Medicare Act of 2003 Creates New Health Savings Accounts

On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”). An important component of the Act is the creation of a new tax-exempt vehicle called a Health Savings Account (“HSA”). HSAs are intended to provide a tax-advantaged method for eligible individuals to pay for qualified medical expenses. HSAs are part of a growing effort to make the consumption of healthcare services more “consumer driven” by allowing individuals (i.e., the consumers) more control over how their healthcare dollars will be spent.

Under the Act, eligible individuals may make tax deductible contributions to an HSA. In addition, contributions to an HSA can be made by an employer on behalf of its eligible employees. The earnings on contributions made to an HSA are exempt from tax and all distributions from an HSA will not be taxable to the extent they are used to pay for qualified medical expenses. The provisions of the Act concerning HSAs are generally effective for tax years beginning on or after January 1, 2004. The rules governing HSAs will be contained in new Section 223 of the Internal Revenue Code.

An eligible individual for HSA purposes is an individual who, with respect to any month, is covered under a “high deductible health plan” as of the first day of the month and who is not covered under any other health plan that provides coverage for any benefit covered under the high deductible health plan. A health plan will constitute a “high deductible” plan if it has an annual deductible of at least $1,000 and an out-of-pocket maximum (e.g., aggregate deductibles and co-pays) of not more than $5,000 for single coverage, and an annual deductible of at least $2,000 and an out-of-pocket maximum of not more than $10,000 for family coverage. Generally, family coverage is defined as any coverage other than individual coverage. The annual deductible floor and the out-of-pocket maximum ceiling are subject to annual cost-of-living indexing after 2004.

For married couples where either spouse has family coverage, both spouses will be treated as having family coverage and if both spouses have family coverage, both spouses are treated as having the coverage with the lowest annual deductible.

The maximum annual amount that an individual can contribute to an HSA will be the lesser of the amount of the annual deductible under the individual’s health plan or $2,250 for individual coverage and $4,500 for family coverage. A “catch-up” provision allows additional contributions to an HSA for individuals who will be age 55 or older by the end of the year. This additional catch-up contribution will be $500 in 2004 and will increase by $100 each year until reaching $1,000 in 2009. The contribution limits will be prorated on a monthly basis where an individual is covered under a “high deductible” plan for only a portion of the year.

Contributions by an individual to an HSA are deductible for federal income tax purposes and will be treated as “above-the-line” deductions and may be claimed even when the taxpayer doe not itemize deductions. Moreover, such “above-the-line” deductions are not subject to the phase-out rule for itemized deductions for those higher income taxpayers who do itemize their deductions.

No contributions can be made to an HSA by an individual who is eligible to receive Medicare benefits or who is claimed as a dependent by another taxpayer. Most significantly, there is no income limit on the ability of an otherwise eligible individual to contribute to an HSA and to claim a deduction for such contribution.

Under the Act, employers may also make deductible contributions to an HSA for those employees who are eligible individuals. In addition, employer-sponsored cafeteria plans established under Code § 125 will be able to offer HSAs as part of the “menu” of benefits to which an employee can contribute on a pre-tax basis. If an employer elects to make a contribution to an HSA on behalf of any eligible employee during a calendar year, the employer must also make comparable contributions to the HSAs of all other comparable participating employees for that calendar year. The rules for determining when contributions are comparable are similar to the rules currently contained in Code §4980E relating the requirement that comparable contributions be made to Archer Medical Savings Accounts by contributing employers. Although the Act is unclear, it appears that failure to comply with these non-discrimination rules will cause the employer to incur an excise tax equal to 35% of its aggregate contributions to all HSAs.

Any employer contributions to an HSA must be reported on the employee’s form W-2 for the year of the contribution. Employer contributions are not taxable to the employee on whose behalf the contribution is made and contributions will not be subject to FICA or FUTA.

