Choose the Right Health Care Account

EXECUTIVE SUMMARY

Health spending accounts offer opportunities for employees to save and pay for health care with pretax contributions. Three basic types are flexible spending arrangements (FSAs), health reimbursement arrangements (HRAs) and health savings accounts (HSAs). FSAs are typically funded by pretax payroll deduction and are subject to cafeteria plan regulations, including a “use-it-or-lose-it” rule that prevents carryover of unused amounts to future years, unless an employer has adopted a 2 1/2 -month grace period provision. COBRA provisions, however, allow benefits to continue if an employee has a qualifying event such as termination of employment. HRAs may accompany high-deductible health plan (HDHP) coverage, and the employer and employee may share the deductible’s cost. An HRA must be funded solely by the employer and cannot be paid for by salary reduction. HSAs allow tax-free investment growth, and distributions for medical expenses aren’t included in income. HSAs must be paired with an HDHP covering the account owner. Owners can designate a spouse as beneficiary, and the account continues to be treated as an HSA after the death of the account holder and its transfer to the surviving spouse. Bart H. Siegel, CPA/PFS, CFP, CFE, is principal of Siegel Forensic Accounting and Consulting of Tampa, Fla. His e-mail address is bsiegel@tampabay.rr.com .

Even people in robust health, faced with the variety of tax-favored health spending accounts now available, can find the whirl of regulations and tax considerations dizzying. Three types of employer-sponsored plans offer tax advantages for out-of-pocket or other medical costs: flexible spending arrangements (FSAs), health reimbursement arrangements (HRAs) and health savings accounts (HSAs). Many employees, self-employed people and small business owners will turn to CPAs to sort out each plan’s intricacies and help them tailor one to their needs and resources.

The good news: While income tax deductions for health care expenses may be limited by itemization thresholds or the AMT, contributions to health spending accounts generally are excluded from taxable income. Employees may use pretax dollars to make medical-care-related contributions, and self-employed individuals are permitted to take a deduction for health insurance premiums or arrangements having the same effect.

FSAs are subject to cafeteria plan regulations, which include a use-it-or-lose-it rule, so an account balance must be spent by the end of each plan year. Starting in 2005, however, the IRS authorized employers to amend their cafeteria plans to allow an optional 2 1/2 -month grace period for expenses incurred after the end of the plan year. Therefore, advise your clients to base the amount they elect to have deducted from their pay on an annual budget of likely out-of-pocket expenses. These can include insurance deductibles and copays and even some over-the-counter medications and health supplies.

Because an FSA is considered a group health plan under COBRA and the Health Insurance Portability and Accountability Act of 1996 (HIPAA), though, it is not subject to use-it-or-lose-it in some circumstances. For example, under COBRA continuation-of-benefit rules, recently terminated employees may keep paying into their accounts. Although they must do so with after-tax dollars, the extension allows extra time to spend an accumulated balance that would otherwise be lost. An FSA is also subject to nondiscrimination rules governing self-insured medical reimbursement plans and is a welfare benefit plan subject to ERISA.

Choosing a Plan Comparing key features of health spending accounts   Flexible spending arrangement Health reimbursement arrangement Health savings account Initial legislation or regulation Revenue Act of 1978 U.S. Department of the Treasury revenue ruling 2002-41 Medicare Prescription Drug Act of 2003 Greatly expands the former Medical Savings Accounts. Date effective Jan. 1, 1979 June 26, 2002 Jan. 1, 2004 Internal Revenue Code reference IRC sections 106 and 125 IRC section 105 IRC section 223 Eligibility All employees except self-employed. All employees. Individuals under age 65 who have a high- deductible health plan. Qualified medical expenses Unreimbursed medical care expenses as defined by IRC section 213, but not premiums for health insurance coverage and long-term care expenses. Unreimbursed medical care expenses as defined by IRC section 213. HSA distributions are tax-free if they are used to pay for qualified medical expenses including prescription drugs, qualified long-term care services and long-term care insurance, COBRA coverage, Medicare expenses (but not Medigap), and retiree health expenses for individuals age 65 and older. Nonqualified medical expenses Expenses not covered under IRC section 213. Health insurance premiums under a continuation-of-coverage arrangement (such as COBRA). Health insurance premiums when receiving unemployment compensation. Qualified long-term care insurance premiums. Expenses not covered under IRC section 213. Distributions made for any other purpose. Must be covered by a health insurance plan No No Yes Contributor Employee, employer or both Employer Tax-advantaged contributions can be made in three ways: (1) the individual and family members can make tax-deductible contributions even if the individual does not itemize deductions, (2) the individual’s employer can make contributions that are not taxed to either the employer or the employee and (3) employers with cafeteria plans can allow employees to contribute untaxed salary through a salary reduction plan. Contribution limits No statutory limit; limits may be set by employer. No statutory limit; limits may be set by employer. The maximum annual contribution is $2,850 for self-only policies and $5,650 for family policies (indexed annually). Individuals age 55 to 65 may make additional “catch-up” contributions of up to $800 in 2007, increasing to $1,000 annually in 2009 and thereafter. A married couple can make two catch-up contributions as long as both spouses are at least 55. Funds carried over to next year No, except plans may offer a 2 1/2 -month grace period. Yes Yes Portability Account cannot be maintained if the employee is no longer working for the employer, except under COBRA continuation-of-benefit provisions. At employer discretion. Amounts contributed to an HSA belong to individuals and are completely portable. Money not spent stays in the account and gains interest tax-free, just like an IRA. Unused amounts remain available for later years. Source: Division of Compensation Data Analysis and Planning, Bureau of Labor Statistics; Department of the Treasury, Office of Public Affairs.

