by George G. Jones and Mark A. Luscombe

As 2004 rolls in, we find ourselves with a brand-new tax-favored savings vehicle with which to work — but this one is not “the same old” savings plan.

Health Savings Accounts, created in the Medicare Prescription Drug Improvement and Modernization Act of 2003 and effective Jan. 1, 2004, allow deductible contributions to be set aside to cover medical expenses that are not covered by a high-deductible medical plan in which the taxpayer-employee participates. This tax-favored savings vehicle, however, is different from all others that have gone before it.

HSAs offer, for the first time on a widespread basis, a tax-favored vehicle that allows not only a deduction for contributions and tax-free accumulation, but also eventual tax-free distributions. (Medical Savings Accounts, a pilot project that closed at the end of 2003, also offered both a tax deduction and tax-free distribution, but were only available to a limited number of people and were generally more restrictive.)

The contributor to the HSA —either the employee or the employer — gets a deduction for contributions going into the HSA, and then the employee is allowed to withdraw the funds tax-free in the same year or in a future year to cover unreimbursed medical expenses.

As an additional kicker, contributions that are not used in any tax year may be rolled over, instead of being subject to the “use it or lose it” rule that is applicable to flexible spending accounts. Upon reaching age 65, accumulated funds in an HSA can be withdrawn tax-free to cover medical expenses, or they can be withdrawn penalty-free (although not tax-free) for any purpose whatsoever.

The HSA side of the equation

HSAs are non-forfeitable individual accounts held in trust and funded either with pre-tax employer contributions, above-the-line deductible contributions dir­ectly from eligible individuals, or through roll-over funds. As with IRAs, management will usually be hand­led by a bank or insurance company.

HSAs can be funded with pre-tax contributions of up to $2,600 each year for individuals and $5,150 for families to cover health care costs (these 2004 figures will be indexed annually for inflation). Deposits are made on a pre-tax basis. Any portion contributed by an employer is not income to the employee and is deductible by the employer.

Individuals who have reach­ed age 55 by the end of the tax year are allowed to increase their annual contribution limit by $500 for 2004, $600 for 2005, $700 for 2006, $800 for 2007, $900 for 2008, and $1,000 for 2009 and thereafter. HSA contributions may not be made after an employee retires.

For aggregation purposes, all payments made by or on behalf of the eligible individual are added together. This includes employer HSA contributions for the individual, as well as those made by the employee. Rollovers from an MSA to an HSA, however, are not taken into account for annual limit purposes. However, they must be done within a 60-day window, beginning with the day that the beneficiary received the payment or distribution.

Covered expenses

A qualified medical expense is generally defined as one incurred to diagnose, cure, treat or prevent disease. Qualified medical expenses also include certain health in­surance premiums, such as Medicare Part A and Part B, Medicare HMO and the employee’s share of premiums for employer-sponsored health insurance. Medigap policies are not covered.

Distributions not made for medical expenses are taxed as ordinary income. However, non-medical distributions avoid the 10 percent penalty for withdrawals if made after death, disability or reaching Medicare eligibility (generally, age 65).

The medical insurance side

Only employees who are enrolled in qualifying high-deductible plans may participate in an HSA. A high-deductible health insurance plan has at least a $1,000 annual deductible for self-only coverage and a $2,000 deductible for family coverage. (The annual deductibles for MSAs in 2003 had been $1,700 and $3,350 respectively.) In addition, annual out-of-pocket expenses for HSAs must be limited to $5,000 for  self-covered and $10,000 for families.

Preventive care expenses, however, need not be subject to a deductible. In addition, “out of network” maximums for out-of-pocket expenses are allowed to be higher.

On the first day of any month, not only must an individual be covered by a high deductible health plan, but she also must not be covered under a non-high-deductible plan. This requirement does not apply to coverage for accidents, disabil­ity, or dental, vision or long-term care. It also does not limit the medical plan options available to an employee, but only applies to that plan in which the employee elects to participate.

Planning strategies

The HSA/high-deductible coverage is especially well-suited to younger employees, since, as a group, they generally do not incur significant medical expenses and will be able to keep contributions in their HSAs for tax-free accumulation over a longer period. Older workers, however, will generally suffer as a group, since they tend to need more medical care, and the cost of traditional insurance presumably will rise as younger workers leave that risk pool.

Employers may see the advent of HSAs as an opportunity to cut medical benefits without too much grumbling from workers. As health insurance premiums skyrocket, one method that is being used to keep costs contained is to increase the deductible each year. Many employers may find themselves already close to the $1,000 minimum deductible needed to offer a high-deductible plan. They might consider jump-starting an HSA/high-deductible plan by contributing some of their premium savings to each electing employee’s HSA, at least for the first few years.

An employer has several ways to establish an HSA. First, an HSA option might be added to an existing cafeteria plan. Since eligible cafeteria plans must offer at least one form of nontaxable benefit, an HSA would aid in satisfying this requirement. However, an employer cannot offer an HSA that covers the same type of medi­cal expenses that are covered under another cafeteria option, such as an FSA.

If an employer opts to provide a combination HSA/high-deductible plan, it must offer comparable contributions for employees with comparable coverage during that time period. That is, the contributions must be of the same amount or of the same percentage of a plan is deductible. The comparability rule is applied separately to part-time employees. Failure to comply with this rule results in a 35 percent excise tax on the amounts contributed to HSAs during the period.

Employers who have already accepted regular medical plan elections for 2004 generally may terminate a traditional health plan (and offer COBRA benefits) at any time, subject to a “promise” made under the existing plan description. The combination HSA/high-deduc­tible plan could then be set into motion immediately for 2004.

Nevertheless, some issues arise. Since the enrollment period for cafeteria plans is likely closing (if not already closed), HSAs may not be an option for 2004. And, even if an HSA option is created for 2004 cafeteria plan participants, it isn’t clear at this time if an employee may change her benefit elections to participate in an HSA. Look for guidance from the Internal Revenue Service about this and other questions.

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