February 3, 2004


Brydon M. DeWitt
bdewitt@williamsmullen.com



In his State of the Union address, President Bush touted the new health savings accounts ("HSAs") created by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (the "Medicare Act"). The Medicare Act permits the establishment of HSAs for taxable years beginning after Dec. 31, 2003. The Internal Revenue Service ("IRS") swiftly published initial guidance on HSAs in the form of Notice 2004-2, and intends to provide additional guidance this summer.

The following paragraphs summarize the legal parameters of HSAs and the highlights of the IRS's initial guidance.

HSAs Defined

An HSA is a tax-exempt trust or custodial account, similar to an individual retirement account ("IRA"), established to receive tax-favored contributions by individuals or their employers. HSA funds may accumulate over several years or be distributed on a tax-free basis to pay or reimburse certain types of medical expenses, known as "qualified medical expenses." Like an IRA, an HSA belongs to the individual and is portable. An HSA stays with an employee who terminates employment.

HSA Eligibility

An HSA may be established by any individual who satisfies four conditions:

• the individual is covered under a "high deductible health plan" ("HDHP");
• the individual is not also covered under any other plan (including a spouse's plan) that is not an HDHP;
• the individual is not entitled to benefits under Medicare; and
• the individual may not be claimed as a dependent on another person's tax return.

Permitted Other Coverage. An individual may establish an HSA even if the individual has coverage for liabilities incurred under workers' compensation laws; tort liabilities; liabilities relating to ownership or use of property (such as automobile insurance); insurance for specific diseases or illnesses; or insurance that pays a fixed amount per day (or other period) of hospitalization. Additionally, an individual may establish an HSA while also having coverage, through insurance or otherwise, for accidents, disability, dental care, vision care, or long-term care.

Health FSAs. Until the IRS issues additional guidance, it is not clear whether an individual with health flexible spending account ("Health FSA") coverage may establish an HSA. If the Health FSA only provides reimbursements for vision and dental care, however, the Health FSA participant should be able to establish an HSA.

High Deductible Health Plan (HDHP) Defined

An HDHP is an insured or self insured health plan that satisfies certain deductible and out-of-pocket limit requirements. For self-only coverage, the plan must require an annual deductible of at least $1,000 and have an annual out-of-pocket maximum of no more than $5,000. The annual deductible for family coverage must be at least $2,000 and the annual out-of-pocket expenses must be capped at no more than $10,000. The deductible for family coverage must apply to the family as a whole and not pay benefits until the family has incurred expenses in excess of the deductible. The following example from Notice 2004-2 illustrates the family deductible requirement.

A plan provides coverage for A and his family. The plan provides for the payment of covered medical expenses of any member of A's family if the member has incurred covered medical expenses during the year in excess of $1,000 even if the family has not incurred covered medical expenses in excess of $2,000. If A incurred covered medical expenses of $1,500 in a year, the plan would pay $500. Thus, benefits are potentially available under the plan even if the family's covered medical expenses do not exceed $2,000. Because the plan provides family coverage with an annual deductible of less than $2,000, the plan is not an HDHP.

Preventative Care. The deductible requirement does not apply to preventative care (e.g. physical examinations, cardiovascular screenings, mammography, etc.). An HDHP may have a small deductible or even provide first dollar coverage for preventative care.

Out-of-Network Providers. A plan that uses a network of providers may qualify as an HDHP even if it caps out-of-pocket expenses for services provided by non-network providers at levels higher than the limits allowed for HDHPs.

Establishing an HSA

An individual may establish an HSA with a "qualified HSA trustee or custodian." A "qualified HSA trustee or custodian" must be an insurance company, bank, or any other person approved by the IRS to be a trustee of an IRA or Archer MSA. The HSA trustee or custodian does not have to be the HDHP provider. If the HSA trustee or custodian is not also the HDHP provider, it may require proof or certification that the individual is eligible to open an HSA.

HSA Contributions

The individual, the individual's employer, and members of the individual's family may contribute to the individual's HSA. Contributions (other than rollover contributions) must be in cash and may be made through a cafeteria plan.

Contribution Limit. For 2004, the maximum annual contribution is the lesser of the HDHP deductible and $2,600 for individuals with self-only coverage or $5,150 for individuals with family coverage. The maximum annual contribution, however, is determined on a monthly basis by taking one-twelfth of the lesser of the HDHP annual deductible and the applicable maximum contribution amount ($2,600 or $5,150). For example, the annual contribution limit for an individual who begins self-only coverage under an HDHP on June 1 with an annual deductible of $5,000 would be computed as follows:

($2,600/12) x 7 months = $1,516.69

The HDHP deductible would not be used because $2,600 is less than $5,000. The monthly contribution limit would be $216.67 ($2,600/12).

All contributions from all sources are aggregated for purposes of the contribution limit.

Catch Up Contributions. Individuals who are between ages 55 and 65 may make an additional $500 in HSA contributions for 2004. The catch up amount will increase by $100 every year until it reaches $1,000 in 2009.

Married Individuals. With respect to married individuals, if either spouse has family coverage, both spouses are treated as having family coverage. If both spouses have family coverage, both are treated as having coverage under the plan with the lowest deductible. Accordingly, the limit for the spouses is the lowest deductible amount divided between the spouses (on whatever division they decide).

For example, suppose H, age 58, and W, age 53, are married and both have HDHP coverage under separate plans. H's plan has a $3,000 deductible. W's plan has a $2,000 deductible. For purposes of the contribution limit, H and W are treated as covered under W's plan. H and W decide to equally divide the contribution limit. Accordingly, H can contribute $1,500 to an HSA in 2004 (one-half of the $2,000 deductible plus a $500 catch up contribution). W can contribute $1,000 to an HSA.

Rollover Contributions. Rollover contributions to HSAs are allowed. Rollovers may be made from Archer MSAs and other HSAs, and may be made in cash or property. The HSA contribution limit does not apply to rollovers. An HSA may not accept a rollover from an IRA, a health reimbursement arrangement ("HRA"), or from a Health FSA.

Employer Nondiscrimination Requirement. An employer that makes HSA contributions must make "comparable" contributions on behalf of all HSA eligible employees who have comparable coverage. Contributions that are either the same amount or based on the same percentage of the HDHP deductible are "comparable." For example, an employer could contribute $100 to every employee's HSA or ten percent of each employee's HDHP deductible. Rollovers are not taken into account for purposes of the nondiscrimination rule. The nondiscrimination rule applies separately to employees who work fewer than thirty hours per week. Violating the HSA nondiscrimination rule subjects the employer to an excise tax equal to thirty-five percent of the employer's aggregate HSA contribution.

Tax Consequences

Individual's Contributions. An individual's contributions to his or her HSA are deductible, regardless of whether the individual itemizes deductions.

Family Member's Contributions. Contributions by a family member to an individual's HSA are deductible by the individual, regardless of whether the individual itemizes deductions.

Employer's Contributions. Employer contributions to an employee's HSA are excludable from the employee's gross income, not subject to income tax withholding, and exempt from Federal Insurance Contributions Act, Federal Unemployment Tax Act; and Railroad Retirement Act Tax. The employer may deduct the contribution as employer-provided coverage for medical expenses under an accident or health plan.

Tax Treatment of the HSA. Like IRAs, HSAs are tax-exempt. Earnings are not taxable while held in the HSA. HSA distributions used exclusively to pay for "qualified medical expenses" of the account beneficiary, his or her spouse, or dependents are tax-free. Other HSA distributions are included in the gross income of the account beneficiary and subject to an additional ten percent tax, unless the distribution is made after the account beneficiary's death, disability or attainment of age sixty-five.

HSA Distributions and "Qualified Medical Expenses"

HSA distributions may be made at any time. As noted above, if the distribution is used to pay for "qualified medical expenses," it is tax-free. Generally, a "qualified medical expense" is any expense that would be reimbursable under a Health FSA (Internal Revenue Code section 213(d) medical care expenses). An expense that is covered by insurance or otherwise, however, is not a "qualified medical expense."

Employers that contribute to employees' HSAs have no obligation to determine whether HSA distributions are used exclusively for qualified medical expenses.

Health Insurance Premiums. As a general rule, health insurance premiums are not qualified medical expenses. The following premiums, however, are HSA qualified medical expenses:

• COBRA continuation coverage premiums;
• Premiums for health care coverage while an individual is receiving unemployment compensation;
• Medicare Part A or Part B premiums (for individuals over age 65);
• Medicare HMO premiums (for individuals over age 65); and
• Premiums for employer-sponsored retiree health insurance (for individuals over age 65).

COBRA

HSAs are not subject to the COBRA continuation coverage requirements.

Advantages and Disadvantages of HSAs.

Advantages. The following are among some of the advantages of an HSA:

• Empowerment. HSAs allow patients and doctors more control over health care decisions because HSA dollars may be spent on any qualified medical expense, without regard to networks, utilization review, or other elements of managed care.

• Carryover. Unlike Health FSAs, unused HSA funds may be used in subsequent years.

• Access to Funds. Individuals may withdraw funds from their HSAs at any time and for any purposes, although taxes and penalties apply if the distribution is not used for qualified medical expenses.

• Potential to Lower Employer Health Care Costs. HSAs make high deductible health plans more attractive to employees and give employees an incentive to be prudent with their health care expenditures.

• Tax Savings. Employees benefit from deductible individual contributions, tax-free employer contributions and tax-free earnings. Employers may deduct contributions and avoid payroll taxes on HSA contributions.

Disadvantages. Disadvantages of HSAs include the following:

• Limits Health Plan Choice. Individuals who establish HSAs must participate in high deductible health plans. HDHPs are not suitable for all individuals.

• Nondiscrimination Requirements. Employers that contribute to employees' HSAs must comply with the HSA nondiscrimination requirement and face an excise tax penalty for failure to do so.

• Contribution Limits. The current HSA contribution limits combined with the HDHP participation requirement may make it difficult for employees to accumulate funds in their HSAs. Individuals who incur significant health care expenses will not find HSAs to be attractive.

• Adverse Selection. An employer that offers an HSA / HDHP option and a more comprehensive health plan option may experience a migration of healthy employees to the HSA / HDHP option, leaving less healthy employees (but fewer premium dollars) in the comprehensive health plan.

The full impact of the HSA legislation will not be known for some time. HSAs, however, should prove to be an effective vehicle for employers and employees to manage the cost of health care.