NOTE: In this Chapter, the person who is the holder of the plan or covered by the plan described, is referred to variously as the “holder,” “individual,” “person,” and when applicable, “employee.” Again, the masculine format is used only for simplicity purposes.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 authorized the establishment of new health savings accounts, effective January 1, 2004. This Chapter describes in detail these plans, particularly since there has been such emphasis on these plans by the Administration and the Congress. These plans have deliberately been made attractive for tax purposes; therefore, this discussion will concentrate on the tax advantages of the various health plans. In respect as to the insurance vehicle, in most of these plans a high-deductible health plan (HDHP) is used. Other than the high deductible, the plans are basically comprehensive major medical plans. Some insurers make some variations, but usually these are minor and are simply for marketing purposes.
Even though the Medical Savings Account (MSAs) have not succeeded in popularity as much as desired or projected, these other plans have been added in an attempt to make the concept of an individual paying for the majority of his medical expenses out-or-pocket—instead of having an insurer pay nearly all of the cost—as attractive to the consumer as possible.
Congress enacted, in 1996, a law that allowed individuals and small employers to fund medical expenses by creating up to 750,000 Medical Savings Accounts (MSAs), which are defined as savings accounts whose funds are used exclusively to pay for an individual’s or family’s medical expenses. Tax-deductible contributions can be made to the account and the interest on the account is tax deferred. Any withdrawals for the purpose of paying for medical expenses are not taxable as income.
MSAs works in the following manner: High-deductible medical expense insurance is purchased, along with the medical savings account, with high deductibles ranging from $1,700 to $2,600 for unmarried individuals, and $3,450 to $5,150 for families and with out-of-pocket maximums of $3,450 for individuals and $6,300 for families (no minimum lifetime benefit is required). Note: These amounts are indexed for inflation and these figures are for year 2004. The reasoning is that relatively small medical expenses will be covered by the MSA, with large expenses covered by the insurance.
Contributions to the MSA have an annual maximum of an amount that equals 65% of the deductible for individuals, and 75% for families—no established minimum.
The MSA holder can claim a tax deduction for contributions made by the holder, even if deductions are not itemized on Form 1040. The interest or other earnings of the assets in the Archer MSA are tax free. Distributions are tax-free if the holder pays qualified medical expenses. (See Discussion of Qualified Medical Expenses under following discussion of HSAs.) The contributions stay in the Archer MSA from year to year until used by the MSA holder.
In order for a person to qualify for an Medical Savings Account, they must be either:
Also, the individual must not have any other health of Medicare coverage except what is permitted under “Other Health Coverage” as defined later, plus the person not can be claimed as a deduction on another person’s tax return, even if the person does not claim the exemption.
A small employer is considered an employer who had an average of 50 or fewer employees during either of the last two calendar years. This definition is modified for new and growing employers.
A small employer may begin HDHPs and Archer MSAs for his or her employees and then grow beyond 50 employees. The employer is considered as meeting the requirement for small employers if he had 50 or fewer employers when the MSA started, made a contribution that was excludable or deductible as an MSA for the last year he had 50 or fewer employees, and had an average of 200 or fewer employees each year after 1996.
If the holder changes employers, the Medical Savings Account goes with him but he cannot make any additional contributions unless he is otherwise eligible.
The person must have an HDHP that has a higher annual deductible than typical health plans and a maximum limit on the annual out-of-pocket medical expenses that he must pay for covered expenses as described previously.
There are some family plans that have deductibles for both the family as a whole and for individual member members and if the individual meets the deductible for one family member, they do not have to meet a higher annual deductible amount for the family. If either the deductible for the family or the deductible for an individual family member is below the minimum annual deductible for family coverage, the plan would NOT quality as an HDHP.
The Medical Savings Account holder generally cannot have any other health coverage except the HDHP, but he (they) may have additional insurance that provides other benefits only for the following:
They may also have coverage, insurance or otherwise, for accidents, disability, dental care, vision care and long-term care.
Contributions to a Medical Savings Account must be made in cash—no stock or property. If the individual is an employee, the employer may make contributions to the MSA and the holder does not pay tax on these contributions. If the employer does not make contributions to the MSA, or if the person is self-employed, he can make his own contributions to the MSA. Both the individual and employer cannot make contributions to the MSA in the same year and it is not necessary for the individual to make contributions to the MSA each year.
If the spouse is covered by the individual’s MSA and an excludable amount is contributed by the spouse’s employer to an MSA belonging to that spouse, the individual cannot make contributions to his own MSA that year.
