For persons who are not eligible for Medicare, the Medicare Act of 2003 authorized the establishment of Health Savings Accounts (HSAs) that provide substantial tax advantages to individuals with sufficient excess income to fund them. The new HSAs will replace the current Archer Medical Savings Accounts.(MSAs), which have not been particularly popular. An individual will be able to withdraw sums from his HSA trust account to cover deductibles and other health care expenses, in connection with a related high deductible health insurance policy. Deposits into the trust account each year will be excluded from taxable income, earnings on the accounts are not taxed, nor are amounts withdrawn from the trust account to pay health expenses.

Amount That Can Be Deducted From Taxes

An individual can deduct up to the lesser of:

For families, the cap on the HSA deduction is twice this amount.

For married couples, the combined deduction cannot exceed one family deduction.

For individuals 55 years of age or older, the cap on the annual deduction is higher, to allow larger contributions. In 2004, the additional allowed amount is $500, increasing by $100 each year to a maximum of $1,000 in 2009 and thereafter. These limits will be raised annually by cost of living increases.

Deposits can be rolled over tax free from MSAs. The HSA deduction is extended to individuals who do not itemize deductions generally.

Employer contributions to HSAs are excluded from income to the extent of other tax-favored employer health insurance costs, and are also excluded from the employee’s income for purposes of employment taxes and unemployment taxes. Contributions to an employee’s HSA can be offered as an option in an employer’s cafeteria plan.

The HSA Trust Account

The HSA must be a trust account established for the sole purpose of paying qualified medical expenses of its beneficiaries. The trustee must be a bank, insurance company, or other person approved by the IRS. Reports to the IRS may be required from the trustee of the HSA and from the high deductible health plan.

The High Deductible Health Insurance Policy

The individual must purchase a high deductible health plan that meets certain requirements to qualify for the HSA deduction. The plan must have an annual deductible of not less than $1,000, or more than $5,000 for an individual, and not less than $2,000 or more than $10,000 for a family. However, if the plan uses a network of providers, the deductible can be higher for services by out of network providers. Individuals must not, at the same time, have another health plan that provides a benefit covered under the high deductible plan, although they are permitted to have other kinds of insurance such as accident, dental, long term care and liability insurance.

Tax Treatment of Withdrawals From the HSA

Withdrawals from an HSA to pay for qualified medical expenses will not be included in the individual’s taxable income. Such withdrawals may not be used for premiums to purchase insurance, except for continuation coverage, long term care insurance, health insurance for those receiving unemployment compensation, or health insurance for seniors, (but not a Medigap policy).

Amounts distributed from an HSA that are not used exclusively for medical expenses will be included in the beneficiary’s gross (taxable) income. Taxable income will also be increased by the amount of any excess contributions to the HSA, up to the amount of the otherwise excludeable contributions to the HSA in that year.

In addition, there will be a penalty in the amount of 10% of a distribution from the HSA that does not meet the requirements for exclusion from taxable income. However, this 10% penalty will not apply to such distributions if the taxpayer is disabled, over 65, or deceased.

If an HSA owner dies, tax treatment of the account depends on who is designated as its beneficiary. A spouse who is named as beneficiary will be substituted as owner of the HSA, but otherwise the trust account will terminate. Any other individual named as beneficiary of the trust account must include the full value of the account in his taxable income for the year of death. If a probate estate is beneficiary, the full value of the HSA shall be included in the decedent’s taxable income for the year prior to death, with a corresponding deduction from the estate tax.

Policy Concerns With Respect To HSAs

The HSA legislation has been criticized as an inappropriate use of tax dollars to subsidize medical expenses for affluent people. Furthermore, the highly tax sheltered nature of these accounts allows them to be used as a wealth accumulation device, notwithstanding the ten percent penalty on withdrawals by persons under 65 that are not used for medical expenses. It is also predicted that HSAs will appeal to individuals with low medical expenses, thus driving up the cost of regular health insurance for people who have greater health care needs. The availability of HSAs may also cause fewer employers to offer traditional health insurance benefits for workers.

© Copyright, Center for Medicare Advocacy, Inc.