HSAs help tackle medical costs and may offer tax-free savings.
Health savings accounts (HSAs) and high-deductible
plans have become important new options for individuals to consider in
improving their health care. Since their creation for the years
beginning after 2003, the numbers of enrollees and insurers offering
the arrangements have increased dramatically. When used properly in the
financial plans of certain individuals, HSAs also can be very powerful
savings tools.
An HSA is an account into which deposits are made to
pay for future qualifying medical expenses. HSAs allow for tax-free
savings for health care expenses for participants under age 65 covered
under high-deductible health plans. The contributions to the account,
the earnings on the account and the distributions are all income-tax
free if certain requirements are met. In addition to the benefits of
tax-free savings for health care expenses, participants potentially may
use these accounts to save and invest tax-free for future retirement.
High-Deductible Health Plans
An HSA is available to an individual who is covered
by a high-deductible health plan (HDHP). The individual may not be
covered under any other health insurance or expense-reimbursement plan,
other than a plan providing certain specified types of coverage, some
of which include dental care, vision care, disability and long-term
care. A high-deductible health plan is one with an annual deductible of
at least $1,000 for individual coverage and $2,000 for family coverage.
In addition, the maximum out-of-pocket annual expenses for allowed
costs, including the deductible, must not exceed $5,000 for individual
coverage and $10,000 for family coverage, with these amounts adjusted
annually for inflation.
To enroll in a high-deductible health plan and
create an HSA, the individual may not be enrolled in Medicare and may
not be claimed as a dependent on another's income tax return. There is
no income limit on persons eligible to contribute to an HSA, and there
is no requirement that the participant have earned income.
Consequently, individuals earning substantial wages, for whom many
income tax benefits are normally disallowed, may make tax-favored
contributions to HSAs.
HDHPs can have first-dollar coverage for
preventative care before the minimum deductible is met. IRS Notice
2004-23 provides a safe harbor list of preventive care expenses that
can have such first-dollar coverage, including annual physicals,
screening services, routine pre-natal and well-child care,
immunizations, tobacco cessation programs and weight loss programs.
Prescription drugs, such as cholesterol-lowering medication, taken to
prevent the onset of a condition for which a person has developed
certain risk factors, can be considered preventative care. Preventative
care, however, does not include services to treat an existing illness,
condition or injury.
After January 1, 2006, prescription drug coverage is
not allowed until the annual deductible is met. Until that time, the
IRS has provided transition relief by permitting an individual covered
by a prescription drug benefit plan that does not satisfy the HDHP
minimum annual deductible to contribute to an HSA until January 1,
2006, if the individual is covered by a separate plan or rider from the
HDHP.
Contributions
Contributions must be made in cash and deductible
contributions are subject to maximum annual limits for individual
coverage or family coverage. In 2005, the maximum deductible is equal
to the lesser of the plan's annual deductible amount or the maximum
specified by law, which for 2005 is $2,650 for individual coverage and
$5,250 for family coverage. Individuals who are over age 55 by the end
of the year may make additional "catch-up" contributions of $600 in
2005. For each subsequent year the catch-up contribution amount
increases by $100 and is capped at $1,000 for contributions in 2009 and
thereafter.
Contributions to an HSA may be made in installments
or in a lump sum anytime during the year, as permitted by the account
trustee or custodian, but cannot be made once an individual is eligible
for Medicare. Excess contributions in any year subject the account
holder to a 6% excise tax, unless such excess is returned to the
account holder by the due date of the account holder's tax return.
Contributions to an HSA can be made by the
participant, by the employer or by others on behalf of the participant,
and all contributions are aggregated each year. Amounts contributed by
the participant or by others for the participant are deductible
above-the-line by the participant. Amounts contributed by an employer
are also excludable from gross income and are excludable from wages for
employment tax purposes, including FICA and FUTA. Employer
contributions to an HSA on an employee's behalf are reported annually
as non-taxable income on the employee's Form W-2.
In addition, under the Fiscal Year 2006 Revenue
Proposals by the Treasury Department, small, nongovernmental,
for-profit employers, who employ fewer than 100 employees and
contribute to HSAs would receive a refundable credit of up to $200 for
employer contributions to an HSA for single coverage and up to $500 for
family coverage. Sole proprietorships, partners and S-corporation
shareholders would be eligible for the credit to the extent that their
businesses are considered small employers or have no employees.
