Health Savings Account Considerations

Health Savings Accounts (HSA’s) were established in January, 2004 by the authority of the Federal Medicare Prescription Drug Act of December, 2003. The purpose was to help individuals save pretax funds to pay for qualified medical expenses for themselves, their spouse or dependents in conjunction with qualified high deductible insurance plans. HSA’s might be described as IRA’s for medical expenses.

Basis:

HSA’s are tax-free savings accounts that are available to individuals covered by high deductible health insurance plans. The minimum annual insurance deductibles and other guidelines are prescribed by the Internal Revenue Service and the US Treasury Department. In 2010, the annual insurance deductible must be not less than $1,200 per individual and $2,400 per family. The 2010 plan maximum-out-of-pocket amounts are $5,950 per individual and $11,900 per family.

Account Contributions:

As opposed to the insurance plan deductibles, the Savings Account tax-free contributions are limited to not more than $3,050 per individual and $6,150 per family in 2010. In addition, for individuals over age 55, IRS permits an annual catch-up contribution of $1,000. For a spouse over age 55, a second catch-up $1,000 contribution can be made, but a separate HSA account for the spouse must be opened to take that second annual contribution.

Individuals who are eligible for the High Deductible-HSA program on the first day of the last month of the taxable year, for example December for most people, are allowed the full annual contribution, plus any catch-up contribution, for that year. For those who are no longer eligible on that date (example December 1), contributions would apply prorata, based on the number of months of eligibility.

Contributions to these accounts are tax deductible, even if the taxpayer does not itemize. Contributions by an employer are not included in the individual account holder’s taxable income. Until the account owner is age 65, contributions can be made to the account by the individual, by the employer or by anyone else. An individual with an existing medical savings account (MSA) can roll the MSA balance into a new HSA. Unused funds from a Flexible Spending Account (FSA) can be rolled into an HSA one time. This can overcome the “use it or lose it” problem with earlier tax benefit plans.

Account Ownership:

The Health Savings Account is owned and controlled by the individual. The owner can deposit the funds in any approved financial institution and choose among various investment alternatives. Most insurers have a low-cost or no cost affiliated banking facility that works closely in conjunction with their eligible high-deductible plans. However, insureds are not required to use insurance company facilities.

Any investment institution allowed for an IRA is allowed for an HSA. Allowable HSA investments include bank accounts, annuities, certificates of deposit, stocks, bonds, mutual funds, and certain types of bullion or coins - see Internal Revenue Code Section 408(m)(3) – subject to any restrictions that may be applied by the account custodian or trustee. Investments not allowed include collectables, life insurance contracts and personal property as specified in IRC Section 408(m)(3) above.

The savings account is portable to the owner. It goes with the owner, just like an IRA. As long as the individual maintains a compliant high-deductible health insurance plan, contributions are tax-free. Interest and investment earnings generated by the account are also not taxable in the account. The account balance and earnings roll over year to year, tax free.

Account Distributions:

Amounts distributed from the account are not taxable as long as they are used to pay for qualified medical, dental or vision expenses. Funds can be used for health plan deductibles and copayments for medical services, prescriptions or medical products. They can be used to purchase over-the-counter drugs or long-term care insurance. Funds can not be used to pay health insurance premiums, except during times of unemployment. Any payments from the account not used for qualified medical expenses will be taxable, plus a ten percent penalty to deter inappropriate use.

IRS Publication 502 provides a list of expenditures that qualify for payment from an HSA – go to Qualified Expenditure List - and a list of expenditures that do not qualify – go to Non-qualified Expenditure List.

Account limitations require that the account be funded before any tax-free payments can be made. An owner can only pay from the account to the extent of the fund balance in the account at the time of payment. HSA legislation cites existing IRA law and operates like an IRA, including the need for a trustee to hold the account.

The account is not available to anyone age 65 or over and can not be utilized in conjunction with a Medicare or Medicaid plan. Once the owner reaches age 65, no further tax free contributions can be made. Enrollment in Social Security and Medicare Part A disqualifies you for an HSA. However, once the owner is past the 65 year age limit, an existing HSA can be a supplemental retirement account, can be used to pay for healthcare items not covered by Medicare, and can be applied to non-medical expenses without incurring the ten percent penalty.

In the event of the death of the HSA owner, the spouse of the owner will inherit the account and funds as an HSA, unless the deceased’s will provides otherwise. If the deceased owner has no spouse, the account funds will no longer be treated as an HSA and will be treated as part of the individual’s estate and subject to estate taxes.

Self-employed, partners and S-corporation shareholders are not generally considered employees and cannot receive pre-tax employer contributions to their HSA. Such principles can only take an above-the-line deduction for their premium and Health Savings Account contribution. An above-the-line deduction reduces your taxable income dollar for dollar. You do not have to itemize to claim this deduction.

Special Situation Examples:

Health Savings Accounts were designed to encourage people to get more involved with their healthcare affairs and to help them reduce and pay medical expenses in conjunction with high deductible health insurance plans. These accounts have excellent application in some situations, as indicated by the following examples:

Small, Family-Owned Employer:

If you operate an small family-owned business, you may want to provide major medical coverage and to allow your family member employees to accumulate tax-advantaged funds in the HSA. You can use the premium savings generated by going from a low deductible to a high deductible plan to fund the HSA’s of your family employees. Accumulated, tax-deferred funds can be used to pay for future medical expense, for long-term care or to supplement retirement income.

Highly Compensated Groups:

If you operate a business of highly compensated individuals, such as attorneys or physicians, you may be most interested in maximizing benefits and tax savings. You can pay for insurance premiums with tax deductible funds and make tax deductible contributions to the savings accounts. Many highly compensated employees may prefer to pay for ordinary medical expenses out-of-pocket, take the tax write-off, and let their account earnings accumulate on a tax-deferred basis.

Groups In Which Employees Share Insurance Costs:

A growing number of employers have employees pay part of insurance costs. If you, as an employer, switch to a high deductible plan, you may be able to pay most, if not all, of the lower premium without increasing your total expense. You could then let employees contribute to their own HSA’s. Employees could save tax-deferred money and be better positioned to control their healthcare affairs.

Subchapter S Shareholders:

If you operate a sole-proprietorship, partnership or sub-s corporation, with shareholders owning more than two percent of stock, you are treated as a partner for purposes of applying fringe benefit rules. You likely will not qualify for an HRA (Health Reimbursement Arrangement) plan. You could set up an HRA for employees and establish an HSA for partners and shareholders to optimize tax benefits in a fashion similar to the family business above.

Groups With Employees of Differing Interests:

If you operate a business in which a high deductible, HSA plan does not fit everyone, you might qualify for up to four different plan designs to try to meet the various needs. You can determine how many HSA-qualified plans to offer, and may include an HRA alternative, with a base benefit to employees. Employees could then select from those options and choose whether to enroll in an HSA plan.

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