On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the “Act”). Title XII of the Act, entitled “Tax Incentives for Health and Retirement Security,” includes provisions which amend the Internal Revenue Code (“IRC”) to provide the basis and favorable tax treatment for Health Savings Accounts (“HSAs”).
On December 22, 2003, the Treasury Department and the Internal Revenue Service (the “Treasury” and the “IRS”) issued Notice 2004–2, available on the IRS’s website at: http://www.irs.gov/pub/irs-drop/n-04-2.pdf, to clarify many of the basic HSA provisions of the Act in an easy to read question and answer format, including illustrative examples (“Q&As”).
Health Savings Accounts In General
A “Health Savings Account” is defined in new IRC section 223(d) as “a trust created or organized in the United States as a health savings account exclusively for the purpose of paying the ‘qualified medical expenses’ of the account beneficiary, but only if the written governing instrument creating the trust meets the following requirements”:
- An individual’s HSA account balance must be nonforfeitable.
- Contributions to an HSA (other than eligible rollover contributions) must be made in cash, and annual contributions to the trust on behalf of any individual must be limited to the maximum contribution for an individual with family coverage plus the additional contribution amount allowed for individuals age 55 or older (for 2004, that is $5,150 plus $500, or $5,650).
- The trustee of the HSA must be a bank or insurance company, or “another person who demonstrates to the satisfaction of the Secretary that the manner in which such person will administer the trust will be consistent with the requirements of [Section 223].” Any person already approved by the IRS as a trustee or custodian of an Individual Retirement Account (IRA) or Archer Medical Savings Account (“Archer MSA”) is automatically approved to be a trustee or custodian of an HSA.
- No trust assets may be invested in life insurance contracts.
- Trust assets must not be “commingled with other property except in a common trust fund or common investment fund.”
Qualified Medical Expenses
“Qualified medical expenses” are defined in new IRC section 223 as amounts paid for “medical care” for
- the individual who owns the HSA;
- that individual’s spouse; or
- that individual’s dependent for federal tax purposes, to the extent these amounts are not payable by insurance or otherwise.
Individuals themselves are responsible for determining whether payments from their HSAs are used for qualified medical expenses — trustees or custodians (or employers who make contributions on behalf of their employees) are not required to make that determination.
“Medical care” is generally defined as amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body” (including prescription and over the counter nonprescription drugs for these purposes). Medical care also includes amounts paid for transportation essential to that care, and for long term care services. Debit, credit, or stored value cards may be used to pay qualified medical expenses from HSAs.
Generally, an HSA may not be used to pay insurance premiums. However, exempt from this general rule are premiums for continuation coverage required under Federal law (e.g., COBRA coverage), premiums for long-term care insurance, premiums for a health plan an individual is enrolled in while receiving unemployment compensation, and, in the case of a Medicare-eligible individual, premiums for any health insurance other than a Medicare supplemental (Medigap) policy.
Who May Establish an HSA
Any individual (whether employed, self-employed, or unemployed) may establish an HSA in any month in which he is an “eligible individual.” An “eligible individual” is defined as an individual who is covered under a high deductible health plan (“HDHP”) on the first day of that month, and who is not also covered by a non-HDHP which provides benefits similar to the HDHP. In making this determination, coverage for accidents, disability, dental care, vision care, and long-term care are disregarded, as is coverage for any benefit provided under any of the following types of “permitted insurance”:
- Insurance provided under workers’ compensations laws;
- Insurance relating to tort liabilities;
- Insurance covering liabilities relating to ownership or use of property (e.g., auto or homeowners’ insurance coverage) or any similar liability insurance as the Secretary may specify by regulations;
- Insurance for a specified disease or illness (e.g., cancer policies); and
- Insurance which pays a fixed daily amount during periods of hospitalization.
Further, in order to establish an HSA, the individual must not be entitled to Medicare benefits, and must not be claimed as a dependent on another person’s tax return.
An individual may establish an HSA with or without employer involvement; that is, an eligible individual who is covered under an HDHP may establish an HSA directly with a qualified trustee or custodian.The trustee or custodian may, at its discretion, require certification or proof that the individual qualifies as an eligible individual, though such proof is not required.
High Deductible Health Plan
In order to qualify as an HDHP, the health plan must meet the following requirements:
For Self-Only Coverage:
- the health plan’s annual deductible must be at least $1,000; and
- the sum of the annual deductible and other annual out of pocket expenses payable by the covered individual under the health plan (e.g., copayments and coinsurance), excluding health plan premiums, together must not exceed $5,000.
For Family Coverage:
- the health plan’s annual deductible must be at least $2,000 (no benefits may be payable for any member of the family until the entire family deductible has been met); and
- the sum of the annual deductible and other annual out of pocket expenses payable by the covered individuals together must not exceed $10,000.
“Family coverage” is defined as any coverage that is not self-only coverage.
Notably, the new IRC section 223 provides a safe harbor for plans which pay first dollar benefits for preventive care — that is, for plans which exempt preventive care benefits from the plan’s annual deductible (according to the Treasury, additional guidance to clarify this provision is forthcoming).
A health plan that utilizes a provider network will not fail to qualify as an HDHP if it has an out of pocket limitation which exceeds these amounts for services provided outside of the network. Also, a health plan will not fail to qualify as an HDHP solely because it is a self-funded plan.