There are two limits on the amount that the individual or his employer can contribute to his Medical Savings Account, the annual deductible limit and an income limit.
The annual deductible limit allows the individual or his employer to contribute up to 75% of the annual deductible of the HDHP (65% if it is a self-only plan) to the MSA. The individual must have had the MSA for an entire year to contribute the full amount. If he does not qualify to contribute the full amount for the year, IRS Form 8853 provides instructions as how to determine the annual deductible.
Simply put, if the individual has an HDHP for his family for an entire year, the annual deductible is $4,000 (for 2004). He can contribute up to $3,000 for the year (75% of the MSA for the year). If, for instance, the HDHP had been in force for 6 months (July thru December), he can contribute up to $1,500 for the year ($4,000 x 75% for 6 months [half of the year]).
If the individual and his spouse each have a family plan, he would be treated as having family coverage with the lower annual deductible of the two health plans. The contribution limit is split equally, unless there is agreement on a different division.
An individual cannot contribute more than they earn for the year from the employer through whom he has the HDHP. If the individual is self-employed, he cannot contribute more than his net self-employment income—defined as income from self-employment less expenses (including the ½ of self-employment tax deduction).
A person cannot contribute to an MSA effective with the first month enrolled in Medicare. However, he may be eligible for a Medicare Advantage MSA, discussed later.
All contributions to an MSA must be reported on Form 8853 which is filed with the IRS Form 1040. All contributions by the individual and/or his employer made for the taxable year must be reported.
The individual should receive Form 5498-SA, HSA, Archer MSA, or Medicare Choice MSA Information from the trustee that shows the amount contributed by the individual and/or employer during the year.
If the contributions to the MSA is larger that the limits as discussed, such excess contributions are not deductible and any excess contributions made by the employer are included in the gross income of the individual. If the excess contribution is not included in Box 1 on Form W-2, it must be reported as “Other Income” on the individual’s tax return and the individual may have to pay a 6% excise tax on excess contributions.
Some or all of the excess contributions maybe withdrawn and no excise tax is payable on the amount withdrawn if the excess contribution is withdrawn by the due date, including extensions, on the individual’s tax return, and the individual withdraws any income earned on the withdrawn contributions and includes the earnings in “Other Income” on the tax return on the year the contributions were withdrawn.
The usual procedure is for the individual to pay medical expenses during the year without being reimbursed by the High Deductible Health Plan until the annual deduction has been reached. When medical expenses are paid during the year that is not reimbursed by the High Deductible Health Plan, the trustee should send the individual a distribution from the Medical Savings Account.
The individual can receive tax-free distributions from the Medical Savings Account to pay for qualified medical expenses. If distributions are received for other reasons, the amount may be subject to income tax and may be subject also to an excise tax.
If the individual no longer is qualified to make contributions, he may still receive tax-free distributions to pay or reimburse his qualified medical expenses.
Note: Qualified Medical Expenses are described in detail in the section following the discussion of the HSA plan.
The individual cannot deduct qualified medical expenses as an itemized deduction on Schedule A of Form 1040 that are equal to the tax-free distribution from the MSA.
As a generals rule, insurance premiums may not be treated as qualified medical expenses for an MSA. However, the individual can treat premiums for Long-Term Care Insurance (amount subject to HIPAA regulations), health care coverage while receiving unemployment benefits, or health care continuation coverage required under any federal law as qualified medical expenses for MSAs. Also, the individual cannot claim this credit for premiums that he paid with a tax-free distribution from the MSA.
A transaction that is prohibited by section 4975 with respect to any MSA during the year makes the account a deemed taxable distribution as it ceases to be an MSA. Therefore, the fair market value of all assets in the account must be shown on Form 8853.
If the individual used any portion of the MSA as security for a loan at any time during the year, the MSA ceases and the fair market value of the assets used as security for the loan must be shown on Form 1040, line 21.
The individual must keep records to show later that the distributions were used exclusively to pay or reimburse qualified medical expenses, the qualified medical expenses had not been previously paid or reimbursed from another source, and the medical expenses had not been taken as an itemized deduction in any year.
These records are not to be send with the tax return but kept with tax records.
If the distribution is used for qualified medical expenses, taxes do not have to be paid on the distribution but it must be reported on Form 8853.
If the distribution is not used for qualified medical expenses, tax must be paid on the distribution and the amount reported on Form 8853.
If an amount, other than a rollover, is contributed to the MSA by the individual or employer, he must also report and pay tax on a distribution received from the MSA that year that is used to pay medical expenses of another person who is not covered by the HDHP, or is also covered by another health plan that is not an HDHP, at the time the expenses are incurred (Form 8853).
