A by-product of last year’s Medicare Prescription Drug, Improvement and Modernization Act was the creation of a new type of tax-favored savings vehicle for health expenses, known as a “Health Savings Account,” or “HSA.” The HSA, which is defined in a new Section 223 of the Internal Revenue Code, is a funded account similar to an IRA to which individuals and/or employers may make annual contributions, within certain limits. HSAs are designed to give individuals more control over the manner in which health care dollars are spent.
Like IRAs, HSAs are owned by the individual account holder, rather than his or her employer, and thus are portable. Earnings in the account grow on a tax-free basis and, if used for medical expenses, may be withdrawn on a tax-free basis. When an HSA participant dies, becomes disabled, or eligible for Medicare, amounts in the HSA may be used for any purpose without incurring a tax penalty (although they must be included in income.) Any other withdrawals must not only be included in income, but are also subject to a 10 percent tax penalty.
The IRS and Treasury Department have issued a plethora of guidance on HSAs this year, as well as model trust and custodial account agreements for use by HSA trustees. Eight separate notices or rulings clarify issues such as which individuals are eligible to participate in an HSA, how contribution limits are calculated, and how HSAs interact with flexible spending accounts and health reimbursement arrangements. The last notice (2004-50), which was handed down on July 23, 2004, promises to be the final official guidance for at least a year. It may therefore be safe at this point to summarize some of the basic rules governing HSAs.
Eligibility to participate in an HSA is determined on a monthly basis. To be eligible, on the first day of the month the individual must be covered under a “high deductible health plan” (“HDHP”) and may not participate in any other non-high deductible health plan, subject to certain exceptions. An HDHP is defined for 2004 to be a plan with a minimum annual deductible of $1,000 for single coverage, or $2,000 for family coverage. The maximum annual out-of-pocket limit for the HDHP must not exceed $5,000 for single or $10,000 for family coverage.
An individual who is enrolled in Medicare, or who may be claimed as a dependent on another person’s tax return, is not eligible to establish an HSA. Merely attaining age 65, however, and thus becoming “eligible” for Medicare, does not disqualify the individual. Instead, actual enrollment in Medicare Part A or Part B is required. Generally, a person who reaches age 65 and is receiving Social Security benefits is automatically enrolled in Medicare Part A. For such an individual to continue contributing to an HSA, he or she would have to affirmatively opt out of Medicare. In addition, individuals who have Medicare coverage because of end-stage renal disease or Social Security disability are ineligible to contribute to an HSA.
HIGH DEDUCTIBLE HEALTH PLANS
In order to constitute an HDHP, the minimum annual deductible must be $1,000 for single or $2,000 for family coverage (indexed annually). The $5,000 single and $10,000 family out-of-pocket maximums also are indexed annually. The most recent IRS guidance clarified that having a reasonable lifetime limit on benefits does not cause a plan to violate the out-of-pocket expense limits. For example, a $1 million lifetime limit on covered expenses is reasonable, as are lifetime limits on specific benefits (e.g., fertility), so long as “significant other benefits remain available under the plan.”
In some circumstances, plans offering family coverage require each covered person to satisfy an individual deductible before the plans begin paying expenses. Such plans also may provide an umbrella deductible, representing the maximum amount of expenses the entire family must pay before the plans begin paying. These plans can qualify as HDHPs to the extent that the combination of individual and family deductibles results in a family paying no more than the out-of-pocket maximum ($10,000 in 2004).
In the case of a mid-year switch from a traditional health plan to an HDHP, amounts considered against the prior plan’s deductible may be considered against the HDHP’s deductible. Special rules apply if the deductible accumulation period is more than 12 months.
The IRS has indicated that an HDHP may offer first-dollar coverage for preventive care expenses, i.e., coverage for expenses that are incurred before the HDHP deductible is satisfied, and still qualify as an HDHP. Examples of preventive care include periodic health examinations, routine prenatal and well-baby care, immunizations, and certain screening services. Preventive care generally does not include treatment for an existing illness or injury. However, any treatment that is “incidental or ancillary” to a preventive care service or screening falls within the meaning of preventive care if it would be unreasonable or impracticable to perform another procedure to treat the condition (such as a polyp removal during a colonoscopy). In addition, drugs or medications that are taken by a person who has developed risk factors for a disease that has not yet manifested itself are considered preventive care.
Anyone may contribute to an eligible individual’s HSA, including the eligible individual, an employer, a family member, or even an unrelated person. Contributions may be made on either a pre-tax basis through a cafeteria plan or an after-tax basis. The maximum HSA contribution for individuals with self-only HDHP coverage is the lesser of: (i) the annual deductible under the HDHP; or (ii) the statutory maximum contribution for single HSA coverage (i.e., $2,600 in 2004). The maximum HSA contribution for family HDHP coverage is the least of three amounts: (i) the statutory maximum contribution for family HSA coverage (i.e., $5,150 in 2004); (ii) the actual family “umbrella” deductible under plans with such deductibles; or (iii) the individual deductible multiplied by the number of family members covered under the HDHP. In addition, catch-up contributions may be allowed for individuals age 55 and older.
