Health Savings Accounts (HSAs):
A review of the Treasury Department Guidance and Planning Implications
By Patrick Haraden, CEBS, CLU, ChFC, REBC
Director, Employee Benefit Services, Longfellow Benefits
Executive Summary
The Treasury Department and the IRS issued their final guidance on Health Savings Accounts (HSAs) for 2004 on July 23, 2004. This notice follows a series of clarifications, corrections, and rulings on the design, funding, and operation of HSAs that were issued over the last seven months. As the guidance is analyzed, there are many issues to consider as employers evaluate their health care and benefits strategies for 2005 and beyond. Employees are looking at HSAs as a retiree medical funding vehicle, to maximize retiree savings, and to utilize their healthcare dollars more efficiently.
Even after the release of this guidance, some of the biggest hurdles to universal acceptance of HSAs still remain. Educating employees on the true costs of receiving health care, (e.g. ER visits, maternity stays, etc.) helping them plan contribution strategies, investment options, and retiree medical options will be a time consuming and difficult undertaking for employers. Planning for prescription drug coverage after January 1, 2006 will also require some education and analysis on both the employee and employer levels.
Over the past few years, employers have shifted the costs for medical care to their employees through increased contributions or increased co-payments and coinsurance. With the advent of HSAs, employees will now have a greater control of these costs, and will have the opportunity to realize some of the benefits from efficient healthcare utilization. As these responsibilities continue to shift from employer to employee, a thorough understanding of HSAs and alternatives (HRAs, FSAs, etc.) will be required.
HSA Overview
An HSA is a tax-exempt trust or custodial account established exclusively for the purpose of paying for qualified medical expenses of the account beneficiary, who, for the months in which contributions are made to the HSA, is covered by a High Deductible Health Plan (HDHP).
[1] HSAs have been compared to Individual Retirement Accounts (IRAs) that exist in the retirement plan arena. Additionally, these accounts operate like money market checking accounts in that funds can be deposited and withdrawn in a similar manner (e.g., check, debit card) and that interest can be paid on the balance, or it can be invested in a variety of products, depending on the HSA provider.
Key features of an HSA:
- Must be used in conjunction with a High Deductible Health Plan (HDHP)
- HDHP are plans that do not provide first dollar coverage for non-preventative care
- Distributions for Qualified Medical Expenses are tax free
- IRC Section 213(d) expenses
- COBRA Premiums
- Health plan premiums while unemployed
- Medicare premiums and out of pocket expenses (but not a supplement policy)
- Qualified long term care insurance premiums
- Account must be set up with an approved trustee or custodian
- Can only be utilized by eligible individuals
- Covered by an HDHP
- Not covered by any other insurance
- Not enrolled in Medicare
- Can’t be claimed as a dependent on someone else’s tax return
· Contributions can be made by an employee, employer, or others
- If an employer makes contributions, they must be “comparable” (if not offered through a Section 125 Plan)
- Same Amount; or
- Same percentage of the annual deductible
- Maximum aggregate contributions are the lesser of the deductible amount, or $2,600 Individual $5,150 Family (for 2004)
- Additional “catch-up” contributions allowed for individuals 55 and older
- Only rollovers from Archer MSAs and other HSAs permitted
- No requirement that money be spent; balance can accumulate or “roll-over”
- HSAs are not ERISA plans
High Deductible Health Plans
High Deductible Health Plans (HDHPs) are used in conjunction with HSAs. An individual is only eligible to establish and contribute to an HSA if they are enrolled in a HDHP. A previously eligible individual may continue to use the HSA to pay for eligible medical expenses after they are no longer covered by a HDHP, but they may not make further contributions.
Key features of a HDHP:
- Minimum deductibles of $1,000 individual and $2,000 family (for 2004)
- Maximum deductibles of $5,000 individual and $10,000 family (for 2004)
- May have no deductible on preventative care
- May have higher out of pocket costs for non-network care
- Must be the only health insurance covering the individual
- Exceptions:
- Specific injury insurance
- Accident
- Disability
- Dental
- Vision
- Long term care
- Workmen’s compensation
Historical Perspective and Treasury Department Guidance
Health Savings Accounts were created by Section 1201 of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, Pub. L. No. 108-173, which added Section 223 to the Internal Revenue Code (IRC). Section 223 of the IRC permits eligible individuals to establish HSAs for taxable years beginning after December 1, 2003.