As a general rule, any distribution from an MSA that is rolled over into another MSA or an HSA, is not taxable if the rollover is completed within 60 days. Only one rollover a year is permitted.
There is a 15% additional tax on the part of the distributions not used for qualified medical expenses. Tax is calculated using Form 8853 and filed with Form 1040.
Note: There is no additional tax on distributions made after the date the individual becomes disabled, reaches age 65, or dies.
An MSA is usually exempt from tax. The individual is permitted to take a distribution from the MSA at any time, however only those amounts used exclusively to pay for qualified medical expenses are tax free. Amounts that remain at the end of the year are generally carried over to the next year. Earnings on amounts in an MSA are not included in the individual’s income while the earnings are held in the MSA.
A holder of an MSA should always choose a beneficiary because the disposition of the MSA upon the death of the holder depends upon who is the designated beneficiary.
If the spouse is the designated beneficiary, the MSA will be treated as belonging to the spouse after death of the holder.
If the spouse is not the designated beneficiary, then the accounts stops being an MSA and the fair market value of the MSA becomes taxable to the beneficiary in the year in which the holder died.
If the estate is the beneficiary, the value is included in the final income tax return of the holder
The amount taxable to a beneficiary other than the estate is reduced by any qualified medical expenses for the decedent that are paid by the beneficiary within 1 year after the date of death.
Please note the discussion of the HSA in the following section in respect to the requirement affecting employers that want to make the plan available to their employees, as the MSA requirements are identical in this respect.
Supporters of the MSA plan to fund individual and small group health care believe that it can lead to greater individual accountability as individuals will be more vigilant in seeking medical care if they have to pay for it by money from their MSA. When individuals have medical plans that are paid by third parties (insurers, for example) there is little incentive to control the expenditures and the danger of over-utilization arises.
In addition to the tax savings and the control of expenses feature, another important advantage is that MSAs will often allow individuals who previously had no health insurance to obtain it on more favorable terms, with greater freedom of choice in health care providers and in health care financing. Individuals who may not be eligible for a major medical plan may be acceptable in many cases if they “share-the-risk” with the insurer through a high deductible that eliminates many of the smaller claims, thereby favorably affecting both the loss ratio and the expenses of the policy.
There are detractors, principally those who maintain that MSAs may discourage insureds from seeking medical care because of their reluctance to spend their own money. This concern applies more readily to preventative care. These same persons also argue that adverse selection will occur inasmuch as the wealthy and healthy will take advantage of the option, which means that other insuring arrangements will have less healthy groups which, in turn, create higher costs for those who are not wealthy.
“The Medicare Prescription Drug, Improvement and Modernization Act of 2003” authorized the establishment of new health savings accounts, effective January 1, 2004. These accounts are similar to Medical Savings Accounts inasmuch as they allow eligible individuals to save for, and pay, health care expenses on a tax-free basis.
A Health Savings Account may receive contributions from an eligible individual or any other person, including an employer or a family member, on behalf of an eligible individual. Contributions, other than the contributions of the employer, are deductible on the eligible individual’s return whether or not the individual itemizes deductions. Employer contributions are not included in income. Distributions from a Health Savings Account that are used to pay qualified medical expenses are not taxed.
Technically, a Health Savings Account is a tax-exempt trust or custodial account that is set up with a qualified Health Savings Account trustee to pay or reimburse certain medical expenses that is incurred by the individual or qualified family member.
It is not necessary to seek permission or authorization from the IRS to establish an HSA but the individual must work with a trustee, which can be a bank, insurance company or anyone that is approved by them to be a trustee of IRAs or MSAs. The HSA can be established through a trustee that is different from the health plan provider.
If the individual has an Archer MSA, generally they can roll it over into an HSA tax free.
(This is where Health Insurance enters the picture, similar to the Medical Savings Account). To be eligible and qualify for the Health Savings Account, he must have a high deductible health plan (High Deductible Health Plan), on the first day of the month. He must have no other health coverage except what is permitted, not enrolled in Medicare, and not be claimed as a dependant on someone else’s tax return. (Note: If another taxpayer is entitled to claim an exemption for the individual, the individual cannot claim a deduction for an HSA contribution—even if the other person does not actually claim the deduction.)
Each spouse who is eligible and who wants a Health Savings Account must open a separate Health Savings Account – no “joint” Health Savings Account.
