CBA Publications >> CBA Regulatory Compliance Bulletin >> Vol 2004 No.2
January 22, 2004

Vol 2004 No. 2 January 22, 2004

Health Savings Accounts - Better Than an IRA?

This article was prepared for CBA by Ellen Marshall of the law firm of Manatt Phelps & Phillips, LLP.

The Medicare Prescription Drug, Improvement and Modernization Act of 2003, which was enacted on December 8, 2003, included an important new tool in retirement savings -- the Health Savings Account (HAS), under new Section 223 of the Internal Revenue Code. Financial institutions that now offer IRAs should consider offering the HSA as well. Generally, the documentation and rules for HSAs will be quite similar to those for IRAs, so the same resources can be devoted to both.

How Will the HSA Work? Unlike IRAs, contributions to HSAs are deductible without regard to income level or active participation in an employer's plan. The funds accumulate tax free. If the funds are used to pay for qualified medical expenses, they are not taxed at all. If the funds are distributed for any other purpose, they are taxed at the time of distribution, plus an extra 10% tax. The extra 10% tax does not apply, however, if the distribution is made after the participant dies, becomes disabled, or reaches age 65.

The HSA will work in a manner very similar to an IRA. The HSA is a trust or custodial account set up with a bank or other financial institution-the same kind of entity that can serve as trustee or custodian of an IRA. The rules for the HSA are similar to those for an IRA on matters such as timing of contributions, method of correction, rollovers from one HSA to another, and splitting an HSA upon divorce.

Who Is Eligible for an HSA? To contribute to the HSA, a taxpayer must be covered by a high deductible health plan, or HDHP. An HDHP is a health plan that has:

• an annual deductible of not less than $1,000 for self-only coverage, or $2,000 for family coverage, and

• an annual out-of-pocket expense requirement for covered benefits of not more than $5,000 for self-only coverage, or $10,000 for family coverage.

The likely policy rationale for the second criterion is to create a demand for low coverage policies that nevertheless have some level of coverage.

The HDHP must be the main health plan, and not just an extra policy. The insured cannot, for example, have another type of coverage in an employer's program, or Medicare. The individual can, however, have another type of plan for ancillary benefits such as dental, vision, disability or long term care.

How Much Can Be Contributed? The maximum contribution to the HSA, all of which is deductible, is the sum of
(a) the lesser of:

• $2,600 for self-only coverage, or $5,150 for family coverage, or

• the actual deductible of the taxpayer's HDHP; plus

(b) an additional amount if the participant is age 55 by the end of the taxable year, in the following amount:
2004 $500
2005 $600
2006 $700
2007 $800
2008 $900
2009 and thereafter, $1,000

The dollar limits will be subject to cost-of-living adjustments in the future.

The contribution amounts must be prorated for the months in the year when the taxpayer has an HDHP, and does not have other medical plan coverage. If the taxpayer first sets up the HDHP at some time during the year, the maximum contribution will be a pro rata share of the above-described limit, based on the number of months in which the taxpayer qualifies as of the first day of the month. If the taxpayer becomes eligible for Medicare during the year, the proration will be based on the number of months that precede the month in which the taxpayer becomes eligible for Medicare. Even though the amount of the contribution is prorated based on months, the time of the contribution can be any time until April 15 of the following year (just like an IRA).

What Happens If the Participant Dies? If the participant dies before the HSA is fully distributed, the funds can be used after the participant's death to pay medical expenses that were incurred before death. After paying all of those expenses, any remaining funds go to the designated beneficiary. If the designated beneficiary is the participant's surviving spouse, that spouse can adopt the HSA as his or her own, and thereby continue the tax-exempt accrual. If there is no surviving spouse, or that spouse is not the designated beneficiary of the HSA, then the remaining assets in the HSA are distributed to the non-spouse beneficiary. The HSA will be considered an asset of the estate of the participant for estate tax purposes, and will be subject to income tax to the beneficiary.

When Is the HSA Available? An HSA can be established for the 2004 tax year, provided that the taxpayer has an HDHP as of the first day of any month in 2004. Because of the proration, the full contribution and deduction is available only for those taxpayers who already had an HDHP as of January 1, 2004.

Are HDHPs Currently Available? For individuals who obtain their health benefit coverage on an individual basis, there are many companies that already have choices that qualify as an HDHP. It is likely that other providers will quickly move to add choices that will qualify.

For individuals who obtain their health benefit coverage through an employer, it is less likely that the existing employer program includes an HDHP option. It is likely that many employers will decide to add an HDHP-qualifying option to their existing programs. In addition, some employees may find that the advantages of using their employer program are outweighed by the advantages of an individual policy, when the tax savings associated with the HSA is factored into the analysis.

How Does the New HSA Differ from the Archer MSA? Since 1997, there has been a Medical Savings Account concept (later renamed the Archer MSA) in the Internal Revenue Code. It was similar to the new HSA, but had more limited availability. It was a pilot program, and was only available to self-employed individuals and employees of small employers. Also, the Archer MSA used a definition of HDHP that was more restrictive, with both a minimum and a maximum deductible amount and a lower out-of-pocket limit.

In 1997, there were few if any providers that even offered benefit plans that would satisfy the statutory definition of an HDHP. Since that time, some insurers began to offer programs that complied with the statutory definition. Some even developed tandem programs that combined an Archer MSA with an HDHP. Because the program was limited to self-employed individuals and employees of small employers, these did not develop into important or well-publicized programs. The universal availability of the tax benefits of the HSA may be expected to prompt many more benefit plan providers to offer products that will qualify as an HDHP.

An individual who did establish an Archer MSA is now permitted to roll over the funds in that account to an HSA, on a tax-free basis.

How Does a Bank Go About Offering the HSA?
The IRS has not yet issued a form trust or custodial document for establishing an HSA, or a procedure for obtaining approval of a bank's form. If it follows its prior practice, the IRS will provide both of these well ahead of the deadline for establishing the HSA trust or custodial account.

Because of the contribution deadline of April 2005, it is not necessary to have all documentation available immediately. Because of the HDHP requirement, however, it could make sense to begin marketing the HSA immediately, so that customers can modify their health plans, if necessary. One way of doing this would be for the bank to take "applications" for the HSA, with a promise to forward the full documentation when it becomes available.

Where Can I Learn More about the HSA? IRS Notice 2004-2, published on January 12, 2004, provides additional detail about these accounts.