Medicare Prescription Drug Act of 2003

Tax Incentives Encourage High-Deductible Medical Insurance Plans

By Kenneth A. Hansen, Robert Dosch, and Steve Carlson

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HSAs differ greatly from the present flexible spending accounts (FSA), which can promote wasteful spending by employees. In FSAs, employees must either spend all contributions withheld from salaries annually or forfeit those contributions. Also, current funds that the employer contributes are not portable when an employee leaves for a new job or retirement. This “use it or lose it” approach provides no direct financial incentive for employees to be thrifty in seeking medical services. HSAs change that. Annual contributions by the employer or employee that are not used for medical services in the current tax year can be transferred by the employee to other HSAs. Requirements and provisions for these plans are covered in IRC section 223.

Defining Qualified High-Deductible Health Plans

The Medicare Act of 2003 allows tax-deductible contributions to HSAs only if the taxpayer exclusively relies on high-deductible health plans for insurance coverage. Such a plan must have a minimum $1,000 deductible for an individual or $2,000 for a family. The policy must limit annual out-of-pocket expenses of the participant (e.g., copayments) to a maximum contribution of $5,000 for an individual and $10,000 for a family. These amounts will be adjusted to a cost-of-living index after 2004. A plan can still qualify as a high-deductible health plan when it has no deductible or a small deductible for preventive care. Except for preventive care, a plan may not provide benefits during the year until the annual deductible is met.

A network plan (e.g., an HMO) generally provides more favorable benefits for services provided by its network of providers than for services provided outside the network. Network plans that are high-deductible health plans are eligible for HSAs, even if out-of-pocket expenses for services provided outside the network exceed allowable participant contribution limits. In computing the annual contribution limit, the participant does not add out-of-network services; rather, the annual contribution limit is determined by reference to services within the network.

Some insurance coverage is disregarded in determining an individual's eligibility. Disregarded coverage includes accident insurance, disability insurance, dental care, vision care, workers’ compensation, insurance for a specific disease or illness, insurance paying a fixed amount per day, and long-term care insurance.

Eligible trustees for contributions to HSAs include banks, insurance companies, or any person approved by the U.S. Secretary of the Treasury. Any person already approved by the IRS to be a trustee or custodian of an IRA or of an Archer Medical Savings Account (a tax-deferred investment account similar to an IRA; see IRS Publication 969) used in conjunction with a qualified high-deductible health plan is automatically approved to be a trustee or custodian of an HSA. A taxpayer can establish an HSA through a qualified trustee or custodian that is different from the high-deductible health plan provider. HSAs vest immediately and are nonforfeitable. Contributions cannot be invested in life insurance contracts or commingled with other property, except in a common trust fund or common investment fund. Sums contributed to HSAs grow tax-free and are portable across employers.

Deductions or Exclusions for HSAs

The Medicare Act of 2003 allows qualified employees or individuals to deduct HSA contributions regardless of whether they itemize deductions. Eligible individuals can make HSA contributions even if they have no wages or if their HSA contributions exceed their wages.

Eligible employees can establish HSAs without the involvement of their employers. Employees who establish an HSA with the involvement of their employer receive additional tax savings by avoiding the employee’s half of Medicare and Social Security taxes. Employer contributions to employee HSAs are excluded from employee taxable income and wage base income in computing all employment taxes or withholding requirements [IRC sections 106(d), 3231(e)(11), and 3306(b)(18)]. Self-insured medical reimbursement plans can also meet the qualifications for a high-deductible health plan.

If an employer contributes to employee HSAs, employer contributions are required for all eligible employees with comparable medical insurance coverage during the calendar year. Employers have the option of offering HSAs under a cafeteria plan where contributions are deducted from employees’ wages. When HSAs are offered as an option under a cafeteria plan, the comparability rule does not apply to HSA contributions. A cafeteria plan, sometimes called a flexible benefit plan, allows employees to choose from a menu of qualified benefits that are excluded from employee taxable income [see IRC section 125(a) and (d)].

Example 1. An employer provides a high-deductible health plan for all full-time employees. The employer also provides a cafeteria plan with employee salary reduction contribution options for HSAs, group term life insurance, and dependent care assistance. A full-time employee elects to participate on a salary reduction basis to contribute to dependent care assistance but not to the HSA. The fact that the employee did not elect to contribute to the HSA will not count against the employer when applying the comparability rule.