[2]
Treasury Notice 2004-2 was issued on December 22, 2003 to provide the first set of clarifying guidance on HSAs. It was issued in a question and answer format, and provided specific examples of eligibility, coverage, contributions and distributions. Notice 2004-50 issued on July 23, 2004 has amended it. That Notice changed the eligibility definition to “not enrolled” from “not entitled” to Medicare.
Key clarifications from Notice 2004-2:
- In order to qualify as a HDHP, the minimum family deductible would need to be satisfied in full before benefits would be available to any member
- An individual can establish an HSA (and purchase a HDHP) with the involvement of an employer
- Contributions to an HSA must be made in cash
- Contributions made by a family member on behalf of an eligible individual to an HSA are deductible by the eligible individual (whether or not the individual itemizes deductions)
- Rollovers from a Flexible Spending Account (FSA), Health Reimbursement Account (HRA), and an Individual Retirement Account (IRA) are not permitted.
- Determination of whether an HSA distribution is a “qualified distribution” is the sole responsibility of the HSA owner
- HSAs can be offered as part of a cafeteria (Section 125) plan
On March 30, 2004, the Treasury Department issued four documents that related to HSAs. They issued Notices 2004-23 and 2004-25, Revenue Ruling 2004-38 and Revenue Procedure 2004-22.
Preventative Care in an HSA
Notice 2004-23 was issued to provide a “safe harbor” for preventative care benefits under a HDHP. Preventative care was the only benefit that could be paid under an HDHP without first satisfying the minimum deductible. There is no requirement that a HDHP do so, however.
Key features of Notice 2004-23:
- Preventive care includes:
- Periodic health evaluations, including test and procedures ordered in conjunction with the evaluations (e.g., annual physicals)
- Routine well-child and prenatal care
- Child and adult immunizations
- Tobacco cessation programs
- Obesity weight loss programs
- Screening services (e.g., cancer, heart disease, drug abuse, etc.)
Notice 2004-25 was issued to provide transition relief for calendar year 2004, for eligible individuals who establish an HSA on or before April 15, 2005, from the requirement that qualified medical expenses may only be paid or reimbursed by and HSA if incurred after the HSA has been established.
With this notice, the Treasury Department realized the early lack of availability of HSAs, as the providers were waiting for guidance to be issued to design their products appropriately. This allows an eligible individual to open an HSA, and pay or reimburse expenses incurred on or after the later of January 1, 2004 or the first day of the month that the individual became an eligible individual (i.e., covered under a HDHP) under section 223.
Prescription Drug Coverage in an HSA
Revenue Ruling 2004-38 and Revenue Procedure 2004-22 were issued to deal with the issue of prescription drug coverage in a HDHP. Traditionally, prescription drug coverage is issued as a rider to most health plans; the coverage is not part of the benefits in the underlying medical plan. A HDHP does not allow coverage for prescription drugs until the minimum deductible is satisfied. (Notice 2004-50 has changed this to include “preventative drugs”)
Revenue Ruling 2004-35 held that an individual that is covered by a HDHP and a prescription drug plan is not an eligible individual for the purpose of contributing to an HSA, unless the prescription drug plan is also a HDHP
[3] (i.e. drug benefits are paid after the minimum deductible is satisfied).
Revenue Procedure 2004-22 provides transition relief from Revenue Ruling 2004-38 for determining an “eligible individual” under Section 223 who may make contributions to an HSA. For months before January 1, 2006, an individual who would otherwise be an “eligible individual” under Section 223(c)(1)(A), but is covered by both a HDHP that does not provide prescription drug coverage and a separate health plan or rider that provides prescription drug coverage before the minimum annual deductible of the HDHP is satisfied, will continue to be an “eligible individual” and may make contributions to an HSA based on the annual deductible of the HDHP.
