Tax-Free Health Savings Accounts Provide Relief

Help is on the way for millions of Americans who are burdened with high health insurance deductibles. Through recent legislation, workers may have an opportunity to enter into tax deductible health care accounts.

These actions are possible through the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 which Congress passed late last year. This legislation established a new health-related savings vehicle that provides tax planning opportunities for individuals and employers. Under the Act, eligible individuals or their employers may establish Health Savings Accounts (HSAs) beginning January 1, 2004, for the purpose of paying qualified medical expenses of eligible individuals and their eligible dependents.

The most appealing feature of these new types of accounts is that, in general, contributions to such accounts are federally tax deductible. More important, if an eligible individual makes a contribution to an HSA, the deduction is considered to be an “above-the-line” tax deduction. This is not the case with respect to most other medical expenses of an individual, which are significantly limited under the itemized deduction rules that apply to individual taxpayers.

In addition, if an eligible individual’s employer establishes an HSA, employee contributions may be made on a pre-tax basis. Finally, if the employer makes a contribution to the HSA, the contribution is tax-deductible by the employer, yet is not considered to be taxable income to the eligible individual (even though, by making the contribution on behalf of the eligible individual, the employer has technically conferred a benefit upon the individual).

The earnings of the HSA grow tax-free. This is important, since earnings, such as interest and dividends, generally constitute taxable income for taxpayers. Further, and more appealing, distributions from an HSA are generally not taxable to an eligible individual if the distributions are used to pay qualified medical expenses. As a general rule, qualified medical expenses include amounts paid for the medical care of the eligible individual, spouse and any tax dependent (unless compensated by insurance or otherwise).

Health insurance premiums, however, are not considered to be qualified medical expenses, except in certain cases, such as premiums paid for COBRA insurance, premiums paid by those who are age 65 and over and premiums for qualified long-term care insurance. Distributions that are used for nonqualified purposes are taxable and subject to an additional 10 percent tax. However, the additional 10 percent tax does not apply in certain cases, such as in the case of distributions made after an individual becomes eligible for Medicare.

As expected, there are limitations with regard to HSAs. Most significant, the maximum pre-tax contribution that may be made in 2004 is $2,600 for those with self-only coverage and $5,150 for those with family coverage. In both cases, the maximum contribution is limited to the annual deductible under such coverage. The annual contribution limit is increased by $500 for 2004 for individuals who have reached age 55 by the end of the year. In order to qualify, the individual must be an “eligible individual,” generally defined as any individual covered under a “high-deductible” health plan. A high-deductible health plan is one that has an annual deductible of at least $1,000 for self-only coverage, and $2,000 for family coverage.

HSAs should be advantageous to taxpayers who qualify as eligible individuals since they are similar to tax-free retirement vehicles. Unlike traditional flexible spending accounts, unused HSA balances are rolled over (and, therefore, are “saved”) from year to year. That is, they are not subject to the so-called “use-it-or-lose-it” rule that is applicable to flexible spending accounts. As such, they may be appealing to younger individuals, since the time period for investment account growth is more significant. In many cases, younger individuals do not incur significant medical expenses, so that the high deductible nature of insurance coverage may not be a deterrent. In the meanwhile, the younger individual will potentially realize the benefit associated with the account’s tax-free growth and potential tax-free distributions, particularly at a time (i.e., retirement) when he or she may have a greater need for assistance with medical expenses.

Joseph P. Nicola, Jr., CPA, JD, CVA, is a Shareholder and Director of the Employee Benefits Services Group for Alpern Rosenthal.

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