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 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, 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.

    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].