Health Savings Accounts: The New Benefits Plan?

By D. Shawn Mauldin and Patricia H. Mounce

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Flexible spending accounts (FSA) allow employees to set aside pretax dollars for reimbursement of qualified medical expenses. FSAs carry numerous restrictions, particularly the “use it or lose it” clause when part of a cafeteria plan. As a result, many employees contribute only minimal amounts to an FSA, to avoid forfeiting unused funds.

Health reimbursement accounts (HRA) are similar to FSAs, but are generally paid by employers. Unused amounts cannot be carried forward to future years, and HRAs are subject to Health Insurance Portability and Accountability Act (HIPAA) rules limiting tax-free reimbursements to expenses that would otherwise be deductible. MSAs were a short-lived attempt to overcome some of the restrictions encountered by FSAs and HRAs. Many have suggested that MSAs were not attractive because of limitations such as penalties for early withdrawal, tight contribution limitations, and ceilings on the number of accounts.

HSA Basics

Trust account. Unlike employer-held amounts in FSAs, HRAs, and MSAs, the new HSAs must be set up as a tax-exempt trust or custodial account. The IRS released model documents that trustees may use as trust or custodial agreements (Health Savings Trust Account, Form 5305-B, and Health Savings Custodial Account, Form
5305-C). The trust is set up solely to pay qualified medical expenses. HSAs differ from previous plans in that an HSA trust can be set up without employer sponsorship. The trust accounts are similar to IRAs and can be set up at banks, credit unions, insurance companies, brokerages, or other financial institutions (Damian Paletta, “Bankers Want More Details on Health Savings Accounts,” American Banker, May 2004). Because an HSA is held by a trustee rather than by an employer, an employee will not lose any amounts in the account because of a job change.

Eligibility requirements. Four primary eligibility requirements must be met for an individual to set up an HSA. First, an individual must be covered under a high-deductible health plan (HDHP), with either individual or family coverage.

Second, when an individual is also covered by a health plan that does not qualify as an HDHP, he is no longer eligible to participate in an HSA. The IRS had provided some flexibility in coverage that does not hinder an individual’s eligibility, such as insurance related to liabilities incurred under worker’s compensation law, insurance related to tort liabilities, insurance to cover liabilities relating to ownership or use of property, insurance for a specified disease or illness, and insurance to provide a fixed payment for hospitalization. Coverage for accidents, disability, dental, vision, or long-term care is also permitted.

There are several exceptions to the second requirement because of problems encountered when workers want to set up an HSA while covered under an FSA or HRA. An employee already covered by an FSA or HRA that pays or reimburses qualified medical expenses generally is not eligible to establish an HSA, but there are some exceptions.

The first exception allows a participant to suspend the HRA before the beginning of an HRA coverage period. The plan must not pay or reimburse, at any time, the medical expenses incurred during the suspension period (except for the permitted coverages listed above).

The second exception allows for post-deductible FSAs or HRAs, which cannot pay or reimburse any medical expenses incurred before a minimum annual deductible amount is met (this deductible does not have to be the same as the HDHP deductible).

The third exception allows retirees’ HRAs to pay for medical expenses. These arrangements may pay or reimburse only those medical expenses incurred after retirement; in addition, participants can no longer contribute to their accounts.

Third, an individual must be younger than 65 in order to establish an HSA. This age requirement coincides with the Medicare requirement.

Fourth, individuals who can be claimed as dependents by another person are not eligible to deduct a contribution to their HSA. Even if an individual is not actually claimed as a dependent by another, this rule holds true.

Contributions. An HSA may receive contributions on behalf of an eligible individual from the individual or any other person, including an employer or family member. One major advantage of HSAs is that contributions by individuals to their accounts are tax deductible even if the taxpayer does not itemize. Likewise, employer contributions are not included in the employee’s income. The maximum contribution for 2004 was $5,150 for family coverage and $2,600 for individual coverage. Individuals over 55 can put an additional $600 into HSAs for 2005, and that amount will increase in $100 increments annually until it reaches $1,000 in 2009. All contributions, from an individual and his employer, are reported on his Form 8889, which is filed with Form 1040. Deductible contributions are not capped at the employee’s earned income. One advantage for companies that contribute to employee HSAs is that employer contributions are not subject to employment taxes.

HSAs Compared to Other Plans

Unlike FSAs, earnings on HSAs are tax free, provided that the earnings remain in the account or are used for qualified medical expenses. An obvious improvement over previous plans is that amounts not distributed for qualified medical expenses by the end of the plan year can be carried over without negative tax consequences.

Whereas MSAs were available only to self-employed individuals and small businesses with an HDHP, HSAs are available to anyone with an HDHP. An individual participant must have a deductible of at least $1,000 ($2,000 for family coverage), but less than $5,000 ($10,000 for family coverage).