[4]
Use of HRAs and FSAs with an HSA Plan
Revenue Ruling 2004-45 clarifies the interaction between HSAs, FSAs, and HRAs using a series of facts and circumstance examples to determine whether an individual is still an “eligible individual”.
Key features of Revenue Ruling 2004-45
Individuals will still be an “eligible individual” for HSA contributions if:
- Covered by a limited-purpose HRA or FSA (e.g., dental, vision, preventative care coverage only)
- An HRA is suspended (only for the time of the suspension)
- Covered by a post-deductible HRA or FSA (i.e., benefits pay after the minimum deductible of the HDHP is satisfied)
- Covered by a retirement HRA
Notice 2004-43 was issued to provide transition relief for individuals in states where HDHPs are not available because state laws require health plans to provide certain benefits without regard to a deductible or below the minimum annual deductible of Section 223(c)(2)(A)(i),
[5]
For months before January 1, 2006, a health plan which would otherwise qualify as a HDHP under section 223(c)(2), except that is complies with state law requirements that certain benefits be provided without a deductible or below the minimum annual deductible of Section 223(c)(2)(A)(i), will be treated as an HDHP for purposes of Section 223(c)(2), if the disqualifying benefits are required by state law in effect on January 1, 2004.
[6]
Final Guidance for 2004
Notice 2004-50 was issued to clarify and resolve some of the outstanding technical issues with HSAs and their operation. It was issued in a question and answer format, covering some 88 questions.
Key features of Notice 2004-50 are:
- Benefits under Employee Assistance Plans, Disease Management Plans, and Wellness programs generally do not disqualify an otherwise eligible individual from contributing to an HSA
- Changes to salary reduction contributions can be made at anytime during the year, as long as they are prospective
- Mistaken distributions from an HSA can be repaid to an HSA without penalty
- Employer matching contributions made through a cafeteria plan are not subject to the comparability requirements
- Account fees paid from HSAs are nontaxable distributions; account fees paid outside of the HSA directly to trustees are not treated as contributions
- Preventative drugs may be permitted (i.e. drugs taken to prevent a specific disease, before the disease has become clinically apparent)
Market Response
Prospective HSA custodians and HDHP providers have been waiting for the above referenced guidance in order that they may design fully compliant products for the marketplace. Despite this hesitation, a number of products and product combinations are available now.
According to the HSA Insider (
www.hsainsider.com), there are 27 custodians that can open your HSA account as of September 15, 2004. Most of these custodians are traditional banks and retirement companies (e.g. Fidelity, Mellon Financial, etc.) Some HSA custodians have partnered with HDHP providers to jointly market and offer a product combination.
For the HSA custodians that have a product available now, the account and fee structure is very similar to a traditional checking or money market account. They differ from Flexible Spending Accounts (FSAs) because it is the eligible individual who determines the qualified distributions from the account; no further verification or authorization is required from the custodian.
A typical HSA account, like the one offered by MSAver (A Lumenos Company) has the following features:
[7]
|
Set up fee:
|
$25
|
|
Annual fee:
|
$60
|
|
Minimum Deposit:
|
$100
|
|
Interest Rates:
|
adjustable, average about 5%
|
|
Investments:
|
Scout Fund
|
Most HDHPs are not available until the fall, or some as late as January 1, 2005. In Massachusetts for example, currently there are only five licensed insurers that can offer HDHPs.
HSA Planning Opportunities
Employers and employees will need to do much more research and planning to determine if HSAs are right for them. Some employers are concerned that a 10% excise tax (and ordinary income tax) on non-qualified HSA distributions, and the readily available HSA withdrawal options (e.g., check, debit card) make it too easy for employees to use their HSA funds on non-qualified expenses, leaving them no remaining HSA money to pay for their deductibles, prescriptions, and other qualified expenses. Employers may not have a choice, as individual employees can open an HSA and purchase a HDHP on their own, without the employers’ knowledge or involvement.