Distributions from an HSA will not be subject to tax to the extent used to pay or reimburse the HSA owner (called an “account beneficiary”) for qualified medical expenses incurred by the account beneficiary, the account beneficiary’s spouse or any of the account beneficiary’s dependants. Qualified medical expenses include amounts paid for “medical care” as defined in Code § 213(d) and include deductibles and co-payments under a health plan, and medical expenses not covered under the health plan (e.g., vision care, dental care, over-the-counter medications, etc.). Health insurance premiums cannot be reimbursed from an HSA although HSAs can reimburse for premiums paid for COBRA continuation coverage, qualified long-term care insurance and for health insurance coverage while receiving unemployment compensation benefits.

Distributions from an HSA in excess of those necessary to pay or reimburse for qualified medical expenses are includible in the account beneficiary’s income and the any excess distribution is subject to an excise tax of 10%. The excise tax is not imposed if the distribution is made after the account beneficiary becomes disabled or after the account beneficiary attains retirement age under the Social Security Act (currently, age 65). Distributions from an HSA may be rolled-over on a tax-free basis to another HSA maintained by the same account beneficiary if the roll-over is completed within 60 days of the date of the distribution. Only one roll-over is permitted in a 12 month period.

It is intended that HSAs will be completely portable and are deemed owned by the account beneficiary. In this (and many other) respects, an HSA resembles an IRA. Accordingly, once established, an HSA is available for the benefit of the account beneficiary for the remainder of his or her life regardless of the individual’s employment status. This compares to traditional flexible spending accounts with their “use-it or lose-it” rule requiring the reimbursement of qualified medical expense on an annual basis and health reimbursement accounts, permitted under Revenue Ruling 2002-41, which are funded exclusively by employer contributions and which provide only limited reimbursements after the termination of employment.

The value of an HSA on the date of death will be includible in the deceased account beneficiary’s estate for Federal Estate Tax purposes but a martial deduction is available to the extent a surviving spouse is designated as the beneficiary of the HSA (in which case the HSA will be treated as the surviving spouse’s HSA). An HSA will cease to be an HSA if payable to any other beneficiary.

An HSA must be in the form of a trust created or organized in the United States. The trustee of an HSA must be a bank, an insurance company or another person who demonstrates to the satisfaction of the IRS that it will administer the trust consistent with the HSA requirements of the Act. No part of the assets of an HSA may be invested in life insurance contracts and the trust assets cannot be co-mingled with other property except in a common trust fund or common investment fund. In addition, HSAs will generally be subject to the prohibited transaction rules and rules concerning the taxation of unrelated business taxable income applicable to IRAs.

Proponents of HSAs believe that they are an important component in implementing a consumer driven healthcare system. The theory behind HSAs is that employers will be able to reduce the cost of providing health insurance protection for their employees by offering policies with higher deductibles and by allowing employees to better manage their own healthcare needs. The National Small Business Association, a proponent of HSAs, believes that HSAs will increase health insurance coverage by allowing employers to obtain less expensive policies which employers will be able to offer to more employees.

The NSBA has provided the following example illustrating how HSAs are intended to work: A small business with 15 employees is paying $72,000 in health insurance premiums a year. By implementing HSAs for its employees, the business reduces its premiums to $40,000 a year by changing to a high deductible health plan with a $2,500 annual deductible for individual coverage. The business then contributes $1,000 to each employee’s HSA (with employees able contribute an additional $1,500 each), bringing the employer’s total healthcare costs down to $55,000, compared with the current cost of $72,000. Arguably, the employees are still receiving the same level of healthcare benefits through the combination of insurance and HSA reimbursements.

Although the IRS intends to issue regulations concerning the details of HSAs and how they must be implemented, a number of large health insurance companies have already expressed their intention of mass-marketing HSAs commencing in 2004. For those individuals covered by a high deductible plan, an HSA appears to be an attractive vehicle for funding non-covered healthcare needs in a cost efficient manner.

Posted with permission:
By Mark L. Silow
Fox Rothschild LLP
2000 Market Street
Philadelphia, PA 19103