Health Savings Accounts

12/02/2011

Health insurance can be a large monthly family expense.  

Self-employed individuals often face difficulty acquiring insurance at group rates and therefore must purchase more expensive individual coverage.

Employees are finding that even if they are participating in their employer's group health plan, they are being asked to bear an increaseinly larger share of the health insurance bill.

Early retirees don’t qualify for Medicare until age 65, and with fewer employers offering post-retirement health insurance, they can be forced to purchase individual coverage at an expensive rate.

An attractive alternative to traditional health insurance is the Health Savings Account (HSA). HSA's came into existence as part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003.

With an HSA, a person purchases a health insurance plan with a high deductible.  A deductible is the amount that must be paid before insurance coverage begins. A high deductible results in a less expensive insurance policy (or premium) because the insured, not the insurer, is at risk for routine healthcare costs up to the deductible amount.

The benefit of an HSA is that it can allow the insured to save for the uninsured medical costs in a tax-efficient manner, thereby lowering the overall outlay.

Let's look at it in a little more detail.

To be eligible for an HSA a person must be an "eligible individual."  An eligible individual for participation in an HSA is defined as an individual that:

  • Is covered under a high-deductible health plan on the first day of any month for which the individual wishes to make a contribution;
  • Is not covered by any other health plan (with certain exceptions)
  • Is not enrolled in Medicar (generally under 65); and
  • May not be claimed as a dependent on anther person's tax return.

This definition is broad enough to include most people interested in an HSA, provided they are covered under a high-deductible health plan (HDHP).

Generally, a HDHP is a health plan that satisfies certain requirements with respect to deductibles and out-of-pocket expenses.  Specifically, for single coverage, a HDHP has an annual deductible of at least $1,200 and annual out-of-pocket expenses (deductibles, co-payments and other amounts, but not premiums) not exceeding $5,950 (2011). For family coverage, a high-deductible insurance plan has an annual deductible of at least $2,400 and annual out-of-pocket expenses not exceeding $11,900 (2011).  These amounts are indexed for inflation.

Any eligible individual may contribute to an HSA. Where the HSA is established and sponsored by an employer, the employee, the employer or both may contribute to the HSA. 

The maximum contribution to an HSA in 2011 is $3,500 for individuals or $6,150 for families.  The entire annual amount can be paid from December through April 15th of the following year.

In addition to the maximum contribution amount, catch-up contributions are allowed for individuals age 55 and older who are not enrolled in Medicare.  

Contributions to HSAs are deductible in determining adjusted gross income (above the line deductions).  Employer contributions to the employee’s HSA are treated as employer-provided coverage for medical expenses and are excludable from the employee’s gross income.

In general, distributions from an HSA may be received at any time and made for any purpose.  However, the purpose for which the distributions are made and their timing determines how they are taxed.  Distributions for purposes other than the following are included in income and may be subject to a 10 percent penalty tax:

  • Distributions to reimburse for Qualified Medical Expenses;
  • Distributions at age 65 and older;
  • Distributions after the account holder's death.

Qualified medical expense are expenses paid by the account beneficiary or his or her spouse or dependents, for medical care as defined in the Internal Revenue Code, but only to the extent the expenses are not covered by insurance or otherwise.

Generally, health insurance premiums are not qualified medical expenses except for (i)  qualified long-term care insurance, (ii) COBRA coverage and (iii) health care coverage while a person is getting unemployment compensation.

Distributions from HSA's to reimburse for qualified medical expenses are income tax free.  In general, HSA distributions to individuals age 65 and older to reimburse for medical expenses such as Medicare can also be paid from an HSA tax free.

On the other hand, distributions to pay for nonmedical expenses (including premiums for Medigap policies) are included in the individual’s income.  However, such distributions are not subject to the 10 percent penalty tax.

The taxation of distributions following the death of the account owner varies depending on whether the beneficiary is the surviving spouse or not.  Upon an employee’s death, any balance remaining in the HSA becomes the property of the HSA beneficiary of the account.  If the surviving spouse is the named beneficiary, the HSA becomes his or her HSA. The surviving spouse can use the funds in the inherited HSA for his or her own medical expenses tax free.  Funds withdrawn for non-medical purposes are included in income and may or may not be subject to a penalty fee depending on the spouse’s age.  If the spouse is under age 65 the 10 percent penalty will apply.  If over age 65, no penalty will apply even if the funds are used for non-medical purposes.

Distributions from HSA's are tax free to the extent they are used to reimburse for qualified medical expenses. This means that retirees can use amounts accumulated in HSA's to help them pay for Medicare copays, deductibles and coinsurance.  In addition, reimbursements can be used to pay for items such as preventive care, vision and dental treatment, and long-term care insurance premiums that are not covered by Medicare.

Early retirees can use tax-free distributions from HSA's to pay for COBRA and reimburse out-of-pocket expenses not reimbursed by COBRA coverage.  Retirees who find that they do not need the amounts in their HSA's to meet medical costs can use the accumulated amounts for any purpose. In general, however, amounts not used to reimburse for medical expenses will be included in income.  Distributions for nonmedical purposes received after age 65 are includible in income, but are not subject to the 10 percent penalty tax.

The bottom line ... look to see if an HSA is right for you.