HSA Contribution Limits
Contributions to all HSAs (including contributions made to an Archer MSA) combined are subject to the following 2004 calendar year limits:
For Self-Only Coverage:
the lesser of:
- $2,600; or
- the HDHP’s annual deductible (for in-network services in a plan that utilizes a provider network) for such coverage.
For Family Coverage:
the lesser of:
- $5,150; or
- the HDHP’s annual deductible (for in-network services) for such coverage.
These limits will be adjusted for inflation in subsequent years, rounded up to the next $50 increment.
The contribution limits are determined on a monthly basis, in an amount that is 1/12 of the annual limits. (The Q&As describe the maximum amount that may be contributed to an HSA as “the sum of the limits determined separately for each month, based on status, eligibility and health plan coverage as of the first day of the month.”) Although maximum HSA contributions are determined on a monthly basis, an individual may make the annual maximum contribution on the first day of the year, provided excess contributions are corrected if, at any time during that year, the individual ceases to be an eligible individual. (Q&A–22 describes how excess contributions are corrected.) Any excess contributions which are not corrected are included in the eligible individual’s gross income (i.e., are taxable), and an excise tax is imposed on such excess.
If either spouse has family coverage, both spouses are treated as having family coverage. Further, if both spouses have family coverage, both are treated as covered under the plan with the lowest deductible. The contribution limit may be divided equally between spouses, unless they agree on a different division.
Additional “catch-up” contributions of $500 are allowed for individuals who reach at least age 55 (and have not yet reached the Medicare-eligible age) before the close of the 2004 taxable year. This additional contribution amount is increased by $100 each year until the additional contribution amount reaches $1,000 in year 2009. Like the annual contribution limit, the catch-up contribution limit is determined on a monthly basis, in an amount that is 1/12 of the annual limit.
Contributions for a particular year may be made any time prior to the due date of the eligible individual’s federal tax return for that year (i.e., generally by the April 15 of the year following the year for which the contributions are being made).
An individual’s allowable contributions to an HSA are reduced to $0 beginning with the first month in which the individual is entitled to Medicare benefits.
Tax Treatment of HSAs
IRC section 223(a) provides for a deduction from gross income in the amount of qualifying contributions made by an eligible individual, up to the annual contribution limits described above, whether or not the individual itemizes other deductions.
If an employer makes contributions on behalf of an eligible employee, those contributions are generally excluded from the employee’s gross income under new IRC section 106(d). Also, the employer contributions are not subject to the Federal Insurance Contributions Act (FICA) or the Federal Unemployment Tax Act (FUTA). Amounts contributed to an HSA for an employee or the employee’s spouse must be reported on the employee’s W–2 in box 12 (as code “W”).
HSAs may also be offered through an employer’s Section 125 cafeteria plan (a plan that offers an employee the choice of cash or qualified benefits), thereby working to reduce the employee’s gross income by the amount of contributions made that year to fund the HSA. Contributions to an employee’s HSA through a cafeteria plan are generally treated as employer contributions (except for purposes of the comparable contributions rule, described below).
Any combination of employer and employee contributions may be made on behalf of an eligible individual, provided the sum of contributions made on behalf of the employee are limited to the maximum annual HSA contributions described above.
Further, as long as an account qualifies as an HSA, it is exempt from taxation — that is, the HSA may accumulate earnings on a tax-free basis. Additionally, any HSA payments or distributions which are made to pay qualified medical expenses are exempt from taxation. (Conversely, any amount paid or distributed from an HSA which is not used exclusively to pay the account beneficiary’s qualified medical expenses shall be included in the beneficiary’s gross income, and a penalty will be imposed in the amount of 10% of any such payment, with exceptions applying in the event of disability or death, and for distributions made after the account beneficiary becomes eligible for Medicare.)
It is important to note that payments or distributions made from an HSA for qualified medical expenses are coordinated with the medical expense deduction allowed under IRC section 213. Any payment or distribution from an HSA used for qualified medical expenses will not be treated as an expense paid for medical care when determining the individual’s medical expense deduction.
Implications for Employers
An employer is permitted to make HSA contributions on behalf of its employees. However, the Act adds a provision to the IRC to impose a tax on an employer who fails to make comparable HSA contributions (similar to the current Archer MSA rules). Generally, an employer who makes a contribution to an HSA on behalf of any employee must make “comparable contributions” for all “comparable participating employees.” “Comparable contributions” are generally defined as contributions which are of the same amount or the same percentage of the annual deductible limit of the HDHP covering the employees. “Comparable participating employees” are generally defined as employees enrolled in the same category of coverage (i.e., self-only or family coverage) in any HDHP offered by the employer.
The Q&As provide that HSAs are not subject to COBRA continuation coverage under IRC section 4980B. However, not yet addressed is whether the requirements for continuation coverage under the Employee Retirement Income Security Act (ERISA) and the Public Health Service Act (PHSA) will apply to HSAs.
Additional Guidance Forthcoming
This article is intended as a general summary of some of the HSA provisions contained in the Act, and is not intended to provide details on all aspects of HSAs, nor has comprehensive guidance been issued on HSAs. In the December 22 press release that accompanied Notice 2004–2 (available at http://www.ustreas.gov/press/releases/js1061.htm), the Treasury and the IRS noted that they intend to follow Notice 2004–2 with additional guidance in the summer of 2004. In the Notice, they state they are seeking public comment regarding seven specific issues.
As we await further guidance on HSAs, we wonder if they are the wave of the future. Regardless, HSAs appear to be another initiative to make individuals better consumers of health care.