A High Deductible Health Plan has a higher deductible than the typical health plans, and a maximum limit on the sum of the annual deductible and out-of-pocket medical expenses that must be paid for covered expenses. Out-of-pocket expenses include copayments and other amounts, but do not include premiums.
An HDHP may provide for preventative care benefits without a deductible, or with a deductible below the minimum annual deductible. Preventive care includes (but it not limited to:
Minimum annual deductible and maximum annual deducible and other out-of-pocket
expenses for HDHPs for 2004.
Minimum Maximum
Type of Annual Annual Deductible and other out-
Coverage Deductible of-Pocket Expenses .
Self-only $1,000 $5,000
Family $2,000 $10,000
(These limits do not apply to deductibles and expenses for out-of-pocket network services if the plan uses a network of providers. Instead, only deductibles and out-of-pocket expenses for services within the network should be used to figure whether the limit applies.)
Note, also, that these amounts pertain only to HDHPs for HSAs and other such plans. MSAs have different minimum deductibles and expenses, as discussed earlier.
“Self-only” HDHP coverage is an HDHP covering only an eligible individual. Family HDHP coverage is an HDHP covering an eligible and at least one other individual, whether or not that individual is an eligible individual.
Note: Some states may require a health plan to provide certain benefits without a deductible or a deductible that is less than the minimum annual deductible, in which case the plan may not be an HDHP. However, for years 2004 and 2005, plans that would otherwise qualify will be treated as HDHP if those benefits were required by state law in effect on Jan. 1, 2004.
There are family plans available that have deductibles for both the family (as a whole) and for individual family members. Under these types of plans, if the individual meets the individual deductible for one family member, the individual does not have to meet the higher annual deductibles for the family. If either the deductible for the family as a whole or the deductible for an individual family member is below the minimum annual deductible for family coverage, then the plan does not qualify as an HDHP.
For example, Jones has a family health insurance plan in force in 2004. The annual deductible for the family plan is $3,500. This plan also has an individual deductible of $1,500 for each family member. The plan does not qualify as an HDHP because the deductible for an individual family member is below the minimum annual deductible ($2,000) for family coverage.
The individual (and spouse if family coverage) usually cannot have any other health coverage that is not an HDHP. However, they may have additional insurance that provides benefits only for the following items:
However, the individual may have coverages, whether by insurance or otherwise, for accidents, disability, dental care, vision care, and long-term care. Plans in which substantially all of the coverage is through these items are not considered as HDHPs. As an example, if the plan is a dread disease policy, it is not considered as an HDHP for the purposes of establishing an HSA.
A prescription drug plan, either as part of an HDHP or as a separate policy or rider, will allow the individual to qualify as an eligible individual if the plan does not provide benefits until the minimum annual deductible of the HDHP has been met. If the individual can receive benefits before that deductible is met, then the eligibility is not present. However, if the individual can receive benefits during 2004 or 2005 under a separate drug plan or rider before the deductible of the HDHP has been met, the individual can still qualify. This is a “grandfather” type of situation and was included as the legislators did not want an individual to go without prescription drug coverage not covered by the HDHP during the first 2 years of this program.
As a general rule, an employee covered by an HDHP and a Health FSA or HRA that pays or reimburses qualified medical expenses generally cannot make contributions to an HSA, Health FSA or HRA (discussed later).
An employee may make contributions to an HSA while covered under an HDHP, and one or more of the following plans:
A limited purpose health FSA or HRA may pay or reimburse the items listed under “Other health coverage” except for long-term care. These arrangements/plans can pay or reimburse for preventive care expenses as they can be paid without having to satisfy the deductible.
A suspended HRA —before the HRA coverage starts, the individual may elect to suspend the HRA. The HRA does not pay or reimburse (at any time) for the medical expenses incurred during the suspension period except preventative care and items listed under “Other health coverages.” At the end of the suspension period, the individual is no longer eligible to make contributions to an HSA.
A post-deductible health FSA or HRA—these arrangements do not pay or reimburse any medical expenses incurred before the minimum annual deductible has been met. The deductible for these arrangements do not have to mirror the HDHP deductible, but the benefits may not be provided before the minimum annual deductible HDHP deductible is met.
Retirement HRA—pays or reimburses only those medical expenses incurred after retirement. After retirement an individual is no longer eligible to make contributions to an HSA.
Any eligible individual can contribute to a Health Savings Account. If it is an employee’s Health Savings Account, the employee and/or the employee’s employer can contribute to the Health Savings Account in the same year. If the HSA is established by a self-employed or unemployed individual, the individual can contribute. Family members or any other person may also make contributions on behalf of an eligible person. However, all contributions must be made in cash—stock or property cannot be used as contributions.
The contribution amount that the individual or any other person can contribute to an HSA, depends entirely upon the type of HDHP coverage and the age of the individual. (There were exceptions for those who established the plan in 2004, but it does not extend further). The individual must be an eligible individual and have the same coverage all year to contribute the full amount. If the individual does not qualify to contribute the full amount for the year, then the contribution limit is determined by using IRS Form 8889 instruction.
These instructions are relatively simple, as, for instance, if the person has an HDHP for the entire months of July through December and the annual deductible is $4,000 (and the person is under age 55), and $4,000 is contributed each month, then the total of these amounts ($24,000) is divided by 12 (months in the year) to determine the contribution limit—$2,000.
Incidentally, if the individual is age 55 or older, the contribution limit is increased by $500. Therefore, as an example, if the individual has a self-only coverage, he can contribute up to the amount of the annual health plan deductible, plus $500, but not more than $3,100. In the example in the preceding paragraph, if the person reached age 55 on September of that year, $4,500 would be shown on worksheet for Form 8889, (July through December), $4,500 times 6 = $27,000, divided by 12 would show contribution limit of $2,250 for the year. (These calculations are for year 2004, for 2005 the additional contribution amount is $600 — $2,300 contribution limit.)
If there are multiple HSAs, the total contributions cannot be more than the limits as discussed above.
The contributions to the HSA must be reduced by the amount of any contribution made to an Archer MSA—including employer contributions—for the year. (Note exceptions for married persons below.)
The amount that can be contributed to the individual’s HSA is the amount made by the employer that is excludable from the individual’s income.
For married couples, if either spouse has family coverage, then both spouses are treated as having family coverage. If each spouse has family coverage under a separate plan, both are considered as having family coverage under the plan with the lower annual deductible. Therefore, the individual must reduce the limit on contributions before considering any additional contributions, by the amount contributed to both spouse’s Archer MSAs. After that reduction, the contribution limit is split equally between the spouses unless they agree on a different division.
If both spouses are age 55 or older and not enrolled in Medicare, each spouse’s contribution limit is increased by the additional contribution. If both spouses meet the age requirement, the total contributions under family coverage cannot be more than $6,150.
An HDHP with family coverage may have deductibles for both the family as a whole (umbrella deduction) and for individual family members (embedded deductible). The limit of contribution under this situation is the least of:
The following example may clarify this provision:
In 2004, Jones had an HDHP with family coverage for him, his wife, and two dependant children. The HDHP will pay benefits for any family members whose covered expenses are more than $2,000 (the embedded deductible) and will pay benefits for all family members when the family’s covered expenses exceed $5,000 (the umbrella deductible). The maximum annual contribution limit is $5,000—the least of $5,150, $5,000 or $8,000 ($2,000 x 4). [If the plan only covered a married couple, then the maximum annual contribution limit is $4,000—least of $5,150, $5,000 or $4,000 ($2,000 x 2)]
A plan will not qualify as an HDHP if either the umbrella deductible or the embedded deductible is less than the minimum annual deductible ($2,000) for family coverage. If there is no umbrella deductible, the deductible for each family member multiplied by the number of family members cannot exceed the maximum annual deductible and other out-of-pocket expenses ($10,000) for family coverage.
A person who enrolls in Medicare cannot contribute to an HSA, beginning with the first month the person enrolls.
Amounts from Archer MSAs and other HSAs can be rolled over into an HSA without being limited by annual contribution limits, and they do not need to be in cash. However, the amount must be rolled over within 60 days after the date of receipt, only one rollover contribution to an HSA is allowed during any one year period, and rollovers from an IRA, an HRA or a health FSA into an HSA, are not allowed.
Employer contributions to an HSA are not included in the individual 1040 tax return. Contributions made and contributions made by any other person (other than employer) can be claimed as an adjustment to income.
All contributions to HSAs are reported on Form 8889, Health Savings Accounts (HSAs), and filed with the Form 1040. The individual should receives Form 5498-SA, HSA, Archer MSA, or Medicare Choice MSA from the trustee showing the amount contributed during the year. Employer’s contributions will also be shown in Box 12 of the employee’s Form W-2, with Code W shown. HSA deduction is reported on Form 1040 line 28.
Contributions to an HSA that is greater than the limits are considered as “excess contributions” and are not deductible. If the employer makes excess contributions, they are not reported in gross income. If the excess contribution is not included in Box 1 on Form W-2, then the excess must be reported as “Other Income” on the tax return, and as a general rule, the individual must pay a 6% excise tax on excess contributions.
