Health Savings Accounts - An Alternative to High Insurance Premiums

By Lynn A. Conover, CPA,
Partner, The Curchin Group, LLC

On December 8, 2003, President Bush signed the health savings account (HSA) legislation into law. The new HSA is basically the "next generation" the Medical Savings Accounts (MSA) plans. Most importantly, almost everyone qualifies for the new HSA plans. Health savings accounts are tax-sheltered savings accounts similar to an IRA, but they are earmarked for medical expenses of the account beneficiary. Deposits are 100% deductible by an eligible individual and can be easily withdrawn by check or debit card to pay routine medical bills with tax-free dollars. Larger medical expenses are covered by a low-cost, high-deductible health insurance plan. Any amounts that are not used from the account each year stay in the account and continue to grow interest on a tax-favored basis to supplement retirement. You could call it a medical IRA.

Simply speaking, take the money currently spent on high cost traditional health insurance and spend some of it to buy a low cost higher deductible policy and deposit the balance into a tax-deductible HSA. The savings accounts can be used to pay medical expenses until the deductible is met. Then, if needed, the high deductible insurance policy covers the medical expenses exceeding the deductible.

Only "eligible" individuals can establish an HSA. The following criteria apply to the individual for each month. The individual must be covered under a high-deductible health plan (HDHP) on the first day of the month. He or she must not be covered by any other health plan that is not a high-deductible health plan. The individual cannot be enrolled in Medicare (generally, has not yet reached age 65). Lastly, the individual may not be claimed as a dependent on another person's tax return.

A high-deductible health plan (HDHP) is one that satisfies certain requirements with respect to deductibles and out-of-pocket expenses. For single individuals, an HDHP has an annual deductible of at least $1,000 and annual out-of-pocket expenses required to be paid not exceeding $5,000. Out-of-pocket expenses include deductibles, co-payments and other amounts, but not premiums. For family coverage, an HDHP has an annual deductible of at least $2,000 and annual out-of-pocket expenses required to be paid not exceeding $10,000. Participants in an HDHP often experience dramatic decreases in premium cost which makes the switch from traditional low deductible insurance rather painless.

An HSA is established with a qualified HSA trustee or custodian. No permission or authorization is needed from the Internal Revenue Service. Any insurance company or bank can be an HSA trustee or custodian. An HSA can be established through a qualified trustee or custodian who is different from the HDHP provider. When choosing a trustee or custodian the individual should consider and compare such factors as set up fees, monthly fees, interest rates, minimum balance and deposit requirements and investments options. Unfortunately, there are only a handful of banks and some mutual funds currently accepting HSA contributions, but as taxpayers learn about the benefits of HSAs, more custodians will appear.

If an HSA is established by an employee, his or her employer may also contribute to the HSA in a given year. An account established by a self-employed or unemployed individual may only accept contributions from that individual. Family members may also make contributions to an HSA on behalf of another as long as that other family member is an eligible individual.

The maximum annual contribution to an HSA is the sum of the limits determined separately for each month, based on status, eligibility and health plan coverage as of the first day of each month. For the calendar year 2004, the maximum monthly contribution for single eligible individuals is 1/12 of the lesser of 100% of the annual deductible under the HDHP (minimum of $1,000) but not more than $2,600. For eligible individuals with family coverage, the maximum monthly contribution is 1/12 of the lesser of 100% of the annual deductible under the HDHP (minimum of $2,000) but not more than $5,150. Catch up contributions may be made by individuals age 55 or older who are not enrolled in Medicare in addition to the maximum annual contributions allowed. In 2004, the catch-up contribution is $500. If an individual has more than one HSA, the aggregate contributions to all the HSAs are subject to the limit. Contributions to an HSA must be made in cash. Contributions in the form of stock or other property are not permitted. Payments for HDHP and contributions to the HSA can be made through a cafeteria plan.

Contributions for the taxable year can be made in one or more payments at the convenience of the individual or employer. They can be made up to April 15 following the year for which the contributions are made. However, they cannot be made before the beginning of the subject year.    Although the annual contribution is determined monthly, the maximum contribution may be made on the first day of the year.   

As previously indicated, contributions within the limits made by an individual to an HSA are deductible by the eligible individual in determining his or her adjusted gross income. They are deductible whether or not the individual itemizes deductions. However, the individual cannot also deduct the contributions as a medical expense deduction. Contributions made by a family member on behalf of an eligible individual are deductible by the eligible individual.

Employer contributions made on the behalf of an eligible individual are treated as employer-provided coverage for medical expenses under an accident or health plan and are excludable from the employee's gross income. The employer contributions are not subject to Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), or the Railroad Retirement Act. Contributions to an employee's HSA through a cafeteria plan are treated as employer contributions. The employees cannot deduct the employer contribution on his or her federal income tax return.

An individual is permitted to receive distributions from an HSA at any time. They must be used exclusively to pay for qualified medical expenses of the account beneficiary, spouse or dependents. These distributions are excludable from gross income even if the individual is not currently eligible for contributions to the HSA. Any amount of the distribution which is not used to pay for qualified medical expenses is includable in gross income and is subject to an additional 10% penalty on the amount includable. An exception to this taxability is made in the case of death disability or attaining age 65. Smart investors will choose to use other funds to pay current medical bills and allow their HSA to grow tax free. An HSA can serve as a replacement for long term care insurance since it can pay for nursing home care.

In these times on rising health insurance costs, the health savings accounts provide an alternative to paying high premium policies. The benefits include tax deductions for contributions and employer contributions are excluded from gross income. Contributions remain in an HSA from year to year until used. Interest and other earnings are tax free, distributions for qualified medical expenses are tax free and the HSA is portable so it stays with you if you change employers or leave the workforce. Why not consider this great alternative?