I. Introduction

The 2003 Medicare Act signed by President Bush on December 8, 2003 expands the opportunities available to save for medical expenses through tax-favored accounts. Health Savings Accounts (HSAs) are similar to the Archer Medical Savings Accounts (MSAs), which have been available since 1997, but will cover more individuals, allow for larger tax-favored contributions, and provide for more flexibility in coordinating individual and employer contributions. With the introduction of HSAs, no new contributions can be made into MSAs other than by current MSA account holders and by employees of participating employers. The new HSAs are being touted as vehicles that will revolutionize medical spending decisions in that they allow participants to save, on a tax-advantaged basis, dollars not spent on health care.

Going forward, HSAs will likely become the predominant savings tool for medical expenses by eligible taxpayers - and with good reason. Up to this point - setting aside the MSA program that HSAs are essentially replacing - there has been limited assistance from the Internal Revenue Code in helping individuals cope with medical expenses they must pay personally. Section 213 of the Internal Revenue Code of 1986, as amended (the "Code"), allows a Schedule A deduction for expenditures for qualifying medical care only to the extent they exceed seven and one-half percent of adjusted gross income. Obviously, taxpayers must have significant medical bills before benefiting from this provision. By contrast, the health flexible spending arrangement (so-called health FSA), which is part of an employer cafeteria plan, provides a vehicle for pre-tax payment of medical expenses beginning with the first dollar. However, an FSA participant must decide before the year begins how much compensation to set aside for the FSA. If the year's medical expenditures exceed such amount, no tax break is available. If they are less than the participant's FSA set-aside, the participant forfeits the difference. As outlined below, HSAs provide large benefits that are lacking in these provisions in order to help eligible individuals cope with uncompensated medical expenses.

II. What Qualifies as a Health Savings Account

Beginning January 1, 2004, an eligible individual may set up an HSA with a qualified trustee or custodian at a bank, financial institution or insurance company. Deductible contributions can be made to these accounts to save for qualified medical expenses incurred by the account holder, his or her spouse, and dependents. Unlike the health FSAs referred to above, contributions to an HSA are vested in the account holder and any unused account balance is not forfeited at the end of the year. Similar to individual retirement accounts (IRAs), HSAs will be invested primarily in cash-type items, marketable securities and mutual funds.

Eligibility. To establish an HSA, an individual must (1) be covered by a high deductible health plan (HDHP), (2) not also be covered by a health plan that is not an HDHP, (3) not be Medicare eligible (generally, age 65), and (4) not be claimed as a dependent on another individual's tax return. In determining whether an individual is eligible, certain insurance coverage is disregarded, including coverage for accidents, disability, dental care, vision care, long-term care, specific diseases or illnesses, and fixed payments for hospital stays, or for coverage in connection with workers' compensation laws, tort liabilities, and property use or ownership (Disregarded Coverage). A plan or policy is not an HDHP if substantially all of its coverage is Disregarded Coverage.

An eligible individual does not need to consult or coordinate with his or her employer prior to setting up an HSA.

High Deductible Health Plan. In general, an HDHP is a group plan or individual plan or policy that has an annual deductible of at least $2,000 for family coverage ($1,000 for individual coverage) and under which the total annual out-of-pocket expenses required to be paid by the participant for covered benefits (other than premiums but including the annual deductible) does not exceed $10,000 for family coverage ($5,000 for individual coverage). An HDHP need not be an insurance product; a self-insured health plan may be an HDHP.

Special rules apply in determining whether the deductible/annual out-of-pocket limits are met. For example, a preferred provider option plan (PPO) that has higher costs and higher deductibles for services provided outside of the PPO's network may qualify as an HDHP, and the contribution limitations will be based on the in-network annual deductible.

III. How Much May be Contributed to an HSA

Contributions must be made in cash and not in stock or other property. Eligibility is determined on a monthly basis, with the amount that can be contributed in a given year being the sum of the monthly contribution limits for the months the account holder was eligible during the year. The monthly limit for 2004 is one-twelfth of the lesser of (1) the HDHP annual deductible or (2) $5,150 for family coverage ($2,600 for individual coverage).