In order to avoid the excise tax, all or some of the excess contributions may be withdrawn if the excess is withdrawn by the due date (including extensions) of the tax return for the year the contributions were made, or the income earned on the withdrawn contributions are withdrawn and included in “Other Income” on the tax return for the year that the contributions and earnings are withdrawn.
Any medical expenses occurring during the year are paid by the individual until such time that the expenses exceed the annual deductible for the HDHP. When medical expenses are paid that are not reimbursed by the HDHP, the trustee of the HSA can (and should) provide a distribution from the HSA.
Any distributions from the HSA used to pay or be reimbursed for qualified medical expenses incurred after establishment of the HSA, are considered as tax-free distributions. If distributions are received for any other reason, the amount withdrawn will be subject to income tax and may be subject to an additional 10% tax. It is not necessary to make distributions from the HSA every year.
If an HSA has been established by April 15, 2005, distributions are tax-free for qualified medical expenses incurred on or after the fist day of the first month that the individual became eligible.
Note: If an individual is no longer eligible, they can still receive tax-free distributions to pay or reimburse for qualified medical expenses.
Are defined as those expenses that would generally qualify for the medical and dental expenses, as explained in IRS Publication 502, Medical and Dental Expenses.
Basically, Qualified Medical Expenses are the costs of diagnosis, cure, mitigation, treatment and prevention of disease, and the costs for treatment affecting any part or functions of the body. They include the costs of equipment, supplies and diagnostic devices needed for these purposes. They also include dental expenses.
Medical care expenses must be primarily to alleviate or prevent a physical or mental defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation.
Medical expenses include premiums paid for insurance that covers the expense of medical care and the amounts that are paid for transportation to get medical care. Medical expenses also include amounts paid for qualified long-term care service and limited amount paid for any qualified Long-Term Care Insurance.
Note: One cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) that are equal to the tax-free distribution from the HSA.
While as a general rule insurance premiums are not considered as qualified medical expenses for HSAs, but premiums for Long-Term Care Insurance, health care coverage while receiving unemployment benefits, or health care continuation coverage required under any federal law are considered as qualified medical expenses for HSAs. If the person is age 65 or older, he can treat insurance premiums (except for premiums for a Medicare Supplement policy) as qualified medical expenses for HSAs.
Premiums for Long-Term Care coverage that can be treated as qualified expenses are subject to the limits as established under HIPAA, which are based on age and are annually adjusted.
One cannot claim credit for premiums paid with a tax-free distribution from the HSA.
The following are considered as taxable distributions from HSAs:
Every person who has an HSA must keep records, according to regulations, that shows that the distributions were used exclusively to pay or reimburse qualified medical expenses, the qualified medical expenses had not been previously paid or reimbursed from another source, and the medical expenses has not been taken as an itemized deduction in any year. It is not necessary to send these records with the tax return, but should be kept with the tax records.
Without going into detail on how distributions are reported to the IRS, basically distributions are reported on Form 8889.
F Distributions that are not used for qualified medical expenses are subject to an additional 10% tax.
There is no additional tax on distributions made after the date the individual is disabled, reach age 65, or die.
As a general rule, an HSA is generally exempt from tax. The individual may take a distribution from his HSA at any time; however only those amounts used exclusively to pay for qualified medical expenses are tax-free. Amounts that remain at the end of the year are generally carried over to the next year. Earnings in an HSA are not included in the individual’s income for tax purposes while held in the HSA.
A holder of an HSA should always choose a beneficiary as the disposition of the HSA upon the death of the holder depends upon who is the designated beneficiary.
If the spouse is the designated beneficiary, the HSA will be treated as belonging to the spouse after death of the holder.
If the spouse is not the designated beneficiary, then the accounts stops being an HSA and the fair market value of the HSA becomes taxable to the beneficiary in the year in which the holder died.
If the estate is the beneficiary, the value is included in the final income tax return of the holder.
If the employer wants to make HSAs available to their employees, the employees must have an HDHP, and the employer cannot provide any additional coverage other than those exceptions listed as “Other Health coverage.”
The employer can make contributions to the employees HSAs and these contributions are listed on the “Employee Benefit Programs” for the year in which the contributions are made.
If contributions are made, the employer must make comparable contributions to all comparable participating employees HSAs. Contributions are comparable if they are either of the same amount, or the percentage of the annual deductible limit under the HDHP covering the employees.
