Funding Medical Expenses

CAFETERIA PLANS
IRC section 125 cafeteria plans are the most common taxpayer-friendly medical expense reimbursement arrangements (after medical insurance). Employee contributions fund flexible spending accounts (FSA) on a pretax, salary-reduction basis to provide coverage for specified expenses (qualified medical expenses or dependent-care-assistance costs, for example) incurred during the coverage period.

Reimbursement is subject to reasonable conditions. Participants must use FSA amounts for the specified expenses or forfeit any amounts remaining as of the plan yearend.

HRAs
Another alternative may be a health reimbursement account (HRA), which reimburses employees for medical expenses other insurance doesn’t cover. In general, employers fund HRAs—without employee salary reductions—to reimburse workers for substantiated medical care expenses incurred by the employee and his or her spouse and dependents. HRAs typically provide reimbursement up to a maximum dollar amount per coverage period, and may provide for a carryforward of any unused amount.

IRA WITHDRAWALS AND 401(k) ROLLOVER BALANCES
Individuals may take withdrawals as needed from their IRAs and/or certain 401(k) or other qualified plan account balances (rollover account balances, for example). This is certainly not preferable from a retirement planning perspective; the distribution will reduce the funds available at retirement and typically will be both taxable and subject to premature withdrawal penalties in the year withdrawn. However, all or a portion of these withdrawals may be exempt from the 10% premature withdrawal penalty under various circumstances.

Hardship withdrawals. Employees can use 401(k) plans to cover medical expenses. To take a hardship withdrawal, a participant must establish immediate and heavy financial need; the requested distribution cannot exceed the amount required to meet such need. Under regulations section 1.401(k)-1(d)(2), a distribution is for immediate and heavy financial need if it will pay for medical care expenses either previously incurred by or necessary for the medical care of the employee or his or her dependents.

CONCLUSION
Families and individuals with long-term special medical needs and expenses often have unusual tax-planning requirements. Taxpayers have available only limited avenues to use deductions to help defray their medical costs. CPAs should be able to identify such situations and recommend from among the potentially viable solutions.

For more information, see the Tax Clinic, edited by Kevin Reilly, in the October 2003 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser