Health Savings Accounts Hit the Marketplace

by David M. Roth

Beginning January 1, 2004, the Internal Revenue Code permits eligible individuals to establish Health Savings Accounts (HSAs). HSAs are private, tax-advantaged savings accounts which can be used to pay for medical expenses incurred by individuals, their spouses, or their dependents. The purpose of this article is to provide a brief overview of the rules governing HSAs.

Only "eligible individuals" can establish HSAs. An eligible individual is any individual who: (1) is covered under a high-deductible health plan (HDHP); (2) is not also covered by any other health plan that is not a HDHP; (3) is not entitled to benefits under Medicare (generally, has not reached age 65); and (4) may not be claimed as a dependent on another person's tax return. No income limits apply, as is the case for other types of special savings accounts. A HDHP is a health plan which satisfies certain requirements with respect to minimum annual deductibles ($1,000 for an individual, $2,000 for a family) and maximum annual out-of-pocket expenses ($5,000 for individuals, $10,000 for families).

Eligible individuals may establish an HSA in much the same way that individuals establish IRAs. No permission or authorization from the Internal Revenue Service is necessary. Once established, tax-deductible contributions may be deposited into the account. The maximum annual contribution is the lesser of the annual deductible under the HDHP or $2,600 for individual coverage and $5,150 for family coverage. In addition to the maximum annual contribution, "catch-up" contributions are allowed by or on behalf of individuals between ages 55 and 65. For 2004, "catch-up" contributions are limited to $500. Deductions for contributions by individuals are "above-the-line," and thus, available whether or not the taxpayer itemizes other deductions.

In addition to contributions by eligible individuals, Employers may contribute to the HSAs of eligible employees. These contributions are excludable from the employee's gross income, and are not subject to tax withholding. Contributions may also be made through the Employer's cafeteria plan. Unlike amounts held in flexible spending accounts, amounts contributed to HSAs can be carried forward from year to year. HSAs can accumulate interest, and are not includable in gross income while held in the HSA.

Distributions from an HSA used exclusively to pay for uninsured "qualified medical expenses" of the account holder, his or her spouse, or dependants are excludable from income. "Qualified medical expenses" are defined broadly in Internal Revenue Code §213(d), and now include certain nonprescription drugs. Such expenses may not be covered by insurance, and must be incurred only after the HSA has been established. Generally, health insurance premiums are not considered qualified expenses. Monies withdrawn from an HSA for purposes other than medical expenses are subject to income tax, as well as a 10% penalty. The penalty will not apply to distributions made after age 65, or for distributions due to death or disability. Employer's who make contributions to HSAs established by their employee's are not responsible to determine whether HSA distributions are used exclusively for qualified expenses.

Upon death, any balance remaining in an individual's HSA is transferred to the named beneficiary of the account. If the named beneficiary is the surviving spouse, the HSA becomes the HSA of the surviving spouse, and the spouse is subject to income tax only to the extent distributions are not used for qualified expenses. If the named beneficiary is someone other than the surviving spouse, the fair market value of HSA assets as of the date of death is taxable to the named beneficiary.

Many planners and industry analysts believe HSAs will make a better showing than their predecessor, Medical Savings Accounts (MSAs), and will put consumers "back in the health triangle" along with insurance companies and medical providers. If you would like to discuss this new option in more detail, please give us a call.