United States: HSAs Take Center Stage - Armed With New IRS and DOL Guidance, Employers Evaluate Account-Based Options

HSAs are tax-advantaged U.S. trust accounts that work in conjunction with high-deductible health plans by covering current or future medical expenses below the deductible amount. They closely resemble Archer Medical Savings Accounts (MSAs), which have been available for several years only to self-employed people or those working for small employers (with 50 or fewer employees). HSAs can be set up by either an employer, an employee, or a combination. They are funded accounts where the amounts are owned by the employee and are not subject to vesting requirements or "use it or lose it" or similar rules. (For a table comparing HSAs and other accounts, see below.)

Employers considering establishing HSA programs received some welcome news from the Department of Labor. In Field Assistance Bulletin 2004-1, the DOL indicated that an HSA that is part of an employer–sponsored arrangement would not itself be an ERISA plan, provided that it was completely voluntary and satisfied criteria based on current exceptions to ERISA plan status. An employer could not put limitations on the ability of an employee to move his or her account to a new HSA provider or conditions on the utilization of HSA funds (beyond the limitations and conditions allowed by the tax rules). An employer also could not make or influence investment decisions related to HSA funds, or receive any payment or compensation in connection with an HSA. Finally, an employer could not represent that an HSA was part of an employer-established ERISA welfare plan.

Only banks or insurance companies or others specifically approved by the IRS can be trustees for HSAs. HSA trust assets cannot be used to buy life insurance and cannot be commingled, except in common trust funds or common investment funds.

Annual contributions to an HSA generally are capped at the lesser of the annual deductible under the high-deductible plan, or up to (in 2004) $2,600 when the employee has individual coverage and $5,150 when he or she has family coverage (numbers will be indexed annually for inflation). This contribution limit is reduced by any amount contributed by an employer or employee to an Archer MSA. Once an individual turns 55, there is also an opportunity to make additional "catch-up" contributions. The additional amounts (for both individual and family coverages) are: $500 in 2004; $600 in 2005; $700 in 2006; $800 in 2007; $900 in 2008; and $1,000 in 2009 and later years. So, for example, the maximum contribution amount in 2004 for an individual who is 55 would be $3,100 for individual coverage and $5,650 for family coverage.

All contributions to an HSA must be made in cash—no securities or other property can be contributed. Employers are subject to one other important restriction on contributions. Any time an employer makes contributions, it must make available "comparable" contributions for all comparable eligible employees. Contributions that are the same dollar amount or the same percentage of the deductible under a high-deductible plan are considered comparable. Violators will be subject to an excise tax of 35% of the aggregate amount they contribute to HSAs over the relevant period.

HSAs can be established only by individuals covered by a "high-deductible health plan" as defined by the Medicare law. These plans have two distinguishing features. They have annual deductibles of at least $1,000 for individual coverage and $2,000 for family coverage. And they limit annual out-of-pocket expenses (including deductibles, but not premiums) to not more than $5,000 for individual coverage or $10,000 for family coverage. Deductibles could be higher, or out-of-pocket expense caps lower, than these annual standards, but the amount that can be contributed to an HSA is limited as described above.

These annual limitations have some flexibility. For example, a plan will qualify as a high-deductible health plan even if it does not require a deductible for preventive care. This is important because many current "consumer-directed" plans provide "first-dollar" coverage for preventive care, requiring no deductible. Additionally, if the plan provides benefits through a network, the out-of-pocket limit may be exceeded for out-of- network expenses.

Initially, this preventive care standard was complicated by the lack of a standard definition for preventive care. To remedy that, the IRS issued a safe harbor, meaning that if a plan includes only these elements of preventive care, it will satisfy the HSA requirements. Notice 2004-23 lists the following as included in preventive care: periodic health evaluation, such as annual physicals; routine prenatal and well-child care, child and adult immunizations; tobacco cessation programs; weight-loss programs; and various screenings (such as mammograms, pap smears and other cancer screening, heart disease screening and mental health and substance abuse screening).

Two other relevant points about high-deductible plans have also been clarified by the IRS. First, these plans can be self-insured if an employer so desires. Second, there is no requirement that an individual maintain an HSA with the same institution that provides his or her high-deductible coverage. This means that banks, mutual fund companies and brokerages, along with recordkeepers and health insurers could all play a role in what will likely be a rapidly evolving marketplace.