Example 2. An employer offers its employees three health plans. One includes a high-deductible health plan with individual coverage and a $2,000 deductible. For each employee electing the high-deductible health plan coverage, the employer contributes $1,000 per year to an HSA on behalf of the employee. The employer makes no HSA contributions for the employees that do not elect the high-deductible health plan. The employer’s plans and HSA contributions satisfy the comparability rule. IRC section 4980G and section 4980E make no distinction between employees and collectively bargained employees.

The comparability rule is applied separately to part-time employees that are customarily employed for fewer than 30 hours per week [IRC section 4980G(b) and section 4980E(d)(4)]. An employer that fails to make HSA contributions for comparable employees must pay a 35% excise tax on contributions. The IRS has been instructed to issue regulations on this excise tax. HSAs are not subject to periods of required continuation coverage under the federal COBRA requirements.

For tax years starting in 2004, the Medicare Act of 2003 allows maximum deductible HSA contributions up to $2,600 for an individual and $5,150 for families [IRC section 223(b)(2) and (g), whose amounts are adjusted for cost-of-living increases from 1997, and IRC section 62(a)(19)]. The smaller of the contribution limit to an HSA and the actual annual deductible of the policy is used to compute deductible contributions to the HSA. Contribution limits are prorated annually for each month the participant is covered [defined as coverage on the first day of the month under IRC section 223(b)(2)(A) and (c)(1)(A)(i)] by a qualified high-deductible medical insurance plan.

Example 3. A qualified individual is enrolled on June 16, 2004, through December 2004 in a plan that has a $3,000 deductible. The maximum deduction for contributions to an HSA is $1,300 for the 2004 tax year (six months/12 months, multiplied by the lesser of $2,600 or $3,000). Alternatively, if the same individual is enrolled in a qualified health plan with a $1,000 deductible on June 16, 2004, through December 2004, the maximum deduction for contributions to the HSA is $500 for the 2004 tax year (six months/12 months, multiplied by the lesser of $2,600 or $1,000).

Employee or employer contributions are allowed for the 2004 tax year up to the due date (without extensions) for filing the individual tax return. Even though the maximum annual contribution is computed and can be paid on a monthly basis, the earliest date the entire year’s contribution can be made is on the first day of the tax year [IRC section 223(d)(4)(B)]. To avoid a 6% excise tax, excess contributions for the taxable year must be paid to the account beneficiary before the last day prescribed by law (including extensions) for filing the tax return.

Individuals age 55 or older can make additional contributions to HSAs. The additional contribution amount is $500 for 2004 and increases by $100 each year, up to $1,000 for 2009 and thereafter [IRC section 223(b)(3)(B)]. This catch-up contribution is added to the maximum limit as previously computed. The additional contribution is prorated based on the number of months an individual participates in a qualified plan during the year before Medicare eligibility. No deductions are allowed once the individual is entitled to benefits under Medicare [IRC section 223(b)(7)].

Example 4. An individual who attains age 65 and becomes eligible for Medicare benefits in July 2004 has been participating in a high-deductible health plan with an annual deductible of $1,000. The individual is no longer eligible to make HSA contributions (including catch-up contributions) after June 2004. This individual may make contributions for January through June totaling $750 (six months, multiplied by the sum of $1,000/12 monthly regular contribution and $500/12 monthly catch-up contribution) but cannot make eligible contributions for July onward.

All contributions made by or on behalf of an individual to HSAs are aggregated for purposes of applying the limits. Contributions made by a family member on behalf of an individual to an HSA are deductible by the eligible individual in computing adjusted gross income. These family contributions are taxable gifts that apply against the unified credit unless the total gifts to the individual are under the annual gift-tax exclusion.

If both the taxpayer and spouse have family coverage high-deductible health plans, both spouses are treated as covered under the family plan with the lower deductible. The lower HSA deduction is divided equally between both spouses unless they agree on a different division. When they are age 55 or over, both spouses may make catch-up contributions.

Tax-free Payouts from HSAs

A participant may withdraw tax-free funds from HSAs to pay out-of-pocket medical insurance deductibles and medical expenses not otherwise covered by insurance [IRC section 223(f)(1)]. The qualified medical expense must be incurred after the HSA has been established. When the participant becomes eligible for Medicare, the participant has the option of withdrawing funds remaining in HSAs for nonmedical reasons that will be taxed at normal rates without penalties. Otherwise, after Medicare eligibility the participant may continue to use HSAs to pay health-care costs with tax-free distributions.

