Tax-Favored High Deductible Health Plan Requirements

A high deductible health plan, generally defined as one having a deductible of at least $1,000 for individual coverage and $2,000 for family coverage, provides part of the incentive for the employee to be a wise consumer of health care. The individual will have to pay at least this deductible amount either from the "health account" or out-of-pocket before the plan will begin to pay for health expenses. This high deductible policy is the basic tool for engaging the individual as an active "consumer," ideally making an informed decision as to whether treatment may be advisable and then shopping for the most efficient provider to deliver that treatment. "Efficient" cannot be a proxy for "cheapest." The decision must weigh both cost and quality of the outcome.

High deductible health plans could be self-insured by the employer or purchased through state regulated insurance companies. These health plans could offer first-dollar coverage for preventive care. Generally, a high deductible health plan participant cannot be covered by any other health insurance plan except for certain "permitted coverages." Permitted coverage includes coverage for dental, vision, specified diseases, and per diem hospital reimbursements, as well as payments for health care from disability or auto insurance.

Note that the high deductible plan does not have to be offered by or paid for by the employer. Individuals could purchase these plans independently. And under current tax law, the employer could reimburse the individual for the coverage on a tax-free basis and could contribute to the individual's HSA. Such individual purchases, reimbursed by the employer, may be especially attractive to small businesses and independent contractors. Much depends on how the consumer-driven health care plan market grows.

Individually Controlled Account for Health Costs

A key element of consumer-driven health care includes a "personal account" under the control of the individual. This account can be used for health care expenses, including copayments, deductibles, health care items, or services not covered by the plan. These accounts can be structured in several ways and go by various names. However, to take full advantage of favorable tax treatment, most of these accounts will fall under one of three legally recognized accounts:

• health flexible spending arrangement and/or account (health FSAs);
• health reimbursement arrangements (HRAs); and
• health savings accounts (HSAs).

Cafeteria Plan Health FSAs

Health FSAs have been popular since the mid-1970s and usually operate as part of a "cafeteria plan," as defined under the federal tax code, and so named because these plans allow an employer to offer employees a selection of various benefits. Health FSAs are funded on a pretax basis by the employer or the employee annually in advance of the coming plan year. Amounts contributed to FSAs also are not subject to FICA taxes, adding another level of savings for both the employer and the employee. The big drawback with FSAs is the "use-it-or-lose-it" rule. Health FSAs do not allow unused balances to carry over from year to year. This "use-it-or-lose-it" feature of FSAs has long been recognized—and criticized—as punishing the "thrifty" employee and encouraging unnecessary health care spending.

Health Reimbursement Arrangements

By early 2002, the Internal Revenue Service (IRS) and its parent agency, the U.S. Department of Treasury, were besieged with insurance companies seeking guidance on the tax treatment of a high deductible health insurance product that would be coupled with an annually funded health care account in which the unused balances would be carried over from year to year. These plans and accounts met with a sympathetic view, perhaps because the IRS realized the insurance market was going to offer them with or without IRS guidance. And as health care costs began to escalate again after a few years of relatively modest growth, the accounts seemed to make sense.

The IRS ruled that health reimbursement arrangements (HRAs) funded solely by the employer and permitting unused amounts to be carried over from year to year, would qualify as health benefits exempt from federal income tax. But the IRS specifically prohibited the use of employee contributions, including arrangements that in effect would be financed with employee money.