The “comparable participating employees” are those who are covered by the employer’s HDHP and are eligible to establish an HSA, have the same category of coverage (family or self), and have the same category of employment (part- or full-time). Note however, that comparability rules do not apply to contributions made through a cafeteria plan.
If the employer makes contribution to the employees that were not comparable, the employer must pay an excise tax of 35% of the amount contributed.
Amounts contributed to the employees’ HSAs are usually not subject to employment taxes, but the amount must be shown in Box 12 of the employee’s Form W-2.
A Medicare Advantage MSA is an MSA designated by Medicare to be used solely to pay the qualified medical expense of the account holder. The holder must be enrolled in Medicare and have a high deductible health plan meeting Medicare Guidelines.
This plan follows the MSA and the HSA plans in respect to operation and tax exemptions of earnings. Unfortunately, as of this date, no HDHP had been approved by Medicare so there has not been any Medicare Advantage plans established.
A health flexible spending arrangement (FSA) allows employees to be reimbursed for medical expenses, and is usually funded through voluntary salary reduction agreements with the employer. No employment or Federal Income Taxes are deducted from the contribution. The employer may also contribute. For other information on the relationship between a health FSA and an HSA, see “Other employee health plans” under “Qualifying for an HSA” earlier,
The benefits of an FSA include
Health Flexible Savings Accounts are employer-established benefit plans, usually offered in conjunction with other employer-provided benefits as part of a cafeteria plan. Employers have complete flexibility to offer various combinations of benefits in the plan. An employee does not have to be covered under any other health care plan to participate.
Self-employed persons are not eligible for a Flexible Savings Account. There are certain limitations that may apply if the individual is a highly compensated participant or a key employee.
The FSA holder contributes to his FSA by electing an amount to be voluntarily withheld from his pay by his employer—often called a salary reduction agreement. The employer may also contribute to the FSA if so specified in the plan.
The holder does not pay federal income tax or employment taxes on the salary they contribute or the amounts his employer contributes to the FSA. If the employer contributes towards a long-term care plan, then those contributions must be included in the income.
At the beginning of each plan year, the holder must designate how much he wants to contribute. Then his employer will deduct amounts periodically (usually each payday) in accordance with his annual election. The election can be changed or revoked only if there is a change in employment or family status and so specified in the plan.
There is no limit as to the amount of money that the holder or employer can contribute to the accounts, but the plan must prescribe either a maximum dollar amount or maximum percentage of compensation that can be contributed to the health FSA.
Any contributed amounts that are not spent by the end of the plan year, are forfeited. Therefore, it is important to base the holder’s contribution on an estimate of the qualifying expenses he will have during the year.
Distributions from a health FSA must be paid only to reimburse the holder for qualified medical expenses incurred during the coverage period. He must be able to receive the maximum amount of reimbursement—the amount that was elected to be contributed for the year—at any time during the coverage period, regardless of the amount that was actually contributed. The maximum amount that he can receive tax free is the amount that he elects to contribute to the health FSA for the year.
The individual must provide the health FSA with a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expenses. Also, he must provide a written statement that the expense has not been paid or reimbursed under any other health plan coverage. The FSA cannot make advance reimbursements of future projected expenses.
(Qualified medical expenses are those explained previously from IRS Publication 502, Medical and Dental Expenses.)
Basically, he cannot receive distributions from his FSA for any amount paid for health insurance premiums, amounts paid for long-term care coverage or expenses, or amounts that are covered under another health plan.
He cannot deduct qualified medical expenses as an itemized deduction on Schedule A, Form 1040, that are equal to the distribution received from the FSA.
Flexible spending accounts are described as “use-it-or-lose-it” type of arrangements, and any amount in the account at the end of the year cannot be carried over to the next year and the employer is not allowed to refund any part of the balance to the individual.
Employers must comply with certain requirements that apply to cafeteria plans in order for the health FSA to maintain the tax-qualified status, such as restrictions for plans that cover highly compensated employees and key employees.
A Health Reimbursement Arrangement must be funded only by an employer. The contribution cannot be paid through a voluntary salary reduction agreement on the part of an employee. Employees are reimbursed tax-free for qualified medical expenses up to a maximum dollar amount for the coverage period. A Health Reimbursement Arrangement may be offered with other health plans, including Flexible Savings Accounts.
The employee benefits from the fact that the contributions made by his employer can be excluded from his gross income. Reimbursements may be tax free if he pays qualified medical expenses. And, any unused amounts in the Health Reimbursement Arrangement can be carried forward for reimbursements in later years.
HRAs are employer-established benefit plans and they may be offered in conjunction with other employer-provided health benefits. The employer has complete flexibility to offer various combinations of benefits in designing the plan. The employee does not have to be covered under any other health care plan in order to participate.