Example

Bill begins individual coverage under an HDHP on July 1, 2004. The deductible under the plan is $3,000. Bill's aggregate contribution for 2004 if he had been enrolled in the plan for a full year would be limited to $2,600 (the lesser of the annual deductible or $2,600). Since he becomes eligible in July, his contribution for 2004 may not exceed $1,300.

Account holders who are at least 55 prior to the end of the year (but not yet 65) may contribute more than the limits just described. For 2004, the allowable annual "catch-up" contribution (whether for individual or family coverage) is $500. The catch-up contribution increases each year by $100 until 2009, when it reaches $1,000.

These limits are reduced by any contributions made to the account holder's MSA and by any contributions made to the account holder's HSA by his or her employer. There is a special contribution rule for married couples with family coverage. If one spouse has family coverage, the other spouse is also deemed to have the same family coverage and can create his or her own HSA. If both spouses have family coverage, both spouses will be treated as having family coverage under the HDHP with the lower annual deductible. The family contribution limit (in other words, the aggregate contribution limit for the couple) is the deductible amount, reduced by employer contributions and the amounts contributed to MSAs of either spouse, if any, for the taxable year. The family contribution limit is allocated between the spouses evenly. However, the couple is permitted to decide on a different allocation so long as the family contribution limit is not exceeded. Importantly, each spouse may make catch-up contributions to his or her own HSA if eligible to do so without exceeding the family contribution limit.

Example

Bill and Sue are married. Bill is 60, and Sue is 54. Bill and Sue both have family coverage under separate HDHPs. Bill has a $3,000 deductible under his HDHP, and Sue has a $2,000 deductible under her HDHP. Bill and Sue are treated as covered under Sue's plan, that is, the plan with the $2,000 deductible. In 2004, Bill can contribute $1,500 to an HSA (one-half the deductible of $2,000 plus a $500 catch up contribution), and Sue can contribute $1,000 to an HSA.

Note that if Bill had already contributed $500 to an MSA in 2004, he could only contribute $1,000 to his HSA.

Similar to rollovers between IRAs, an account holder may roll over (once a year) to an HSA his or her balance in an MSA or in another HSA. These rollover contributions need not be in cash and are not taken into account in determining annual contribution limitations. In addition, contributions up to the contribution limits may be made until the time prescribed for filing the account holder's tax return (without extensions), which is generally April 15th. Conversely, an account holder may make his or her entire annual contribution on the first day of the year. However, if too much is contributed, the excess over the contribution limit will not be deductible and, if made by the eligible individual's employer, will be included in the employee's income in the year contributed. Further, an annual excise tax of 6% is imposed on the account holder for excess individual and employer contributions. This penalty tax can be avoided if the excess contribution is "corrected" by distributing the excess contribution to the account holder, along with the net income attributable to it, prior to the timely filing of his or her income tax return for the year in question (including extensions). The net income on the excess contribution is included in the account holder's gross income in the year it is received.

IV. How the Income Tax Law Treats HSAs

Like MSAs and IRAs, HSAs grow tax free.

Contributions to an HSA that are within the limits outlined above are deductible in determining the account holder's adjusted gross income. Because this is an above-the-line deduction, contributions to HSAs can be deducted even if the account holder does not itemize his or her deductions.

Distributions from an HSA are not included in the account holder's gross income to the extent the distributions are used exclusively to pay for, or reimburse the account holder for payments made to cover, qualified medical expenses of the account holder, his or her spouse, and dependents. To receive this favored tax treatment, the medical expenses must have been incurred after the HSA was created and must not be compensated for by insurance or otherwise. Qualified medical expenses are amounts paid for medical care as defined in Section 213 of the Code and include expenses for the diagnosis, cure, mitigation, treatment or prevention of disease, including prescription and non-prescription drugs, transportation primarily for and essential to this care, and qualified long-term care expenses. Qualified medical expenses do not include expenses for insurance except for (1) long-term care insurance, (2) premiums for health coverage during any period of continuation coverage required by federal law (that is, COBRA premiums), and (3) premiums for health coverage while receiving unemployment compensation. In addition, for individuals over 65, premiums for Medicare Part A or B, Medicare HMO, and the employee share of employer-sponsored health insurance, including retiree health insurance, will be qualified medical expenses.