Employees are also concerned about the additional financial risk associated with HSAs as well as the lack of accurate cost data and personal education resources to assist them in making wise health plan and investment choices. Employers who wish to offer HSAs or other consumer driven or consumer centric models may need to provide individualized health and welfare education to their employees. The education should cover expected health care costs – real costs of procedures and office visits, not just copays, deductibles, and coinsurance amounts, HSA investment allocations, and health plan operations.
For these reasons, as well as the uncertainty over non-preventative care prescription drug coverage after January 1, 2006; many employers and employees are moving slowly in establishing HSAs, but there are other alternatives.
Limited Purpose HRAs and FSAs
For employers who want cost savings, with some level of employee “consumerism”, an combination of HRA, HSA, and FSA plans may be an appropriate solution for some employers, particularly if there are a large number of highly paid employees.
Medical Flexible Spending Accounts (FSAs) can still co-exist with the HSA if they cover only dental, vision, and other benefits that are not part of the HSA/HDHP. The dependent care account in an FSA can still be offered to all eligible employees.
Another option would be a limited purpose Health Care Reimbursement Account (HRA). Employers could create higher deductible plans, or deductibles on certain services (e.g., $1,000 hospital inpatient), and offer them to employees along with the HRA. The employer and employee (through reduced contributions) would receive a lower monthly premium due to the decreased level of benefit available through the underlying health plan. For those employees (or members) that utilize services and incur a deductible, the HRA could reimburse a portion, the entire deductible, or an amount in excess of a dollar limit (e.g., $500). In this way, the employer “self-insures” part of their medical plan, employees and employers receive reduced costs up front, and those employees that use medical services are not responsible for the entire deductible(s). Obviously, a thorough review of the employer’s census and prior claim history would need to be evaluated to ensure that this is a cost effective solution.
An HRA/HSA dual offering to employees (the employee could not be covered by both plans for health care) may be a good interim solution as well. The employee education and decision tools required are similar, and some vendors could administer both types of plans. This type of offering provides options for workers at all salary levels.
To encourage participation in HSAs, the employer may want to offer additional services to employees such as personal health education and medical and wellness (lifestyle) coaching. These services will increase employees understanding of the programs, demonstrate the value of the plan to employees, better their health, and help reduce medical costs. There are also other employer benefits as employees become more health care savvy.
As employees better understand the costs and causes of illness, they will become better health care consumers. This increased understanding can lead to lower rates of absenteeism, increased productivity and job performance, decreased workplace accident rates, and therefore lower operating costs.
HSAs as an Executive Benefit
HSAs are also an excellent vehicle for an executive retirement savings plan. Although the current limits may not allow for the full costs of lifetime retiree medical insurance to be accumulated through the HSA, it is still a viable option.
The balances in the HSA roll over from year to year, there is no requirement that any of the contributions be spent, and there are investment options within the HSA account. These features make them attractive to higher paid employees to utilize them to help save for retirement and retiree medical insurance.
The employee would set up and HSA and purchase the HDHP, either through the employer or individually. The employee could then fund the out of pocket expenses (e.g., deductibles, co pays, etc.) with after tax money, and allow the HSA balance to accumulate. The HDHP would cover the expenses after the deductible. The employee maximum annual contribution is the lesser of the deductible or $2,600 for an individual plan, and $5,150 for a family plan for 2004. The employee could also deduct the after tax medical expenses paid if the employee itemized (subject to certain limits).
Future Direction
There will be no more guidance issued in 2004 on HSAs; health plans, potential vendors and custodians, as well as employers and employees must digest all of this information to determine their strategy for 2005 and beyond.
There are many different views on the future of HSAs and other “consumer directed/driven” medical plan options. Some feel they provide an excellent opportunity for employers to get out of the business of sponsoring medical insurance for its employees, others feel these are the perfect plans to help control medical costs and foster a healthier, more engaged employee. Similar to analysis done on HMOs since the 1980’s, an evaluation over a long period of time will be needed to determine if the promised cost savings and quality results materialize.
