United States: IRS Issues New Guidance for Health Savings Accounts

Last month, the IRS issued new guidance for the creation and administration of a health savings account plan (HSA) for employees. A HSA is very similar to a medical flexible spending account or FSA, which often supplements an employer’s group health plan, but there are significant differences. In particular, the new guidance makes it clear that any individual or custodian can establish a HSA and although permitted, an individual’s employer need not be involved in its creation.

Similar to a FSA, a HSA can be established and funded by an employer. Contributions to a HSA are not included in an employee’s gross income for federal income tax purposes and are not subject to FICA withholding requirements. Also, a HSA operates very similar to a FSA, to which an individual can also make tax-deductible cash contributions that can then be used to reimburse the individual for qualifying medical expenses. Distributions from a HSA are not included in the beneficiary’s gross income. Distributions made for purposes other than qualifying medical expenses, however, will be subject to income taxes and, in most cases, additional excise taxes. Qualifying medical expenses include amounts paid for "medical care" as defined in Internal Revenue Code Section 213(d). The expenses include deductibles and co-payments under a health plan, as well as expenses not covered under the health plan (e.g., vision care, dental care, over-the-counter medications, etc.). Health insurance premiums generally are not qualifying medical expenses for HSA purposes, but HSAs can reimburse premiums for COBRA continuation coverage, for qualified long-term care insurance, for health coverage while receiving unemployment compensation benefits, or for health insurance (other than a Medicare supplemental policy) covering Medicare eligible HSA beneficiaries.

Unlike a FSA, a HSA can carry over unused amounts from year to year to build up an accumulation for future medical expenses (including medical expenses in retirement years). There is no annual "use-it-or-lose-it" requirement. As a result, for persons who do not need the HSA to reimburse current expenses, one possible use of a HSA would be to accumulate funds to pay for medical coverage needed, or expenses incurred, after retirement. Investment earnings on an HSA also accumulate tax exempt if used for qualifying medical expenses.

HSA’s are not available to everyone. Individuals not yet eligible for Medicare who are covered under a "high deductible" health plan and not covered by any other health plan are permitted to contribute to a HSA. A health plan will qualify as a "high deductible" health plan if it has a deductible of at least $1,000 and an out-of-pocket maximum of not more than $5,000 for single coverage, and a deductible of at least $2,000 and an out-of-pocket maximum of not more than $10,000 for family coverage. The annual contribution limit for each year will be the amount of the annual deductible under the health plan or, if less, $2,250 for individual coverage or $4,500 for family coverage. Similar to 401(k) retirement plans, an additional "catch-up" contribution can be made by individuals who will be age 55 or older. In 2004, "catch-up" contributions are limited to $500.

Further guidance from the IRS concerning the creation and administration of a HSA is expected to be released later this year. In the meantime, now is the time to start reviewing how a HSA may be a new opportunity to better control the rising costs of health insurance plans.