A distribution from an HSA that is used to pay medical expenses will not be deemed an expense paid for medical care for purposes of meeting the percentage threshold for determining whether a taxpayer has reached the seven and one-half percent floor for taking a deduction for medical expenses under Code Section 213.

It is the HSA account holder's responsibility to maintain records showing that distributions are used for qualified medical expenses. Neither the HSA trustee or custodian nor the account holder's employer has responsibility for determining how distributions are spent. Distributions made for expenses other than qualified medical expenses will be included in the gross income of the account holder and the tax imposed on that distribution will be increased by an amount equal to 10% of the amount includible. However, once an account holder reaches the age of Medicare eligibility (generally, age 65), becomes disabled or dies, distributions that are not used to cover qualified medical expenses will be included in gross income, but no penalty tax will apply. This means that an HSA balance unused at age 65 converts to a useful source of retirement income for the account holder.

V. Employer Contributions to HSAs

Unlike MSAs, both employees and employers can contribute to an eligible individual's HSA. Employer contributions, including contributions made through a cafeteria plan, are excludable from the employee's gross income. Contributions made by employees and their employers are aggregated for purposes of the annual contribution limitations. Employer contributions are not subject to income tax or social security tax withholding. Nondiscrimination rules apply that require employers who contribute to their employees' HSAs to make comparable contributions available to all participating employees.

VI. What Happens to HSAs on Death

The treatment of an HSA upon the death of the account holder is determined by who is the designated beneficiary of the account. If the account holder's surviving spouse is the designated beneficiary, the account continues to be an HSA and the spouse is treated as the new account holder. If the designated beneficiary is someone other than the surviving spouse or is the account holder's estate, the account ceases to be an HSA.

Estate Tax Treatment. No matter who is designated as the beneficiary of the HSA, the accumulated assets in the account are included in the account holder's estate for estate tax purposes. However, if the account passes to the account holder's surviving spouse, either as the designated beneficiary of the account or pursuant to the account holder's estate plan, the accumulated assets in the account are eligible for the unlimited marital deduction in the decedent's estate, meaning that the balance can pass free of estate tax to the surviving spouse.

Income Tax Treatment. As mentioned above, if the surviving spouse is the designated beneficiary of the HSA, the account will continue to be an HSA with the spouse as the new account holder, and the rules governing the deductibility of contributions and the income inclusion of distributions outlined above will apply. If the designated beneficiary of the HSA is someone other than a spouse, the account ceases to be an HSA and the value of the account is taxable to the beneficiary. An income tax deduction, however, can be claimed pursuant to Code Section 691(c) for that portion of the federal estate tax on the decedent's estate that is attributable to the HSA balance.

If the HSA is paid to the decedent's estate, the fair market value of the account is included in the decedent's gross income for the year of his or her death.

Gift Tax Treatment. Contributions to an HSA can be made by family members on behalf of an eligible individual, and such contributions will be deductible for income tax purposes by the donee subject to the deduction limits described above. Contributions that are made on another's behalf will be treated as taxable gifts but may qualify for the gift tax annual exclusion. (A contribution to a family member's HSA does not qualify for the unlimited gift tax exclusion for payments for medical care.)

VII. Conclusion

In addition to the advantages available for those making medical expense payments, for those individuals who do not have to draw heavily on their accounts for qualified medical expenses, HSAs provide another tax-favored savings vehicle well worth considering. There are questions remaining as to certain aspects of how HSAs will be implemented and how they will be coordinated with other health plan coverage and existing health savings plans, and it is expected that the Internal Revenue Service will be issuing further guidance in the upcoming months. However, we anticipate that Health Savings Accounts, like IRAs, will be embraced by taxpayers, as well as the financial institutions that are qualified to offer them, and may have a profound effect on the health insurance plans offered by employers.

If you have any questions regarding the new Health Savings Accounts, please contact Ameek A. Ponda at (617) 338-2443, Jonathan B. Dubitzky at (617) 338-2936, David A. Guadagnoli at (617) 338-2938, Judith G. Edington at (617) 338-2422 or another member of the Sullivan & Worcester Tax Group at (617) 338-2800.

© 2004 Sullivan & Worcester LLP

Because sound legal advice must necessarily take into account all relevant facts and developments in the law, the information you will find in this Advisory is not intended to constitute legal advice or a legal opinion as to any particular matter.

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