On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Medicare Modernization Act").1 Among its more notable provisions is the creation of a new tax-free savings vehicle aimed at assisting individuals and employees in funding their health care expenses.2 The Administration's goal in enacting this sweeping legislation is to provide greater access to health care, specifically for those currently covered under health insurance plans with high annual deductibles or without coverage as a result of such high deductibles. Known as "Health Savings Accounts" or "HSAs," they are meant to replace the existing Archer Medical Savings Account ("MSA") in providing health coverage through tax-free savings.
Effective January 1, 2004, HSAs may be established at a financial institution, such as a bank or insurance company, as tax-exempt trusts or custodial accounts.3 These accounts allow an individual or employee to either pay, or be reimbursed for, qualified medical expenses that are incurred prior to having met the annual deductible imposed by their health plan. Such medical expenses may be incurred on behalf of the individual or employee, a spouse, and/or dependents.
Eligibility to participate in an HSA is not unqualified. In order to establish such an account, the individual or employee must (1) be covered under a "high deductible health plan" ("HDHP"), (2) not be covered under any health plan which is not an HDHP, and (3) not be a dependent of another for tax purposes, regardless of whether an exemption is claimed.4 In addition, Medicare-eligible individuals or employees may neither establish an HSA nor continue to contribute to an existing HSA.5 The HSA, in comparison to the MSA, greatly expands the scope of those eligible to establish tax-advantaged savings vehicles to encompass not only small business employees and the self-employed, but any individual or employee meeting the aforementioned criteria. Additionally, HSAs provide for higher account contributions and allow for lower deductibles in determining ownership eligibility. Unlike the MSA, employees may supplement employer contributions to their accounts in the same year, subject, of course, to the applicable maximum annual contribution limitations.6
As referenced above, in order to be an HSA "eligible individual," an individual or employee must be covered under an HDHP. An HDHP is defined as a health plan having an annual deductible which is not less than $1,000 ($5,000 cap on total out-of-pocket expenses) for a self-only policy and $2,000 ($10,000 cap on total out-of-pocket expenses) for family coverage.7 An annual contribution of up to 100 percent of the HDHP deductible may be made; however, maximum annual contribution limits are statutorily imposed at $2,600 and $5,150, respectively. "Catch-up" contributions, amounting to $500 for 2004, are allowed for individuals or employees 55 to 65 years of age.8 Contributions to an HSA may be made by an individual or employee, an employer, or a family member.
Establishing an HSA can provide substantial tax benefits. Employer contributions are made on a pre-tax basis and are not taxable income to the employee. Contributions made by an individual or employee may be deducted even if deductions are not itemized, and investment earnings on contributed amounts accrue tax-free.9 Contributions may also be made by a family member, subject to a gift tax. Further, distributions from an HSA are not includable in gross income as long as they are deemed to be for the payment of, or reimbursement for, "qualified medical expenses." Qualified medical expenses are those amounts paid for medical care, as such term is defined in the IRC,10 for the benefit of the individual or employee, the spouse of such individual or employee, and any dependents.11 Such amounts generally consist of expenses incurred prior to the HDHP deductible being met. Examples of qualified medical expenses include payment for prescription and over-the-counter medications, COBRA continuation coverage premiums, qualifying Medicare expenses (not including Medigap), amounts for long-term care services, and necessary hospital services not covered by insurance. Any distributions which are not used to pay for qualified medical expenses are includible in the account beneficiary's gross income for the year in which such distribution was received, and an additional 10 percent tax is assessed on such amount.12
Additionally, HSAs provide numerous non-tax benefits for qualified individuals. One such benefit is an HSA's portability. These accounts are established and owned by the individual or employee, not the employer. As such, they may be transferred by an employee who either makes a change in employment or leaves the workforce altogether. Rollover contributions from either an established MSA or another HSA are also permitted, and these rollovers are not subject to the above-referenced annual contribution limits.13 In addition, one need not be in the employ of another to establish an HSA; otherwise eligible individuals who are either self-employed or unemployed may participate.
Further, certain benefits accrue to the surviving spouse upon the death of the HSA beneficiary. If the surviving spouse is the designated beneficiary of the decedent's HSA, the HSA shall be treated as if the surviving spouse were the account beneficiary. The result: a tax-free transfer of the account assets to the surviving spouse. However, if the decedent beneficiary has designated a non-spouse beneficiary to receive the HSA assets at death, the account shall cease to be an HSA and the fair market value of the account assets shall be included in the designated beneficiary's gross income.14
Employers offering the HDHP benefit option must be aware of certain issues surrounding the establishment of HSAs by their employees. Notably, the IRC imposes a non-discrimination requirement upon employers that contribute to an HSA. An employer must make "comparable contributions" on behalf of all "comparable participating employees." This non-discrimination requirement applies separately to part-time employees, and does not apply to rollover contributions, or contributions made to an HSA which is part of a cafeteria plan. Failure by an employer to comply with this non-discrimination rule will result in the imposition of an excise tax amounting to 35 percent of the aggregate amount contributed by the employer.15 Additionally, employers must comply with all applicable reporting requirements under the IRC; they are not, however, responsible for ensuring that distributions made to the individual or employee are used for the payment, or reimbursement, of qualified medical expenses. HSAs are also not subject to COBRA coverage, and they do not, as a general rule, constitute "employee welfare benefit plans" subject to Title I of the Employee Retirement Income Security Act of 1974, as amended ("ERISA").16
There is evidence that employers of all sizes are contemplating a change in the way in which they provide health care coverage to their employees. A recent study, conducted by one of the leading consulting organizations, concluded that approximately three-quarters of the 991 employers surveyed would offer an HDHP with an HSA by 2006. The survey further found that both very large employers (those employing 20,000 or more employees) and very small employers (those employing 10 - 49 employees) would likely be amongst the first employers to offer the HSA. The results of the survey suggested that approximately 81 percent of very large employers and 78 percent of very small employers were either "very or somewhat likely" to offer these accounts to their employees by 2006.17
Finally, it must be noted that the IRS has recently released technical guidance concerning transitional relief to aid in the implementation of the HSA program. Specifically, the guidance concerns the establishment of HSAs by those having prescription drug coverage outside of their HDHP, as well as guidance addressing the interaction of HSAs, FSAs, and HRAs.
1 Pub. L. No. 108-173.
2 See Medicare Modernization Act, Section 1201; codified by Section 223 of the Internal Revenue Code of 1986, as amended ("IRC").
3 IRC Section 223(d)(1).
4 Id., at Section 223(b)(6) and (c)(1)(A).
5 Id., at Section 223(b)(7).
6 See Shelly Brandel & Scott Weltz, Alphabet Soup: HSAs, HRAs, and MSAs, Milliman USA (2004).
7 IRC Section 223(c)(2).
8 Id., at Section 223(b)(2) and (3).
9 Id., at Section 223(a), (e), and (f). See also, IRS Press Release JS-1045 (December 8, 2003).
10 See IRC Section 213(d) and Treas. Reg. Section 1.213-1. See also, IRS Publication 502, Medical and Dental Expenses (2003).
11 IRC Section 223(d)(2).
12 Id., at Section 223(f)(2) and (4).
13 Id., at Section 223(f)(5).
14 Id., at Section 223(f)(8).
15 IRS Notice 2004-2, Q&A -32, 2004-2 I.R.B. 269 (January 12, 2004).
16 DOL Field Assistance Bulletin 2004-01 (April 7, 2004).
17 See, Mercer Human Resources Consulting, U.S. Employers See A Role For New Health Savings Accounts In Their Benefit Programs (April 27, 2004).
Published August 1, 2004.