Tax-free withdrawals for qualified medical expenses cover all “medical care” as defined in IRC section 213(d), including over-the-counter medicine [IRC section 223(d)(2)(A)]. Qualified withdrawals are also tax-free for alternative minimum tax purposes [IRC section 56(g)(4)(B) as amended]. When taxpayers itemize deductions, they can also deduct prescription drugs as an itemized medical expense, even when the expense is reimbursed with tax-free funds from an HSA (IRC section 139A). Thus, the taxpayer can claim deductions for prescription drug expenses even though the taxpayer received an excludable subsidy related to the same expense. For medical expenses other than prescription drugs, taxpayers cannot claim itemized deductions for expenses that have been reimbursed by HSAs [IRC section 223(f)(6)].

HSAs are portable and can be rolled over to new HSA plans with other employers or to individual HSA plans. Unlike regular HSA contributions, rollover contributions need not be in cash and are not subject to annual contribution limits. The rules for IRA rollovers apply similarly to HSAs. A payout from an HSA that is paid back into an HSA within 60 days is not taxable. HSA payouts that are allowed tax-free rollover treatment are limited to one per 12-month period ending on the day of such receipt [IRC section 223(f)(5)]. Taxpayers can also rollover amounts contributed to an Archer Medical Savings Account to an HSA under the 60-day reinvestment rule [IRC section 220(f)(5)(A)]. Except for rollovers, contributions to HSAs must be in cash.

In general, the premiums paid on health insurance do not qualify for tax-free payouts from HSAs [IRC section 223(d)(2)(B)]. For example, premiums for Medigap policies (Medicare supplemental policies) are not qualified medical expense payments. The following exceptions [IRC section 223(d)(2)(C)] allow health insurance premiums to be paid with HSA funds without taxable income consequences :

• Periods of COBRA health-care continuation coverage;
• Qualified long-term care insurance contracts;
• Periods the individual receives unemployment compensation; and
• For individuals eligible for Medicare, the following premiums: Medicare Part A or B; Medicare HMO; and the employee share of premiums for employer-sponsored health insurance, including premiums for employer-sponsored retiree health insurance.

Nonqualified payouts are included in taxable income and assessed a 10% penalty. Payments made after the disability or death of the taxpayer for nonmedical expenses are includable in income but not penalized [IRC section 223(f)(4)].

Under the Medicare Act of 2003, employer-reporting requirements for medical payments are reduced or eliminated to further encourage employers to provide medical care benefits. Payments covered for medical care benefits include flexible spending arrangements funded by employee contributions, and health reimbursement arrangements funded by employer contributions. Employer 1099 information-reporting requirements for these nontaxable employee medical care payouts have been eliminated, retroactive to January 1, 2003 [IRC section 6041(f)]. Employer contributions to an employee’s HSA must be shown on the employee’s W-2 [IRC section 6051(a)(12)].

Distributions After Death

In most situations, taxpayers should name their spouse as the primary beneficiary on the HSA. The HSA for all purposes then becomes the HSA of the surviving spouse [IRC section 223(f)(8)(A)]. Distributions from the HSA are taxed only if they are not for the medical care of the surviving spouse. Although the HSA is included in the gross estate of the decedent, naming the spouse as beneficiary qualifies the HSA for the estate tax marital deduction [IRC section 2056(a)].

A taxpayer naming a nonspousal beneficiary on the HSA causes the HSA to be taxable income to the nonspouse beneficiary in the year the taxpayer dies. The account ceases to be an HSA for the nonspouse beneficiary. The beneficiary can reduce amounts included in income by the decedent’s predeath expenses paid by the beneficiary within one year of the taxpayer’s death. The amounts included in income can also be reduced by a pro rata share of the estate taxes attributable to inclusion of the HSA in the decedent’s gross estate [IRC section 223(f)(8)(B)(ii)(II)].

If the taxpayer names no beneficiary on the HSA, upon the taxpayer’s death the account ceases to be an HSA and is considered taxable income on the decedent's final income tax return [IRC section 223(f)(8)(B)(i)(II)]. This rule applies in all cases where there is no named beneficiary, even if the surviving spouse ultimately receives the HSA. The spouse must be named as a beneficiary for the HSA to become theirs free of income or estate tax.