Health Savings Accounts

In 1997, Congress waded timidly into tax-favored medical savings accounts (MSAs) that could be carried forward from year to year, if coupled with a high deductible health insurance policy. No other health coverage could be offered by the employer. But these Archer MSAs, named for their chief proponent in the Congress, House Ways and Means Committee Chair Bill Archer, were limited to small employers. Congress also originally limited the number of MSAs to no more than 600,000 accounts in the entire country and imposed numerous other limitations. In 2000, the restriction on the number of MSAs was dropped, but in fact the number of MSAs never approached even the legally permitted number of accounts.

Proponents of consumer-driven health care plans were able to move forward using the IRS-authorized HRAs, but these accounts had the considerable disadvantage of permitting only employer funding. Employees who needed more tax-favored money to pay out-of-pocket expenses could not supplement the employer account with pretax dollars. Consumer-driven health care proponents were finally able to convince Congress that an account funded by either employers or employees or both on essentially a tax-free basis could truly provide a boost to consumer-driven health care and increase participants' active involvement because the participant would see the account as "my money" not the employers. Congress adopted HSAs as part of the Medicare Modernization Act (MMA) and the IRS has moved quickly to provide additional guidance on their usage.

Because HSAs offer much more flexibility in funding and encourage participant savings, most employers are likely to want to use an HSA, rather than an HRA or a traditional health care flexible spending account offered under a cafeteria plan. Unlike HRAs and health FSAs, which by law can be coupled with any type of health plan or insurance or stand alone as the only employer health benefit, an HSA can be used only if it is coupled with a high deductible plan that meets specific criteria.

The high deductible plan's annual deductible must be at least $1,000 for individual coverage or $2,000 for family coverage. Out-of-pocket limits, excluding premiums, cannot exceed $5,000 for an individual policy or $10,000 for a family policy in 2004. (This amount will be adjusted for inflation annually.) These out-of-pocket limits could provide for higher deductibles than the $1,000 and $2,000 deductible limit, so long as the combined deductible and copay limits do not exceed the out-of-pocket limits.

Table 1 compares the features of the HSAs (first made available in 2004), the IRS-authorized HRAs, and the long-established health FSAs.

Table 1: Comparisons of Health Care Savings, Reimbursement, and Flexible Spending Accounts

	Health Savings Accounts (HSA) (Medicare Act of 2003)	Health Reimbursement Arrangements (HRA)	Cafeteria Plan Health Flexible Spending Arrangements (FSA)
Eligibility Requirements
Who Can Set Up the Account	Individuals or employers, if the account holder is covered by a "high deductible plan" and no other health insurance, except specifically listed coverages.	Only employers.	Only employers.
Funding
Who Can Contribute	Employers and employees.	Only employers.	Employers and employees.
Carry Over of Unused Balances from Year to Year	Yes. No annual or lifetime limits on the amount that can be carried over or accumulated.	Yes. In employer plans, employers may impose annual or lifetime carryover limits.	No.
Transfer of Account Balances	HSAs can accept rollovers from other HSAs and Archer MSAs.	There is no specific mechanism for HRA rollovers, although employers could agree by contract to do so.	No.
Permissible Reimbursements
General Coverage	HSAs can pay for "qualified medical expenses" incurred by the account holder, his or her spouse, and dependents.	Same as HSAs.	Same as HSAs.
Health Insurance Premiums	HSAs generally may not pay other health insurance premiums on a tax-favored basis, except certain premiums paid by. COBRA beneficiaries; individuals receiving federal or state unemployment benefits; and Medicare-eligible individuals (The exception for Medicare-eligible individuals does not apply to Medigap premiums.)	Yes.	No.
Payment for Long-Term Care Insurance Premiums	Yes.	Yes.	No.
Payment for Long-Term Care Services	Yes.	No.	No.
Over-the-Counter Drugs	HSAs may pay if the expense is a qualified medical expense.	Same.	Same.
Tax Treatment
Tax Status of Employer Contributions	No federal income or employment taxes on amount up to funding limits (see below).	Not subject to federal income or employment taxes.	Same as HRAs.
Tax Status of Contributions by Individual	Subject to funding limits, contributions are deductible even if the individual does not itemize deductions Employers can allow employees to make pretax, contributions using IRC §125 cafeteria plans. No deduction for individuals enrolled in Medicare Part A or B or dependents claimed on another's tax return.	Employees cannot contribute to HRAs.	Employee contributions to health FSAs generally are made on a pretax, salary-reduction basis and are not subject to employment taxes.
Tax-Favored Funding Limits	In 2004, the lesser of: The annual deductible under the individual's high deductible health plan, or $2,600 ($5,150 if family coverage), indexed for inflation each year, reduced by the individual's contributions (if any) to Archer MSAs for the year. The funding limit will be increased for individuals age 55 and older by $500 in 2004 and increased by $100 per year to a maximum of $1,000 in 2009.	No limits.(Employers may impose a limit.)	No limits. Employers may set plan-specific limits.(The fact that participants forfeit unused account balances each year imposes de facto limit and the FSA plan document may impose a limit.)
Earnings on Accounts	Earnings generally are not taxable, but may be subject to the IRC § 511 unrelated business income tax rules.	Employers generally maintain HRAs as notional accounts so there are no earnings.	Same as HRAs.
Distributions	No income tax on medical reimbursements or on timely distributions of excess contributions. All other distributions are subject to federal income tax plus a 10% penalty tax, but no penalty tax is applied to distributions after the account beneficiary becomes Medicare eligible, disabled, or dies.	Only to reimburse qualified medical expenses.	Only to reimburse qualified medical expenses.
Employer Compliance Issues
ERISA	Not ERISA plans, even if funded by employers, unless (1) ERISA generally applies to the employer, and (2) the employer limits the employees' ability to move their funds to other HSAs beyond restrictions imposed by IRC; restricts the use of HSA funds beyond restrictions permitted by tax law; makes or influences HSA fund investment decisions; represents the HSAs are ERISA plans; or receives any payment or compensation in connection with HSAs.	HRAs sponsored by employers subject to ERISA generally are ERISA plans.	Same as HRAs.
Nondiscrimination Rules	Comparable employer HSA contributions to all comparable employees participating in an HSA for each coverage period; HSA contributions made through a cafeteria plan are subject to the cafeteria nondiscrimination rules, not the general HSA comparability rules.	HRAs are subject to the general nondiscrimination requirements for self-insured medical expense reimbursement plans.	Health FSAs are subject to both the general nondiscrimination requirements for self-insured medical expense reimbursement plans, and to the cafeteria plan nondiscrimination rules.
COBRA Health Continuation	Not subject to COBRA.	COBRA continuation coverage rules apply.	Same as HRAs.
Trust Requirement	HSA assets must be held in a trust or custodial account.	No trust required.	Same as HRAs.
Vesting Requirement	HSA beneficiaries must be 100% vested in their account balances at all times.	No vesting requirements.	Same as HRAs.