With respect to partnerships, IRS Notice 2005-8
provides that a contribution by a partnership to a partner's HSA is not
treated like an employer's contribution to an employee's HSA. Depending
upon the treatment of the contribution, as either a partnership
distribution or a guaranteed payment, the partner will report the
payment appropriately. Amounts taxed as distributions to the partner
are not deductible by the partnership and do not affect the
distributive shares of partnership income and deductions.
These amounts are reported as distributions of money
on Schedule K-1 and will not be included in income for purposes of
self-employment income tax. If the partner is an eligible participant
in an HDHP, the partner will be entitled to deduct the contribution as
an adjustment to income on his or her federal income tax return.
Amounts treated as guaranteed payments to a partner are deductible by
the partnership and are includable in the partner's self-employment
income. If the partner is an eligible participant in an HDHP, the
partner will be entitled to deduct the contribution as an adjustment to
income on his or her federal income tax return.
For contributions made by an S corporation to the
HSA of a 2% shareholder who is also an employee, Notice 2005-8 provides
that an S corporation is treated as a partnership and the shareholder
is treated like a partner who has received a guaranteed payment.
Accordingly, the S corporation may deduct HSA contributions for the
shareholder, and the shareholder includes such amount in gross income,
but this amount is not subject to FICA tax. If the shareholder is an
eligible participant in an HDHP, the shareholder will be entitled to
deduct the contribution as an adjustment to income on his or her
federal income tax return.
Distributions
Distributions, including the earnings, from an HSA
used to pay qualified medical expenses of the participant and his or
her spouse or dependents are not considered taxable income to the
participant. Distributions that are not for qualified medical expenses
are includable in income and subject to an additional 10% tax. The
additional 10% tax does not apply if the distribution occurs after the
death or disability of the participant or after the participant becomes
eligible for Medicare (currently age 65).
When withdrawing from an HSA, the participant must
maintain only sufficient records to satisfy the favorable tax
treatment, but no third-party claims substantiation is required.
Amounts withdrawn that are not used for qualified medical expenses when
the participant reaches age 65 are treated as retirement income subject
to income tax.
Distributions for "qualified medical expenses" are
those defined in section 213(d) of the Internal Revenue Code and
include expenses incurred in the diagnosis, cure, treatment, mitigation
and prevention of disease. Distributions generally may not be made for
the cost of health insurance premiums except for certain limited types
of premiums, such as long-term care insurance premiums, premiums paid
under a health plan during continuing coverage required under federal
law, including COBRA coverage, or premiums, other than Medigap
premiums, for individuals eligible for Medicare.
Employers providing health insurance may permit
employees to pay premiums on a pre-tax basis, and self-employed
individuals may deduct premium payments in computing adjusted gross
income (AGI). Under current law, other individuals who purchase their
own insurance may claim only an itemized deduction for the premiums to
the extent that the premiums paid and other medical expenses exceed
7.5% of adjusted gross income, but the law soon may change. Under the
Fiscal Year 2006 Revenue Proposals by the Treasury Department, these
individuals also would be allowed a deduction in the amount of the
premium in determining AGI.
To the extent that distributions from one HSA are
rolled over to another HSA within 60 days, HSA distributions not used
for qualified medical expenses are not included in income or subject to
the 10% tax. An individual is entitled to only one tax-free rollover
during each year ending on the date the HSA distribution is received.
In addition, a transfer of an HSA from one spouse to another that is
incident to a divorce or separation agreement is not treated as a
taxable transfer for either spouse. Unlike amounts held in traditional
cafeteria or "flex" plans that must be consumed by the end of each
year, the balance in an HSA is allowed to accumulate and grow
income-tax-free at the end of each year.
