MEDICAL SAVINGS ACCOUNTS : Contributions & Distributions

Contributions
Either the account holder of an MSA or the account holder's employer, but not both, may make a contribution to an MSA. If the employer makes a contribution, even one below the allowable limit, the account holder may not make a contribution. Contributions must be in the form of cash.

Contributions by an employer are tax deductible to the employer and are not included in an employee's gross income or subject to Social Security and other employment taxes. Employee contributions are deductible in computing adjusted gross income. As with IRAs, individuals' contributions must generally be made by April 15 of the year following the year for which the contributions are made.

The amount of the annual deductible contribution to an employee's account is limited to 65 percent of the deductible for the health coverage if the MSA is for an individual. The figure is 75 percent if an MSA covers a family. If each person in a married couple has an MSA and if one or both of the MSAs provide family coverage, the aggregate deductible contribution is equal to 75 percent of the deductible for the family coverage with the lowest deductible. The deductible contribution is split equally between the two persons in the couple unless they agree to a different division.

The actual MSA contribution that can be deducted is limited to 1/12 of the annual amount, as described in the previous paragraph, times the number of months that an individual is eligible for MSA participation. For example, assume that the deductible under an individual's health plan is $1,800. The maximum annual contribution to the MSA is then 65 percent of this amount, which is $1,170, and the monthly amount is $97.50. If the individual is covered under a high-deductible plan for only the first eight months of the year, then the annual deductible contribution is eight times $97.50, or $780. Note, however, that there are no requirements that contributions be made on a monthly basis or at any particular time. In this example, the full $1,170 could have been made early in the year. The excess over $780 would then be an excess contribution.

An excess contribution occurs to the extent that contributions to an MSA exceed the deductible limits or are made for an ineligible person. Any excess contribution made by the employer is included in the employee's gross income. In addition, account holders are subject to a 6 percent excise tax on excess contributions for each year these contributions are in an account. This excise tax can be avoided if the excess amount and any net income attributable to the excess amount are removed from the MSA prior to the last day prescribed by law, including extensions, for filing the account holder's income tax return. The net income attributable to the excess contributions is included in the account holder's gross income for the tax year in which the distribution is made.

An employer that makes contributions to MSAs is subject to a comparability rule that requires the employer to make comparable contributions for all employees who have MSAs. However, full-time employees and part-time employees (those working fewer than 30 hours per week) are treated separately. The comparability rule requires that the employer contribute either the same dollar amount for each employee or the same percentage of each employee's deductible under the health plan. Failure to comply with this rule subjects the employer to an excise tax equal to 35 percent of the aggregate amount contributed to MSAs during the period when the comparability rule was not satisfied.

Growth of MSA Accounts
Unused MSA balances carry over from year to year, and there is no prescribed period in which they must be withdrawn. Earnings on amounts in an MSA are not subject to taxation as they accrue.

Distributions
An individual can take distributions from an MSA at any time. The amount of the distribution can be any part or all of the account balance. Subject to some exceptions, distributions of both contributions and earnings are excludible from an account holder's gross income if used to pay medical expenses of the account holder and the account holder's family, as long as these expenses are not paid by other sources of insurance. For the most part, the eligible medical expenses are the same ones that would be deductible, ignoring the 7.5 percent of adjusted gross income limitation, if the account holder itemized his or her tax deductions. However, tax-free withdrawals are not permitted for the purchase of insurance other than long-term care insurance, COBRA continuation coverage, or health coverage while an individual receives unemployment compensation. In addition, in any year a contribution is made to an MSA, tax-free withdrawals can be made to pay the medical expenses of only those persons who were eligible for coverage under an MSA at the time the expenses were incurred. For example, MSA contributions cannot be withdrawn tax free to pay the unreimbursed medical expenses of an account holder's spouse who is covered under a health plan of his or her employer that is not a high-deductible plan.

Distributions for reasons other than paying eligible medical expenses are included in an account holder's gross income and are subject to a 15 percent penalty tax unless certain circumstances exist. The penalty tax is not levied if the distribution is made after the account holder turns 65 or because of the account holder's death or disability. In addition, the penalty tax does not apply to funds rolled over to a new MSA as long as the rollover is done within 60 days. Transfers of MSA accounts as a result of divorce are also tax free.

