HSAs have the flexibility and favorable tax treatment of an IRA but are earmarked for medical expenses instead of retirement. These accounts should have a strong place in the growing arena of health spending accounts and will likely raise interest in consumer-driven health plans.
Included in the recent Medicare reform legislation, HSAs are allowed as of Jan. 1, 2004. Annual contributions equal to the lesser of the deductible, or $2,600 for individuals and $5,150 for families, may be deposited into an eligible individual's HSA on a tax-free basis.
Employer contributions to an employee's HSA are excludable from the employee's gross income, as well as from employer payroll taxes. Earnings on amounts in an HSA are not included in gross income, and distributions from an HSA are tax-free when used to pay for qualified medical expenses.
There are specific criteria that define eligibility for an HSA -- you must be covered under a HDHP (deductibles of $1,000+/individual; $2,000+/family) and not covered by any other health plan. IRS notice 2004-2 contains the first official HSA guidance, and more detailed clarification is expected in June.
How are HSAs different?
HSAs are the latest addition to the alphabet soup of health spending accounts that include FSAs (flexible spending accounts), MSAs (medical savings accounts) and HRAs (heath reimbursement arrangements). In some cases, HSAs will replace their predecessors.
Similar to an MSA, an individual establishes an HSA with a qualified trustee or guardian. The individual owns the HSA, and funds are portable and can roll over from year to year, unlike FSAs.
Account owners may continue to use their accumulated funds for qualified expenses and receive favorable tax treatment, regardless of whether the individual remains HSA eligible.
HSAs are policed by the individual rather than by trustees or employers. The HSA owner determines whether distributions are being used for qualified medical expenses. Unlike with an HRA or FSA, employees need not submit expenses for reimbursement because they receive distributions through means such as a debit card or checkbook. This may allow employers to reduce third-party administration expenses.
The downside is that if distributions are used for nonqualified expenses, they are subject to income tax and a 10 percent penalty tax. The penalty tax will not apply to distributions made after the account owner reaches age 65.
Employers and employees may contribute to HSAs. In contrast, HRAs are funded by employer money only, and MSAs are funded by either the employer or employee, but not both.
If an employer funds an HSA, contributions must be made regardless of whether the money is spent, whereas HRAs are typically funded on an as-needed basis. HSAs do not need be funded up front; periodic or monthly deposits can be made throughout the year.
Employees then have first dollar access to the money in their accounts. It appears employers will be precluded from restricting or dictating through plan design how an individual's funds are used.
Questions and concerns
Employers are asking questions such as, "How will nondiscrimination testing apply to employee-funded HSAs?" and "What is the relationship between HSAs and the rules governing FSAs in cafeteria plans?" Questions of this nature may be answered in June 2004, but more complex concerns will remain.
* Will HSAs only benefit the healthy and wealthy?
* Will HSAs cause conventional health insurance to increase in cost due to adverse selection if healthy individuals migrate to high deductible plans, leaving older and sicker individuals in conventional plans?
* Do HSAs represent too generous a tax break?
* Will HSAs help control health care costs?
What we do know is that as HSAs are established and used, consumers of health care will become more aware of what health care truly costs. Christopher Herbruck ChFC, CLU, is an account executive and shareholder at Herbruck Alder, a Cleveland-based employee benefits brokerage and consulting firm established in 1963. Herbruck has more than 10 years experience designing and managing benefit programs for Northern Ohio employers. Reach him at (216) 623-2600 or firstname.lastname@example.org.