSA. Also, an individual who is covered under a retiree-only HRA or a suspended HRA is eligible to contribute to an HSA.
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 HRA 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
HSAs are exempt from the COBRA provisions in the tax code, and employer-funded HSAs that are not subject to ERISA will also be exempt from the COBRA provisions in the Employee Retirement Income Security Act (ERISA). The DOL recently issued field guidance clarifying how ERISA applies to HSAs. In the DOL’s view, HSAs are personal health care savings vehicles over which individuals exercise exclusive control. The DOL believes that HSAs are arguably different from employer-funded group type insurance arrangements and should not be subject to the same ERISA rules. Accordingly, the DOL guidance provides that an employer-funded HSA will not be an ERISA plan provided that employees voluntarily adopt HSAs and the employer does not (i) limit the ability of eligible individuals to move their accounts to other HSAs; (ii) impose conditions on the use of HSA funds; (iii) make or influence investment decisions with respect to HSA funds; (iv) represent that HSAs are an employee welfare benefit plan maintained by the employer; or (v) receive any payment or compensation in connection with an HSA. An employer can, however, impose conditions on contributions that are required to satisfy tax code requirements, forward contributions through its payroll system, and limit or select HSA providers, as long as the employer does not impose restrictions beyond those in the tax code. The DOL guidance will make it easier for employers to contribute to HSAs on behalf of their employees without worrying about the fiduciary, reporting and disclosure requirements of ERISA. Guidance is still expected from the Department of Health and Human Services on whether non-ERISA HSAs are catch-all health plans subject to the privacy and security requirements of HIPAA.
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 employers will face challenges 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.