Health Care Account Comparisons
|
|
Health Savings Accounts
|
Health Reimbursement Accounts (Arrangements)
|
Flexible Spending Accounts
|
|
Overview
|
A tax-exempt trust or custodial account created exclusively to pay for qualified medical expenses of the account holder/employee and spouse or dependents.
|
An employer funded account that reimburses employees for qualified medical expenses.
|
A cafeteria plan under Section 125 of the IRS code. FSAs are used to pay qualified medical expenses and dependent care expenses.
|
|
Establishment
|
Employee or Employer
|
Employer
|
Employer
|
|
Funding
|
Employer, employee, or both
|
Employer only
|
Employer, employee, or both
|
|
Rollover
|
Yes, within 60 days. One is allowed per 12-month period.
|
No
|
No, use it or lose it provision.
|
|
Retiree Medical Premiums
|
Yes
|
No
|
No, use it or lose it provision.
|
|
Plan design requirements
|
Individual: Deductible must be at least $1,000 with an out of pocket maximum of not more that $5,000 per year.
(Deductible must be included as part of the out of pocket maximum).
Family: Deductible must be at least $2,000 with an out of pocket maximum of not more than $10,000. (Deductible must be included as part of the out of pocket maximum).
The deductibles and out of pocket maximum will be indexed for inflation each year.
|
None
|
None
|
|
Annual contribution limits
|
Yes, up to a lesser of the deductible amount or $2,600/$5,150 for 2004
|
None; set by employer
|
None; set by employer (for Medical Care)
|
|
|
Health Savings Accounts
|
Health Reimbursement Accounts (Arrangements)
|
Flexible Spending Accounts
|
|
Payment of insurance premiums
|
While receiving:
Unemployment benefits
COBRA continuation benefits
Medicare (but not a supplement policy)
|
Funds can be used for premiums under:
The employee’s health plan.
A spouse’s health plan.
The employer’s retiree health plan.
COBRA continuation.
|
EE Contributions
|
|
Long Term Care Premiums
|
Yes
|
Yes
|
No, Section 125 specifically excludes long-term care insurance.
|
|
Excise taxes and penalties
|
Yes, distributions not used exclusively to pay for qualified medical expenses under Section 213d are subject to a 10% excise tax, except when an individual turns 65 or older, is disabled, or has died. A 6% penalty applied for excess contributions.
|
Yes, distributions not used exclusively to pay for qualified medical expenses under Section 213d are subject to a 15% excise tax, except when an individual turns 65 or older, is disabled, or has died.
|
No.
|
|
Taxation
|
Employee contributions are tax deductible. Employer contributions are excludable from gross income.
|
Employer contributions are generally excludable from employee’s gross income.
|
Employees pay no federal, Social Security or (in most states) state taxes on FSA contributions.
Employers pay no FICA tax on FSA contributions.
|
|
Portability
|
Yes
|
Yes
|
No, unused FSA balances are forfeited to the employer.
|
|
Interest accumulation
|
Yes. Interest accrues tax-free.
|
There is no requirement that interest accrue but employers have discretion to credit interest to the HRA accounts.
|
No
|
About the Author
Patrick J. Haraden is a Director of Employee Benefit Services at Longfellow Financial, LLC in Boston, which provides employee benefits consulting and brokerage services to both local and national employers. He earned BSBA in Accounting and Management from Northeastern University and an MBA in Taxation from Bentley College. He is a licensed life, health, and property casualty insurance adviser, broker, and consultant. He has attained the designations of a Certified Employee Benefit Specialist (CEBS), a Chartered Life Underwriter (CLU), a Chartered Financial Consultant (ChFC), a Registered Employee Benefits Specialist (REBC), and a Registered Health Underwriter (RHU).
Resources
This article provides general information and does not constitute legal or tax advice. Readers should consult with their attorneys, accountants, and benefit professionals for advice and recommendations on their specific situation
[1] Department of Treasury Notice 2004-2, December 22, 2003
[2] Public Law No. 108-173
[3] Revenue Ruling 2004-38, March 30, 2004
[4] Revenue Procedure 2004-22, March 30, 2004
[5] Notice 2004-43, June 25, 2004