Health Savings Accounts:
Save Now, Save Later
As health care costs explode, health insurance policies with high deductibles are becoming increasingly prevalent. By leaving more costs for a patient to cover out of pocket, rapidly rising insurance premiums will be kept in check at least in theory.(1) The next logical question is how to pay the large deductibles and other expenses not covered by High Deductible Health Plans.
This issue was addressed by Congress in the Medicare bill of 2003. Health Savings Accounts (HSAs) were created to help individuals save for qualified medical expenses on a tax free basis. An HSA combines a High Deductible Health Plan (HDHP) with a special savings account which is used to purchase health services. HSAs allow participants to save money with an above-the-line income tax-deductible contribution, tax-deferred accumulation and tax-free withdrawals.
Most persons covered under an HDHP are eligible to create an HSA. To qualify, an HDHP must have an annual deductible of at least $1,050 for individuals or $2,100 for families. Annual out-of-pocket expenses, including deductibles and co-pays, cannot exceed $5,250 for individuals or $10,500 for families (in 2006). These amounts are indexed annually for inflation.(2) An individual is not eligible to open an HSA if he or she is already covered by a non-HDHP, including a comprehensive major medical plan, employer-sponsored plan, or prescription drug plan with low or no deductible. Some exemptions to this apply, such as accident, disability, dental, vision and long-term care coverage, and insurance for a specific disease or illness, such as cancer. Other factors which will render an individual ineligible for an HSA include enrollment in Medicare and being claimed as a dependent on someone else’s tax return.(3)
An HSA is a custodial account or tax-exempt trust which is established through a qualified custodian or trustee, such as a bank, credit union, insurance company, or third-party administrator. Contributions to the HSA can be made by the individual, employer, or both, as well as by others on the individual’s behalf; however, only the account holder may take the tax deduction.(4) Employer contributions are not taxable to the employee, and are not subject to FICA or FUTA taxes.
The amount which can be contributed, in 2006, is 100 per cent of the HDHP deductible up to an annual maximum of $2,700 for individual coverage, and $5,450 for family coverage. Because an HDHP must be in place before an HSA can be established, contributions are pro-rated on a monthly basis for the first year of the HDHP. The annual contribution limit, for example, $2,700, is divided by 12, then multiplied by the number of months the HDHP has been in effect. For an HDHP that begins on August 1, 2006, for example, the formula would be:
$2,700 (annual contribution limit) divided by 12 months = $225 (approximately).
$225 x 5 (number of months of coverage) = $1,125 maximum contribution amount.(5)
Distribution of HSA funds is tax free if taken for “qualified medical expenses.”(6) Qualified medical expenses may include prescription and non-prescription drugs, laboratory fees, eyeglasses and hearing aids, ambulance and dental services, nursing home insurance premiums, and many other health care expenses. Distributions for non-qualified expenses are treated as taxable income and are subject to an additional 10 per cent penalty. This penalty does not apply if the distribution is made because the account holder died, became disabled, or reached age 65. (7)
A distinct advantage that HSAs hold over previous types of medical savings accounts is the lack of a “use it or lose it” provision. There is no forfeiture provision for funds remaining in the account at year’s end, and savings can continue to accumulate tax-free until withdrawn. Contributions, investment growth and withdrawals for health related expenses are all free from taxation, giving the HSA a tax advantage even the IRA does not enjoy. With these benefits, many health care experts predict that Health Savings Accounts have the potential to become the pre-eminent form of health care financing in the coming years.
Endnotes
1. Fogarty, Thomas A. “Health Savings Can Be Tax Shelter.” USA Today 5 Dec. 2003: B.04.
2. United States. Dept. of Treasury. Office of Public Affairs. All About HSAs. Washington: GPO, 2005.
3. Ibid., p. 4
4. Richard A. Beale and Brian Puckett, “Should We Be Using Health Savings Accounts?” 77 O.B.J. 1175, 1176 (Apr. 14, 2006).
5. Ibid.
6. United States. Dept. of Treasury. Office of Public Affairs. All About HSAs. Washington: GPO, 2005, 27.
7. Beale and Puckett, 1177.