HSA's Latest Tool for Combating High Health Care Costs
he Medicare Prescription Drug, Improvement, and Modernization Act of 2003 signed into law on December 8, 2003 did more than just revamp the Medicare Prescription Drug Plan, it authorized the creation of Health Savings Accounts ("HSAs") beginning in 2004 to help individuals and employers fight the ever-increasing cost of health care. Similar to an Archer Medical Savings Account, an HSA basically allows an individual that is covered by a high-deductible health plan whether as an employee, spouse or self employed individual, to establish an HSA and make tax deductible contributions to the account to be used to pay for medical expenses not otherwise covered under the health plan. The account's earnings are tax-free and withdrawals used for medical expenses are tax-free. HSA's will allow employers, especially small employers, to offer a less expensive, high-deductible health plan which employees can supplement with an HSA. If an individual does not use all of the money in the account for a given year it rolls over, for future years. Even better, the entire account balance may be withdrawn tax-free and used for any purpose after the individual reaches age 65. Thus, a young, healthy, individual can build up quite an account that, if not used sooner, can supplement his/her lifestyle at retirement.
Eligibility. To be eligible for an HSA, in any given month, an individual must be covered under a high-deductible health plan as of the first of the month and not be covered under any other health plan. A high-deductible health plan is one that has an individual annual deductible of at least $1,000 and a total out of pocket expense limit not exceeding $5,000. For families the deductible must be at least $2,000 and out-of-pocket limit not more than $10,000.
Contribution Limits. An individual may contribute up to $2,600 for individual coverage ($4,500 for family) or the actual plan annual deductible if less. These dollar amounts will be adjusted annually for inflation. Eligibility and contributions are measured on a per month basis. In addition, similar to retirement plans, people age 55 or older can make additional annual contributions of $500 in 2004 and the amount increases $100 annually until it reaches $1,000 in 2009. Contributions may be made after the close of a given tax year and deducted for that tax year, provided they are made prior to the due date for the return, similar to the deduction for IRA contributions.
An example will help demonstrate the advantages of an HSA. Assume an employer maintains a high-deductible health plan providing for a $4,000.00 annual deductible for family coverage. Employee Smith participates in the plan and establishes an HSA contributing $4,000.00 annually to the account beginning in 2004. Employee Smith and his family are in good health and only use $1,000.00 of the $4,000.00 contributions annually for the next 10 years. Ignoring inflation adjustments, in the 25% federal income tax bracket the $4,000.00 annual contribution saves the Smith's $1000.00 in federal income tax annually or $10,000.00 over the 10-year period. Additionally, during that period at a 4% annual return, the account grows to $36,018.00 by 2014 and is available tax-free for a health care catastrophe or for any purpose once Employee Smith reaches age 65. The $6,018.00 in earnings is tax-free, saving an additional $1,504.50 in federal income tax. Put another way, without the tax advantages spending $10,000.00 over 10 years on medical expenses and saving the $36,018.00 would cost $57,522.50.
Employers Can Deduct Contributions. An employer may deduct contributions it makes to its employees' HSA's within the above described limits, provided it makes comparable contributions to all other participating employees. The contributions are excluded from the income of the employees. Comparability is measured separately for part-time and full-time employees. Failure to make comparable contributions subjects the employer to a 35% excise tax on the aggregate amount contributed to HSA's. Thus, a fledgling company could adopt a high-deductible health plan and encourage employees to establish and take advantage of HSA's by making some contributions for them. Additionally, HSA contributions may be offered as part of an employee's cafeteria plan's choices of benefits.
Comparison to Other Plans. The concept of HSA's may sound familiar. In fact, they are very similar to Archer Medical Savings Accounts ("MSAs"), which allowed eligible employees participating in a high-deductible medical plan to make contributions to an account on a tax-deductible basis. The Archer Medical Savings Account program expired on December 31, 2003. The major differences between HSAs and MSAs are: 1) only employees of small employers (with no more than 50 employees) could participate in an MSA; 2) only a limited number of taxpayers (750,000) could benefit from such accounts annually; 3) the definition of a high-deductible plan had even higher deductibles (between $1,700 and $2,500 for individual coverage in 2003 and between $3,350 and $5,050 for family coverage; 4) contributions were not 100% deductible, and 5) accounts could not be used tax free after the age of 65.
Flexible Spending Accounts. HSA's are also similar to health care flexible spending accounts. These accounts allow employees to make salary deferral contributions on a pre-tax basis to accounts to be used for reimbursement for medical expenses not otherwise covered by insurance. The principal differences between an HSA and a flexible spending account is that: 1) a flexible spending account must be adopted by the employer; 2) unlike a flexible spending account which is administered by the employer, HSAs are held by a bank or insurance company as custodian similar to an IRA; 3) contributions to a flexible spending account are made with pre-tax salary deferrals whereas HSA contributions are made with after tax dollars and qualify for an above the line deduction (unless contributions are made under a cafeteria plan or by the employer); 4) The biggest differences between the HSA and a flexible spending account is that under a flexible spending account amounts deferred in a given year but not used for reimbursement are lost to the employee under the "use it or lose it" rule while under an HSA unused contributions may be rolled over to future years. Also, from the employer's standpoint, the flexible spending account has the disadvantage that while an employee chooses an annual amount to contribute to the account and prorata contributions are then contributed through payroll deduction, the entire annual amount must be available for reimbursement throughout the year regardless of actual contributions. For example, if an employee decides to defer and contribute $600.00 annually, only $25.00 would be withheld and contributed per bimonthly pay period. However, if the employee incurs a $600.00 expense in January and submits it for reimbursement in February, the entire $600.00 must be reimbursed even though only $50.00 has been actually withheld and contributed to the account. Worse yet, if the employee then quits after being reimbursed, the employer has no practical mechanism for recovering the excess $550.00 reimbursed. On the other hand, HSA's do not work this way, only amounts in the account may be used for medical expenses and the employee is in control of the account.
Conclusion. HSA's are Congress' latest tool to help employers and employees with the high cost of health benefits. When properly used HSA's can help employers, particularly small employers whose current health plan may already qualify as a high-deductible plan, save money on insurance premiums by maintaining high-deductible health plans, providing basic benefits to employees and also providing employees the opportunity to pay their deductibles and uncovered expenses with un-taxed dollars. Further, an HSA also encourages employees to stay healthy as the unused cumulative account balance can be used tax-free at retirement.
Major insurance companies are quickly jumping on the HSA bandwagon to offer such accounts. Small employers are likely to be the first companies to benefit from HSAs as larger employers usually conduct open enrollment during the fall and are less likely to make a dramatic change until then.
As is true when employers consider adopting any employee benefit plan, numbers should be run and alternatives weighed to ensure that a plan is structured to best suit the goals of the employer. However, HSAs are a new tool in structuring an overall health benefit package. For questions regarding HSA's or any other employee benefit plan, please contact Scott E. Galbreath, J.D., LL.M. (Tax) of our office.
For more information on issues highlighted here, please contact one of the following Shaheen, Novoselsky, Staat & Filipowski professionals:
Henry N. Novoselsky
Lawrence G. Staat
Steven C. Filipowski
James J. Eccleston
William E. Hofmann
Scott E. Galbreath
Michael D. Weis
Jack L. Haan
Sharyn B. Alpert
Jeffrey M. Gershon
Ronald M. Amato
April J. Lindauer
Scott A. Sissel
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