When HSAs were first introduced, taxpayers feared that other health coverage would interfere with their eligibility because of low-deductible items within an HDHP or coverage under other insurance policies. The IRS has provided guidance on items that do not hinder the eligibility of a participant. Preventive healthcare costs for periodic health evaluations, such as annual physicals, routine prenatal care, and well-child care, are covered on a low-deductible basis by an HDHP plan without jeopardizing the tax benefits of an HSA. In addition, various screening services—including those for cancer, heart, and vascular diseases; infectious diseases; obstetric and gynecological conditions; mental health conditions and substance abuse; and many others—may be covered without hindering the plan. Smoking-cession and obesity weight-loss programs may also be covered.

Like older accounts, withdrawals from HSAs used to pay for or reimburse qualified medical expenses of the account owner, spouse, and qualified dependents are tax-free. Qualified medical expenses include expenses that would qualify for the medical and dental deduction. Because the “use it or lose it” rule does not apply to HSAs, withdrawals can be made for postretirement qualified health expenses. Withdrawals for purposes other than medical expenses are subject to income tax, and, if distributed prior to age 65, death, or disability, withdrawals are also subject to an additional 10% tax.

HSA participants can roll over amounts from MSAs or other HSAs within 60 days after the date of receipt. Participants can make only one rollover contribution to an HSA during a one-year period. Rollover contributions do not have to be made in cash and are not subject to the annual contribution limits. Participants may not, however, roll over into an HSA amounts from an IRA, HRA, or FSA.

Retirement and Estate Planning Considerations

Other positive aspects of HSAs include retirement and estate planning considerations. Once an individual reaches 65, distributions may be made for any purpose without incurring the additional 10% tax. Once an individual reaches Medicare eligibility, however, tax-free contributions are not allowed. When an HSA holder dies, assuming the beneficiary is a spouse, the account becomes the spouse’s HSA. If the beneficiary is not a spouse, the account ceases to be an HSA and the beneficiary will not be limited by HSA rules. The beneficiary is, however, taxed on the fair-market value of the assets, reduced by any qualified medical expenses paid by the beneficiary for the decedent within one year of death. If the HSA holder’s estate is the beneficiary, the account value is included in the individual’s final tax return.

Drawbacks to HSAs

One negative aspect for employers contributing to HSAs is the provision for immediate vesting, and employee freedom to withdraw funds for nonmedical purposes (J. Geisel, “Government HSA Guidance Expected to Answer Key Questions, Boost Use,” Business Insurance, June 2004). Although these distributions are taxable to the employee and subject to a 10% penalty, employees might be willing to pay the penalty to receive the employer-provided funds.

A second drawback is the complex rules governing HSAs (Geisel, 2004). For example, when both spouses are covered by HDHPs, or when one spouse enters the HSA during the year, a complex set of rules must be followed. Another complexity is that Form 8889 must be filed if any activity occurred during the year, even if the taxpayer’s employer made contributions to the HSA.

A third downside to HSAs is that contributions must be made in cash. Individuals or employers cannot contribute assets, such as stock. As previously mentioned, an exception to this rule is rollover contributions from MSAs or other HSAs.

Finally, HSA providers often charge high fees for opening or closing accounts, as well as for each transaction. The high fees may not translate into higher savings or more services (Kaja Whitehouse, “Fees of Health Savings Accounts Draw Scrutiny of Consumers,” The Wall Street Journal, July 20, 2005).

Pros and Cons of HSAs

HSAs have been highly debated in Washington. Opponents argue that HSAs have the potential to undermine the healthcare system, will do little more than add another tax shelter for the wealthy, and will increase the number of uninsured Americans if they encourage some employers to drop healthcare coverage for workers (J.B. Finkelstein, “New Health Savings Account Perk Pushed,” American Medical News, June 2004). In addition, critics say they will not help the uninsured working poor, who do not have discretionary cash to contribute to HSAs.

Proponents of HSAs counter that, in the long run, the plans will reduce an employer’s health costs and are “consumer-directed,” designed to let a participant select the timing and level of health expenditures (R.B. Barker and K.P. O’Brien, “Health Savings Accounts: Many Issues, Fewer Solutions,” Benefits Law Journal, Summer 2004). The growing popularity of HSAs is evidenced by the increased number of employers who are adding this option to their employee benefit plans. A survey by the U.S. Chamber of Commerce found that two-fifths of the 1,000 employers surveyed were likely to offer an HSA in 2005, and almost three-quarters indicated that they were likely to do so in 2006 (Finkelstein, 2004). The number of HSAs reached 391,000 in 2005, and some experts expect the number to reach 6.3 million by 2008 (Lee Conrad, “For the Enterprising, Health Savings Funds Are Anything But Bitter Medicine,” USBanker, June 2005).

Rising healthcare costs and health insurance premiums affect most Americans. Individuals and businesses look for remedies to balance adequate medical coverage with affordable plans. For CPAs advising businesses on how to minimize costs while providing maximum employee benefits, HSAs represent a new tool. HSAs may prove to be a useful way to supplement high-deductible health insurance and give employees a tax-favored benefit.