Individuals covered by high-deductible plans usually will not be able to have other health-related coverage and still use an HSA. Specifically, they cannot have other coverage (under a spouse’s plan, for example) that is not a high-deductible plan and that covers any benefit that the high-deductible plan also covers. There are some exceptions to this duplicate coverage prohibition. An individual would remain eligible to use an HSA even if he or she had accident, disability, dental, vision or long-term care coverage (whether insured or self-insured). Similarly, eligibility would not be lost if an individual had certain types of "permitted insurance" (such as specified disease, fixed-amount hospitalization, workers compensation or auto coverage). This basic rule against having other coverage creates several awkward situations for employers.

• Most obviously, an employee who participated in a standard health flexible spending account would be in violation. To avoid this, employers that adopt HSA arrangements may want to modify their health flexible spending accounts, or FSAs, at least for those employees who elect an HSA option. Em-ployees with traditional FSAs would be ineligible to participate in an HSA arrangement. Restricted FSAs, such as those that could provide only dental or vision benefits, may still be a viable option for employees who use HSAs.

• Coverage that includes prescription drugs with modest copayments and no deductibles would similarly be violating this standard. Employer lobbyists had pressed for an exception to the rule broad enough to include prescription drug programs with modest copayments. But the IRS did not oblige. Instead, in Rev. Rul. 2004-38, the IRS finds specifically that an individual with prescription drug coverage (other than high-deductible coverage) is not eligible to contribute to an HSA.

As of the first of the month in which a person becomes entitled to Medicare benefits (due to age, for instance), he or she would no longer be eligible to contribute to, or have his or her employer contribute to, an HSA. As described below, though, an individual who had enrolled in Medicare and was receiving benefits could still use funds in an HSA to pay for certain expenses.

HSAs can be used to pay "qualified medical expenses"— meaning expenses for "medical care" (under the very broad tax code definition) that are incurred by the employee or his or her spouse and dependents and that are not compensated by insurance or otherwise (e.g., reimbursement under an HRA or FSA). Generally, HSA funds cannot be used to pay insurance premiums, though there are some important exceptions. Most significantly, HSA funds could be used to pay for health coverage, other than Medicare supplemental coverage, once an individual turns 65. HSA funds could also pay for COBRA or long-term care coverage, and for coverage during a period when an individual is getting federal or state unemployment assistance.

One potential problem with the "qualified medical expenses" provisions in the Medicare law was addressed recently by the IRS in Notice 2004-25. Because that law took effect only weeks after it was enacted, many employers, individuals and vendors had little time to establish HSAs before 2004, which creates a problem because generally an HSA may reimburse only expenses incurred after the account was established. Notice 2004-25 provides a transition rule, indicating that eligible individuals can be reimbursed for qualified medical expenses incurred after the later of: January 1, 2004, or the first day of the first month in which an individual becomes covered by a high-deductible health plan.

Employer contributions to an HSA are excluded from employee gross income for federal income tax purposes (this includes employee pre-tax payroll deductions through a cafeteria plan, which are considered "employer" contributions under the tax rules). Employer contributions are also excluded from "wages" for employment tax purposes, which will create FICA tax savings for employers.

When an individual contributes to an HSA (and does not do so through an employer-sponsored cafeteria plan), contributions are deductible to the individual in determining his or her gross income. This is true whether or not the individual itemizes other deductions.

HSA distributions used to pay "qualified medical expenses" for an employee and his or her spouse and dependents are generally excludable from the gross income of the employee. This is generally true even in cases, such as a post-65 retiree who is receiving Medicare benefits, where an individual would not be currently eligible to make contributions.

Distributions for anything other than these qualified expenses (and other limited exceptions described above) do not receive that tax-favored treatment. Such distributions generally will become subject to both regular income tax and a 10% penalty tax. Again, though, there are some important exceptions. Penalty taxes will not apply – though income taxes will – to payments that are made after an account beneficiary is disabled, turns 65, or dies.

HSAs provide individuals more flexible ways to accumulate savings for health care expenditures. An employee could "roll over" amounts from one employer’s HSA program to another’s, or from an Archer MSA to an HSA. HSA accounts may also be transferred upon divorce or separa-tion, much like retirement plan benefits can be split by means of a QDRO.

Upon the death of an HSA account holder, the tax treatment will depend on who was the named beneficiary under the account. If it was the spouse, the HSA becomes the tax-favored account of the spouse (and that amount may be deducted in computing the decedent’s taxable estate). If the named beneficiary is someone else, the HSA ceases to be a proper HSA and the beneficiary has to include (with certain exceptions) the fair market value of the account assets in his or her gross income.

What's in a name?
Key features of some types of health accounts that employers can offer

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.