Employers that contribute to HSAs must make available comparable contributions to the HSAs of comparable participating employees. Contributions are comparable if they are in the same dollar amount or the same percentage of the HDHP deductible. Employees are comparable based upon their coverage (single or family) and whether they are full- or part-time. It is not clear whether this comparability requirement also applies to former employees with HDHP coverage (e.g., through COBRA or a retiree medical program).
Some employers had expressed interest in making HSA contributions as matching contributions. The IRS guidance generally indicates that matching contributions will violate the comparability requirement, unless the matching contributions are made through a cafeteria plan. The same is true with respect to employer contributions that are premised upon the employee’s participation in a wellness program. In these cases, however, employer contributions that are made to a cafeteria plan are subject to the Code Section 125 nondiscrimination rules. Testing employer contributions under those rules could prove to be an administrative headache.
CAFETERIA PLANS AND HSAS
The interaction of HSAs with cafeteria plans, health flexible spending accounts (“FSAs”), and health reimbursement arrangements (“HRAs”) is extremely complicated. Issued in May 2004, Revenue Ruling 2004-45 addresses when an individual may be eligible to contribute to an HSA while being covered by a health FSA or an HRA. Generally, current health FSA and HRA coverage below the minimum HDHP deductible will disqualify an individual from participation in an HSA. This is because such FSA or HRA coverage will be deemed to constitute non-HDHP coverage. Thus, an employer considering an HSA arrangement should give careful consideration to the effect it may have on any existing cafeteria plan or HRA.
HSAs are not subject to the election-change rules that are applicable to cafeteria plans, nor are they subject to the “use-it-or-lose-it” rules that require FSA participants to spend their entire account balances each year. Employees can change their pre-tax HSA contribution elections as often as the employer and HSA vendor allow. Although the new HSA election may be made regardless of whether a change in status event has occurred, it must be prospective only.
Employers considering the addition of an HSA during the middle of the year should be aware of a potential pitfall for employees who also participate in a health FSA. Adding HDHP coverage during the year would constitute the addition of a new benefit option, and thus would permit employees who elect coverage under the HDHP to drop other health coverage provided through a cafeteria plan pursuant to the Code’s change-in-status rules. Unless they have another status change event, however, employees who also participate in an FSA may not drop or change their FSA elections until the next open enrollment period. This is because the Code’s election change rules do not allow participants to change FSA elections upon the addition of a new benefit option. And, as noted above, continuing to participate in an FSA could make the employee ineligible to participate in the HSA.
THE EMPLOYER’S ROLE
Employers generally play a very limited role in the administration of an HSA. With respect to determining whether an individual is eligible to participate, the employer is required to determine only (i) whether the individual is covered under the employer’s HDHP (and the deductible amount) or low-deductible health plan (including a health FSA or an HRA), and (ii) the individual’s age (for purposes of catch-up contributions). Implicit in these requirements is that the employer not make HSA contributions to (nor allow salary reduction HSA contributions by) an ineligible employee, nor in an amount greater than the deductible, increased by any permissible catch-up contribution.
The employer is not responsible for determining whether contributions exceed the permitted amounts; the HSA account holder has that responsibility, as well as the responsibility to correct any excess contributions. Nor are employers responsible for approving distributions from an HSA, or monitoring their uses. Moreover, so long as the employer does not attempt to exercise control over the HSA, the Department of Labor has taken the position that HSAs are not subject to ERISA. Employer contributions to an HSA will not change this result as long as the employee’s establishment of the HSA is voluntary and the employer does not limit the employee’s ability to move funds to another HSA, limit the participant’s use of the HSA funds, influence the employee’s investment decisions, or represent the HSA as an employer-sponsored plan.
Some employers had expressed concerns about the possibility that employees could withdraw HSA funds – including employer contributions – for non-medical purposes. Such withdrawals, although subject to a 10 percent penalty and ordinary income taxes, generally are permitted. Employer groups lobbied the IRS to let them create rules that limit withdrawals of employer funds. Those efforts were rejected. Thus, an HSA account holder must be allowed to take distributions for any reason, subject to the applicable tax consequences.
Employers should consider carefully the impact an HSA may have on their other welfare programs, especially cafeteria plans, health FSAs, and HRAs. Adopting an HSA will require not only new informational materials for employees about that benefit, but also modifications to existing welfare plan documents and summaries.