HEALTH REIMBURSEMENT ARRANGEMENTS
An HRA, as the name implies, reimburses employees for eligible expenses. As with an FSA, those reimbursements are made from an untaxed account into which the employer pays. Unlike an FSA, the payment is not deducted from the employee’s salary but is an additional benefit. It can be accompanied by an HDHP or other insurance plan, but doesn’t have to be (see sidebar, “ High-Deductible Health Plans”). If it is, the employer can pay the premiums of the HDHP and share the deductible’s cost with the employee.

An HRA reimburses only qualified medical expenses and allows the carryover of unused amounts to later years. If the plan is used for nonqualified expenses, all amounts paid become taxable, including prior medical reimbursements.

HEALTH SAVINGS ACCOUNTS
An HSA allows your employees and clients to build tax-free assets to pay for medical care. Similar to an IRA, it allows eligible individuals under 65, their family members or employers to make annual tax-deductible contributions. An HSA is paired with an HDHP. The Tax Relief and Health Care Act of 2006 increased contribution limits this year to $2,850 for an individual or $5,650 for families, regardless of the HDHP’s deductible amount. The act also authorized rollovers from FSAs and HRAs, as well as a one-time rollover from an IRA. The latter must be a direct trustee-to-trustee transfer, however. Holders may tap the account to pay qualified medical expenses, with the payments not taxed as distributions. Money withdrawn for other purposes by account holders under 65 is subject to a 10% penalty. The account’s investments grow tax-free.

Account holders under age 65 must be covered under an HDHP but no other health policy providing any of the same benefits.

Your clients can use an HSA to save for anticipated big-ticket services, such as orthodontics, which may not be covered fully, or even at all, by other health plans. But it may be to your clients’ advantage to instead pay for medical bills out of pocket and let their accounts’ investments appreciate. The account continues to be treated as an HSA after the death of the holder and its transfer to a surviving spouse, provided the surviving spouse is the designated beneficiary.

“You’re under no obligation to pay your medical bill out of the HSA account,” says Martha Priddy Patterson, a director with Deloitte & Touche. “If you can afford not to, it’s smart.”

Here’s an additional side benefit to your clients: Because they are paying for most of their health care out of savings, they’re likely to reduce costs by using medical care more judiciously.

Clients can sign up for HSAs with banks, credit unions, insurance companies and other approved companies. As with IRA contributions, post-year-end contributions to HSAs made by the due date for the tax return for the prior year will be deductible. Many states also exempt HSA contributions from state income tax.

Your client owns and controls the money in an HSA, including deciding how it is invested, except that it may not be invested in life insurance. But here are some restrictions to watch out for:

Contributions over the limits are not deductible, and IRC section 4973 imposes a 6% excise tax on the excess funds.

Excess contributions by an employer generate taxable income to the employee.

People may withdraw funds at any time for nonmedical expenditures, but distributions not used for medical expenses must be included in income and are subject to a 10% penalty. When an individual becomes eligible for Medicare, dies or becomes disabled, however, the funds may be used for any purpose without incurring the penalty (although withdrawals for nonmedical purposes are taxed as ordinary income).

» Practical Tips

Flexible spending arrangements’ use-it-or-lose-it feature pertains not just to the end of a calendar year (and possible 21/2-month grace period) but to termination of employment with a company. If employees know they’re going to leave a job where they have an FSA, they can review their contributions and expenditures since the beginning of the year and make qualifying purchases from any unspent balance. But they’ll have to do it before they leave the job. If an HSA holder’s spouse is the account’s designated beneficiary, following the death of the account holder and the transfer of interest, the account continues to be treated as an HSA, with the spouse as the account holder. If the designated beneficiary is not the account holder’s spouse—for example, the estate or another individual—the account ceases to be an HSA as of the date of death, and the fair market value of the funds is includible in the beneficiary’s gross income.

An HSA with an HDHP can offer significant savings over traditional insurance, especially if you don’t have—or lose—group coverage. For example, my wife left a company that provided our coverage. We received a notice, as a result of COBRA, that we had the right to continue coverage for a limited period as long as we assumed the employer contribution of the cost. Talk about sticker shock: Our monthly premiums rose from about $300 a month to more than $1,200. Most individual policies with comparable benefits were similarly expensive. Then I priced HDHPs with a health savings account.

First, I was pleased to find that as my annual deductible rose to $10,000, my monthly premium fell to $250 a month. After the deductible, the plan provided almost 100% coverage. So compared with paying $14,400 annually in premiums, plus copayments, I found the HSA to be the obvious choice, before I even started analyzing the significant tax benefits.

Next, I found that doctors often lower their fees when they know you are paying out of pocket. Prescription costs, although higher than health insurance copayments, were much lower than we expected. An HDHP may have contracted rates with medical providers like conventional insurance plans, which also reduces out-of-pocket costs.

Especially with recent changes expanding the flexibility of HSAs, the time has never been better for people to take charge of financing their health care and take advantage of the range of options. That’s where CPAs, as advisers in this increasingly important aspect of financial planning, can help point clients in the right direction, at the crossroads of health and wealth.