The Alphabet Soup of Non-insurance Plans

By David Hovey

In December of 2003, President George W. Bush signed into law the Medicare Prescription Drug, Improvement, and Modernization Act of 2003.  In addition to making sweeping changes to the Medicare program, the Act created Health Savings Accounts (“HSAs”) effective January 1, 2004.  So now that we have HSAs, along with the previously available HRAs, MSAs, and FSAs, how is one to understand what all of these mean and ultimately which is the best for him or her?  The tax advantages conferred upon HSAs are significant, but before we dig into the details, let’s go back and briefly review the others so we can better understand the new benefits offered by HSAs.

It should but its already way over the word count limit so can’t -- Health Reimbursement Arrangement (HRA) - This is an employer-funded arrangement offered by employers to its employees to reimburse employees for qualified medical expenses.  These vehicles are funded solely by the employer and the employer controls the account, so employees are not permitted to contribute to the account either on a pre-tax or after-tax basis.  Employees are reimbursed tax-free for qualified medical expenses, and the reimbursements are tax-deductible for the employer.  Distributions from these accounts are not permitted for non-medical reasons, and substantiation is required by the employee to verify that distributions are for qualified medical purposes.  These accounts are not portable, so the employee cannot take the account balance with him or her upon termination of employment. 

Medical Savings Account (MSA) – An MSA is an account created to help self-employed individuals and employees of certain small employers meet the medical care costs of the account holder, and his/her family.  An MSA is designed for employers with 50 or fewer employees, and either the employer or the employee can contribute to the account, but not both.  These accounts are portable, so the account balance stays with the account holder even upon termination of employment.

Health Flexible Spending Arrangements (FSA) – This is an arrangement that allows an employee to set aside a portion of his/her earnings to pay for qualified medical expenses.  This type of account can only be established by the employer, and they are subject to an end-of-the-year “use it or lose it” requirement that limits the employee’s ability to protect against unexpected out-of-pocket medical expenses.  As such, these accounts are not portable.  Health FSAs are typically offered as a benefit option under a cafeteria plan and are financed with employee pre-tax salary reduction contributions.  Distributions are only allowed for qualified medical expenses and are subject to a “claims substantiation rule” that requires the employee to provide substantiation that the distribution was used for such qualified medical expenses.  Distributions that are properly substantiated are not taxable income to the employee recipient.

Health Savings Accounts – Using the above overview of the other arrangements as background, let’s delve into the HSAs and see the advantages it offers.  An HSA is a tax-exempt trust or custodial account that is set up by the account holder in conjunction with an HSA eligible plan to pay or reimburse certain medical expenses that are incurred by the account holder.  Contributions to the account may be made by the employee account holder, the employer or any third party.  Contributions to an HSA made by an eligible individual are deductible as an “above-the-line” deduction on the individual’s tax return.  Similarly, contributions made by an employer are excluded from the individual’s income and wages.  Distributions are tax-free provided that they are used for qualified medical expenses; distributions used for non-qualified expenses will be taxed at normal tax rates plus a penalty of 10% of the amount distributed.  The account is owned by the employee; thus it is fully portable and any unused funds remaining in the account remain available for use in later years.  The account balance can earn interest and other earnings which are tax-free since the account is a tax-exempt trust.  The account is also fully portable so the account holder keeps control of the account even upon termination of employment.  Thus, a healthy individual can create a sizeable account balance to be used in later years.

Overview of HSA Requirements – The favorable tax treatment for HSA contributions applies only to eligible individuals who establish an HSA.  An “eligible individual” is any person who, as of the first day of any month, is covered under a high deductible health plan (“HDHP”) and not covered under a non-high deductible health plan (“non’HDHP”) that provides coverage for a benefit covered under the HDHP.

An HDHP is an insured or self-insured health plan with a minimum annual deductible and a maximum out-of-pocket limit.  Both of these limits are increased annually for cost-of-living adjustments, but for 2009 the limits are $1,100 minimum annual deductible for an individual and $2,300 for a family; and $5,800 maximum out-of-pocket expenses for an individual and $11,600 for a family.

The maximum contributions that can be made to an HSA are also limited, and these limits are adjusted annually for cost-of-living adjustments.  For 2009 the maximum contribution limits are $3,000 for an individual and $5,950 for family coverage.  Individuals age 55 and older are also allowed an additional “catch-up” contribution which is $1,000 for 2009.

Executive Summary – A Health Savings Account (“HSA”) is a tax preferred account owned by an individual and used to pay for current and future medical expenses.  HSAs are funded by tax deductible individual contributions.  In addition, employers may contribute to employees’ HSAs as well, as long as the total contributions are within the maximum limits allowed for a given year.  Contributions to an HSA qualify for an “above-the-line” deduction by an eligible individual and distributions from the account are tax-free as long as they are used for qualified medical expenses.  Distributions are allowed for other reasons; however such distributions are subject to regular tax plus a 10% penalty tax.

The interest and investment earnings generated by the account are tax-free while kept in the HSA.  HSAs are portable, so an individual is not dependent on a particular employer to enjoy the advantages of having an HSA.  Similar to an Individual Retirement Account (“IRA”), the HSA is owned by the individual, not the employer, so if the individual changes jobs, the HSA goes with the individual.

About the Author
David Hovey is a Sr. Tax Manager with Kingery & Crouse PA in Tampa, FL.  Dave, an international tax expert, joined the firm in August, 2009 offering 17+ years of experience building, leading, and advising professional staff through complex international structuring, restructuring, acquisition, sales, and related compliance for multi-national entities.  Kingery & Crouse PA is a full service public accounting firm offering audits of private and public companies, tax planning & research, employee benefit plan audits and many other accounting services.  You may contact Dave @ (813) 874-1280 ext 201 or find us on the web at www.tampacpa.com