Estate Tax Treatment
Upon death, the remaining balance in an MSA is includable in the account holder's gross estate for estate tax purposes. If the beneficiary of the account is a surviving spouse, the MSA belongs to the spouse and he or she can deduct the account balance in determining the account holder's gross estate. The surviving spouse can then use the MSA for his or her medical expenses. If the beneficiary is anyone else, or if no beneficiary is named, the MSA ceases to exist.

MEDICAL SAVINGS ACCOUNTS : Overview & Eligibility

The concept of medical savings accounts (MSAs) is a method of reforming the nation's health care system. The use of MSAs has increased as a result of HIPAA. The act provides favorable tax treatment for MSAs established under a pilot project that began on January 1, 1997, as long as prescribed rules are satisfied. The project, which runs through the end of 2000, allows the establishment of up to approximately 750,000 MSAs. However, as of late 1999, fewer than 100,000 had been purchased. At the end of the four-year trial period, no more tax-favored MSAs can be established unless Congress expands the program, but existing MSAs can generally continue in force after that time under the current rules. During this four-year period, the act calls for two studies to assist Congress in making its decision regarding MSAs. First, the Treasury Department will assess MSA participation and its effect on tax revenue. Second, the General Accounting Office will assess the effect of MSAs on the small-group market by looking at such factors as the effect of MSAs on health care costs and the use of preventive care.

The following discussion is limited to MSAs that receive favorable tax treatment. It should be noted that many MSAs, which existed on a non—tax-favored basis prior to 1997, have been revised to meet the act's requirements and receive favorable tax status.

General Nature
An MSA is a personal savings account from which unreimbursed medical expenses, including deductibles and copayments, can be paid. Coverage can be limited to an individual or include dependents. The MSA must be in the form of a tax-exempt trust or custodial account established in conjunction with a high-deductible health (that is, medical expense) plan. An MSA is established with a qualified trustee or custodian in much the same way that an IRA is established. Any insurance company or bank (as well as certain other financial institutions) can be a trustee or custodian, as can any other person or entity already approved by the IRS as a trustee or custodian for IRAs. While there are some similarities between MSAs and IRAs, there are also differences. As a result, an IRA cannot be used as an MSA, and an IRA and MSA cannot be combined into a single account.

Even though employers can sponsor MSAs, these accounts are established for the benefit of individuals and are portable. If an employee changes employers or leaves the workforce, the MSA remains with the individual.

Eligibility for an MSA
Two types of individuals are eligible to establish MSAs:

1. An employee (or spouse) of a small employer that maintains an individual or family high-deductible health plan covering that individual. These persons will establish their MSAs under an employer-sponsored plan.

2. A self-employed person (or spouse) maintaining an individual or family high-deductible health plan covering that individual. These persons will need to seek out a custodian or trustee for their MSAs.

A small employer is defined as an employer who has an average of 50 or fewer employees (including employees of controlled-group members and predecessor employers) on business days during either of the two preceding calendar years. In the case of a new employer, the number of employees is based on an estimate of the reasonably expected employment for the current year. After the initial qualification as a small employer is satisfied, an employer can continue to make contributions to employees' MSAs, and employees can continue to establish MSAs until the first year following the year in which the employer has more than 200 employees. At that time, participating employees may take over contributions to their accounts, but no employer contributions can be made and nonparticipating employees may not start new accounts.

A high-deductible health plan, for purposes of MSA participation, is a plan that has the following deductibles and annual out-of-pocket limitations (These amounts are for 2000 and subject to inflation adjustments.):

In the case of individual coverage, the deductible must be at least $1,550 and cannot exceed $2,350. The maximum annual out-of-pocket expenses cannot exceed $3,100.

In the case of family coverage, the deductible must be at least $3,100 and cannot exceed $4,650. The maximum annual out-of-pocket expenses cannot exceed $5,700.

A high-deductible plan can be written by an insurance company or a managed care organization such as an HMO. Currently, the high-deductible plans are being written primarily by insurance companies in the form of traditional major medical products but possibly with the requirement that covered persons use preferred-provider networks. No HMOs have yet established high-deductible plans.

A high-deductible plan can be part of a cafeteria plan, but the MSA must be established outside the cafeteria plan.

With some exceptions, a person who is covered under a high-deductible health plan is denied eligibility for an MSA if he or she is covered under another health plan that does not meet the definition of a high-deductible plan but that provides any benefits that are covered under the high-deductible health plan. The exceptions include coverage for accident, disability, dental care, vision care, and long-term care as well as liability insurance, insurance for a specific disease or illness, and insurance paying a fixed amount per period of hospitalization.