Self-employed persons are not eligible for an HRA. Certain limitations may apply if the individual is a highly compensated participant.
HRAs are funded solely through employer contributions and may not be funded through employee salary deferrals under a cafeteria plan. These contributions are not included in the employee’s income. The employee does not pay federal income taxes or employment taxes on amounts the employer contributes to the HRA.
There is no limit on the amount of money that the employer can contribute to the accounts, and also, the maximum reimbursement amount credited under the HRA in the future may be increased or decreased by amounts that are not previous used.
HRA distributions must be paid to reimburse the employee for qualified medical expenses incurred; such expenses must have been incurred on or after the date of enrollment in the HRA. If any distribution is, or can be, made for other than the reimbursement of qualified medical expenses, any such distribution (including reimbursement of qualified medical expenses) made in the current tax year is included in gross income.
Reimbursements can be made to current and former employees, spouses and dependants of these employees, or spouses and dependents of deceased persons.
Qualified medical expenses are discussed earlier in this text. In addition, qualified medical expenses from an HRA include amounts paid for health insurance premiums, amounts paid for long-term care coverage, and amounts that are not covered under another health plan.
Qualified medical expenses cannot be deducted as an itemized deduction on Schedule A (Form 1040) that are equal to the distribution from the HRA.
Amounts that remain at the end of the year generally can be carried over to the next year. The employer is not permitted to refund any part of the balance to the employee and these amounts may not be used for anything but reimbursements for qualified medical expenses.
Note: For further and more detailed information on these plans, go to IRS Publication 969, available through the IRS or on the internet at http://www.irs.gov/publications/p969/ar02.html
STUDY QUESTIONS
1. Contributions to an MSA has an annual maximum of
A. 65% of the deductible for individuals, 75% for families.
B. 100% if the deductible for individuals, no maximum for families.
C. $500 for individuals, $1,000 for families.
D. no more than 25% of the gross adjusted income reported on Form 1040.
2. The interest or other earnings of the assets in an MSA are
A. tax deferred.
B. taxed as ordinary income.
C. considered as deferred compensation.
D. tax free.
3. If the holder of an MSA changes employers
A. he just continues to make additional contributions in any event.
B. he loses the tax protection of the MSA.
C. the MSA is cashed in and the growth is considered as earned income.
D. the MSA goes with him but he cannot make additional contributions unless he is
otherwise eligible.
4. An MSA holder, and spouse if it is family coverage, generally cannot
A. have a high deductible health plan.
B. be covered under a Worker’s Compensation plan.
C. have a specific disease policy.
D. also have an in-hospital indemnification policy.
5 Contributions to an MSA must be
A. made by the employer only.
B. in cash only.
C. in cash, real estate or stocks traded on the American Stock Exchange.
D. made only through an employers flexible benefit Section 125 plan.
6. Insurance premiums may not be treated as qualified medical expenses for an MSA
A. except premiums for Long Term Care Insurance subject to HIPAA regulations.
B. except life and other health insurance premiums.
C. but he can claim this credit for premiums paid out of a tax-free distribution from the
MSA.
D. until the premiums paid for the calendar year exceed $2,500.
7. A tax-exempt trust or custodial account that is set up with a qualified trustee to pay or reimburse certain medical expenses incurred by the individual or qualified family member, is
A. an MSA.
B. a 401(k).
C. an HSA.
D. an HRA.
8. An HSA HDHP
A. has a higher deductible than the typical health plans and a maximum limit on the annual
deductible and out-of-pocket medical expenses that must be paid.
B. does not allow for preventative care benefits unless the high deductible is paid.
C. does not allow for a deductible below the minimum annual deductible for cancer screen
D. has a much lower deductible than an HDHP used with an MSA.
9. A prescription drug plan as part of an HDHP or as a separate policy or rider
A. will not allow the individual to qualify as an eligible individual under any circumstances.
B. is immaterial for plan purposes.
C. will allow the individual to qualify as an eligible individual if the plan does not provide
benefits until the minimum annual deductible of the HDHP is met.
D. will be allowed as part of an HDHP except the total premium must be paid by the em-
ployer.
10. “Qualified Medical Expenses” according to the IRS, include
A. vitamins if prescribed by a Naturopath.
B. a certain amount of time at a health spa.
C. treatment and prevention of diseases.
D. Yoga.
ANSWERS TO STUDY QUESTIONS
1A 2A 3D 4A 5B 6A 7C 8A 9C 10C