The New Health Savings Account

In late 2003, President Bush signed into law the Medicare Prescription Drug Improvement and Modernization Act. One provision of that law helps eligible individuals save and pay for health-care costs by establishing Health Savings Accounts (HSAs).

Beginning on January 1, 2004, eligible individuals (and/or their employers) can make tax-advantaged contributions to these HSAs and receive qualifying distributions from the HSAs tax free. The idea behind the accounts is to provide people who have high out-of-pocket health-care costs with a tax-advantaged way to pay for those costs.

Who Can Set Up an HSA?

Only “eligible individuals” can establish and benefit from an HSA. An eligible individual is one who, in any month, is:

• Covered under a “high deductible health plan” (HDHP) as of the first day of that month,

• Not covered by a health plan other than an HDHP (though some exceptions apply),

• Not entitled to benefits under Medicare (generally, then, the individual must be under age 65), and

• Not able to be claimed as a dependent on another person’s income-tax return.

What Is a High Deductible Health Plan?

An HDHP is a health plan that meets certain requirements regarding the deductible amounts and the maximum out-of-pocket expenses that a covered person must pay (including deductibles, co-payments, and other amounts, but not premiums). Separate deductibles and out-of-pocket-expense limits apply to plans that provide self-only coverage and to those offering family coverage.

Generally, for self-only coverage, the annual deductible must be at least $1,000 and the annual out-of-pocket expenses payable under the plan must be no more than $5,000. For family coverage, the deductible must be at least $2,000 and the out-of-pocket expenses must not exceed $10,000 for the year. These amounts are indexed for inflation.

A self-insured medical reimbursement plan sponsored by an employer can qualify as an HDHP.

Who Can Contribute?

If an eligible individual sets up an HSA, the individual, his or her employer, or both may contribute to the HSA. If the HSA is set up by a self-employed or unemployed person, he or she makes contributions. Family members can make contributions to an HSA on behalf of another family member, as long as the beneficiary of the HSA is an eligible individual.

How Much Can Be Contributed?

HSA contributions can be made in a lump sum or in several payments over the year. However, contribution limits are determined month by month. These limits are based on the individual’s status, eligibility, and the health plan coverage as of the first day of the month. The maximum annual contribution limit is the sum of the monthly limits.

For eligible individuals with self-only HDHP coverage, the maximum annual contribution for 2004 is the lesser of the annual deductible under the HDHP ($1,000 minimum in 2004) or $2,600. The monthly maximum is one twelfth of the annual limit (that is, the monthly maximum in 2004 is one twelfth of the annual deductible or $216.67, whichever is less).

So, if you are an eligible individual and have self-only HDHP coverage, and the plan’s deductible is $1,500, you may contribute up to one twelfth of $1,500, or $125, for each month you are eligible for coverage during 2004.

Those with family HDHP coverage may contribute an annual maximum amount equal to the annual deductible under the plan (a minimum of $2,000 in 2004) or $5,150, whichever is less. The monthly maximum is one twelfth of the annual limit (that is, the monthly maximum in 2004 is the lesser of one twelfth of the annual deductible or $429.17).

For married couples, if either spouse has family HDHP coverage, both are treated as having family HDHP coverage. If the spouses are covered under separate HDHPs, both spouses are considered covered under the HDHP with the lower deductible. The contribution limit is determined by the lower deductible amount, divided equally between the spouses.

In addition, eligible individuals (and their spouses who are covered by the HDHP) who are between ages 55 and 65 can make “catch-up” contributions. The maximum annual catch-up contribution for 2004 is $500. The maximum will increase in $100 yearly increments until it reaches $1,000 in 2009. The catch-up contribution limit, like the regular contribution limit, is computed on a monthly basis.

HSA contributions must be made for a specific year on or before the due date (without extensions) for filing tax returns for that year. So, for 2004, contributions must be made on or before April 15, 2005.

Amounts may be rolled over to an HSA from existing Archer Medical Savings Accounts or from other HSAs. Rollovers from IRAs, health reimbursement arrangements, or flexible spending arrangements are not allowed.

What Is the Tax Treatment of Contributions?

If you make eligible contributions to an HSA, they may be claimed as an “above-the-line” income-tax deduction. That means the contributions may be deducted whether or not you itemize deductions. HSA contributions made by a family member on behalf of an eligible individual are also deductible by the eligible individual, but not by the family member who made the contribution.

Contributions an employer makes to an HSA on behalf of an eligible employee are treated as employer contributions to a medical plan for tax purposes. As such, they are excluded from the employee’s gross income and are deductible by the employer. Employer contributions are also not subject to Social Security (FICA), federal unemployment tax (FUTA), or income-tax withholding.

If an employer contributes to HSAs for employees, certain nondiscrimination rules apply to assure that the contributions do not favor highly compensated employees.

Distributions from HSAs

As the owner of an HSA, you may take distributions anytime you choose. If the distributions are used to pay qualified medical expenses for you or your spouse or dependents, the distributions are tax free.

“Qualified medical expenses” are generally the same as those that qualify for the tax law’s medical expense deduction. These expenses are fairly broad in nature, and include amounts paid for the diagnosis, mitigation, treatment, and prevention of disease or for the purpose of affecting any structure or function of the body. The qualified medical expenses must be incurred after the HSA has been established.

Individuals who establish HSAs are responsible for determining whether an expense is a qualified medical expense. If you have an HSA, then you should maintain sufficient records to show that the distributions are made exclusively for qualified medical expenses.

If any amount is paid out of an HSA for reasons other than reimbursing qualified medical expenses for you, a spouse, or a dependent, that amount is includable in your gross income and is subject to regular income tax and a 10% “penalty” tax. There are exceptions to the 10% penalty tax when distributions are made after you’ve reached age 65, become disabled, or died.

Is an HSA Right for You?

With many employers looking at high deductible health plans for employees, HSAs are expected to become a key component of many employees’ health-care financing strategies.

If you are covered by an HDHP at work or are self-employed and have an HDHP for yourself, you should consider setting up an HSA for your benefit.

Our firm can look at your situation and help you decide if you are eligible for an HSA and whether one is right for you. Contact us at your convenience.

The information provided in the newsletter has been obtained from sources believed to be reliable but its accuracy is not guaranteed.