Potential Disadvantages
A potential disadvantage of implementing an HSA is
that, during its initial years the participant and his or her family
may incur medical expenses in excess of the funds available in the
account. Most insurance plans, and therefore HSAs, are funded on a
monthly basis. Since an individual is responsible for the amount up to
the plan deductible, which may be substantial in an HDHP, this
individual may be at risk that expenses will accumulate before enough
has been set aside in the HSA to reimburse the expenses. As a result,
the participant may be required to borrow or liquidate other amounts to
satisfy the medical expense obligations. If this risk is too great, a
participant may be permitted to switch to a traditional first-dollar
insurance program.
Another disadvantage is that insureds who have
reached certain ages, such as 50 and older, may find that the annual
premiums under HDHPs are significantly higher than those in traditional
plans. This additional cost, coupled with the high deductible amount,
may make HSAs an uneconomical option for such insureds.
HSA Accounts
A bank, insurance company or any other entity that
qualifies under IRS standards for serving as an IRA Trustee or
Custodian can be an HSA Trustee or Custodian. Although the IRS has
issued model HSA Trustee or Custodial Account documents, Trustees or
Custodians can modify existing IRA trust or custodial documents for
HSAs. The HSA trust document must provide that it will accept only cash
contributions (except for rollover contributions), will not accept
contributions in excess of the annual contribution limits, will not be
invested in life insurance contracts and will not permit HSA assets to
be commingled with other property, except in a common trust fund or
common investment fund. Allowable HSA account investments include all
investments approved for IRAs, such as stocks, bonds, annuities,
certificates of deposit, mutual funds and bank accounts.
Death of Participant
At the HSA account holder's death, if the
beneficiary is the surviving spouse, the surviving spouse is treated as
the account holder and there are no estate or income tax effects. If
the beneficiary of a deceased HSA account holder is a person other than
the surviving spouse, then the HSA ceases to be an HSA upon the
holder's death and is both taxed in the decedent's estate and treated
as an IRD receivable. The fair market value of the account, less
payments made on behalf of the decedent within one year of death, is
income-taxable to the beneficiary in the year in which the account
holder dies. Unlike IRA or qualified plan benefits, which may be
payable over the life expectancy of a beneficiary, an HSA account
balance payable to a beneficiary other than the surviving spouse is
taxable in a lump sum at the participant's death. The beneficiary's
income tax liability, however, is reduced due to estate tax payable on
the HSA account in the deceased holder's estate. If the decedent's
estate is the beneficiary, then the HSA account balance is taxable to
the account holder on his or her final income tax return, and there is
no deduction for estate tax attributable to the HSA account.
A Savings Tool
Health savings accounts can be a tremendous savings
tool. HSAs couple the ability to save for retirement with providing
individuals with more control over their health-care decisions, with no
income limitations. While these plans are still new, many health
insurers are offering an HSA option, and many employers have added this
option to their benefit programs or are considering offering an HSA
option in the near future. The cost savings between traditional
first-dollar coverage medical insurance and high-deductible medical
insurance is often enough to fund the entire HSA.
For the participant who has the little or no medical
expenses and the ability to fund medical expenses out-of-pocket, an HSA
takes on a new realm of possibilities. The account is always vested and
fully portable at all times. The participant is not required to
reimburse himself or herself from an HSA, and neither the employer nor
HSA trustee is required to substantiate whether HSA distributions are
used exclusively for qualified medical expenses. Instead, the
participant is required to maintain records of qualified medical
expenses, which may be paid with debit or credit cards. A participant
in higher income tax brackets may consider not taking distributions
from his or her HSA to accumulate the pre-tax funds for tax-free
growth, and tax-free withdrawals for future medical costs.
Conclusion
As HSAs gain momentum with mutual fund companies
that see additional investment opportunities, they eventually may have
as many investment options as IRAs or 401(k) plans. Offering
deductibility, tax-free growth, unpenalized carryovers from year to
year, tax-free withdrawals and portability, an HSA is a financial
planning tool that needs to be considered.
Susan W. O'Donnell, JD, LLM, is
in-house counsel at Valley Forge Financial Group, where she specializes
in sophisticated estate and tax planning. She can be reached at
610-783-6650 or by e-mail at [email protected]. Sean Maher, CFP, is
president of Valley Forge Financial Group, which is an M Group member
firm, specializing in sophisticated estate and financial planning for
high-net-worth clientele throughout the U.S. He can be reached at
610-783-6650 or by e-mail at [email protected].