Issue: April, 2005
Author: Joe Greenman
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Health Savings Accounts - An Attractive Option for Employers Facing Escalating Health Care Costs
The soaring cost of health care has emerged as a top national issue. As employers are faced with increasing contributions for health care insurance premiums, they are often confronted with difficult choices, as they are forced to pass costs along to their employees, reduce salaries, or reduce benefits. This no doubt has had an effect on the number of uninsured in America, which has reached 45 million this year. Many believe that distorted purchasing decisions and uncontrollable health care inflation will remain problems so long as someone other than the patient is paying the bill. The employee out-of-pocket share of health premiums has fallen from 49% in 1960 to 24% in 1980 to 14% in 2001. These statistics suggest that distorted purchasing decisions and uncontrollable inflation will remain problems unless the consumers of health care are put in a position to handle their own health care decisions.
To address these problems, many are advocating a consumer-driven approach to health care aimed toward inducing behavior change through cost transparency, financial involvement, compliance incentives and education. Recent major federal legislation has embraced this model of health care reform. These recently enacted statutes provide interesting new options for employers and their lawyers when deciding how best to structure health benefits.
On November 25, 2003, Congress passed the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. Title 12 of the Act amends the Internal Revenue Code (IRC) of 1986, to provide for health savings accounts (HAS) by redesigning Code section 223 and 224 and inserting a new Code section 223 enabling HSAs. An individual is allowed to fully deduct contributions to a HSA (if eligible) in an amount up to the aggregate amount paid in cash to the HSA during the taxable year subject to certain limitations. A health savings account is a tax-exempt trust established exclusively for paying qualifying medical expenses of the account beneficiary.
Qualifying individuals may initiate a HSA, without the action of his/her employer, and save substantial amounts of money to pay deductibles, co-pays, etc., under “high deductible” health plans (HDHPs). A ‘qualifying individual’ means, any individual who: (1) is covered under a HDHP on the first day of such month; (2) is not also covered by any other health plan that is not a HDHP; (3) is not entitled to benefits under Medicare; (4) may not be claimed as a dependent on another person’s tax return.
Eligibility – Determination of a Qualified High Deductible Health Plan
HSAs may be established by an individual or an employer. In order to be eligible to contribute to a HSA, the individual must be covered under a HDHP. While the individual is covered under the HDHP, the individual must not be covered under any health plan which is not a HDHP and which provides for coverage for any benefit which is covered under the HDHP. The individual also may not be covered by Medicare and may not be claimed as a dependent on another’s tax return. Permissible insurances are workers’ compensation, tort liability, liability for ownership or use of a property, and any other similar type of coverage as determined by regulation. Other permitted insurance coverage includes dental care, disability, vision care, insurance for a specified disease or illness, insurance that pays a fixed amount per day (or other period of hospitalization), and long-term care.
A HDHP is a plan that has an annual deductible for an individual of at least $1,000 and $2,000 for family coverage, and requires the sum of the annual deductible and the other out-of-pocket expenses--including deductibles, co-payments, and coinsurance--be paid under the plan for covered benefits, not exceeding $5,000 for self only coverage and $10,000 for family coverage. The minimum deductible for a HDHP is adjusted for inflation using calendar year 2003 as the base year, with adjustments rounded to the nearest $50 increment.
The plan cannot pay for any benefits until the deductible is reached, with the exception of a safe harbor for preventive care. Preventive care that may be provided by a HDHP is preventive care defined in section 1871 of the Social Security Act (SSA), except as otherwise defined by the Secretary of the Treasury. Section 1871 of the SSA, as added by this act, defines preventive care to include the physician’s services of a physical exam (including height and weight measurement, blood pressure and an electrocardiogram) with the goal of health promotion and disease prevention. Preventive care also includes education, counseling, and referral with respect to screening and other preventive services, but does not include clinical laboratory tests.
The IRS has recently ruled that coverage of a treatment that is incidental or ancillary to a preventive care service, such as removing polyps during a diagnostic colonoscopy, is also allowed. Furthermore, preventive care includes medication taken to prevent a disease or reoccurrence of a disease--for example, taking cholesterol-lowering medications to prevent heart disease.
Contributing to a HSA
A HSA must be established pursuant to a trust created or organized in the U.S. exclusively for the purposes of paying qualified medical expenses for the beneficiary of the account. This is done in much the same way that individuals establish individual retirement accounts (IRAs) with qualified trustees or custodians.
Like an IRA, an HSA is generally exempt from tax. No permission or authorization from the IRS is necessary to establish an HSA. Any large financial institution (such as banks, insurance companies, mutual funds, or brokerages) can be an HSA trustee or custodian. The National Credit Union Administration (NCUA) has recently issued a final rule permitting federal credit unions (FCUs) and their members to take advantage of the authority granted in the Medicare Act, authorizing the establishment and maintenance of HSAs at FCUs. Existing health plans plan to team up with financial institutions to offer HDHPs along with the HSAs.
Family members may make contributions to an HSA on behalf of another family member as long as the other family member is an eligible individual. Contributions are deductible whether or not the eligible individual itemizes deductions up to the statutory minimums; this is called an “above-the-line” deduction. Contributions to an HSA must be made in cash.
Employer contributions to HSAs are excludable from the employee’s income. The employer’s HSA contributions must be shown on the informational forms such as W-2s that are sent to individuals at the end of the year showing the aggregate amount that was contributed. Any earnings such as interest or dividends and capital gains grow free from current taxation and are still tax-free when taken out to pay for qualified medical expenses.
Comparable employer contributions must be available on behalf of all “comparable participating employees” (i.e., eligible employees with comparable coverage) during the same period. Contributions are considered comparable if they are either the same amount or same percentage of the deductible under the HDHP.
For calendar year 2004, the maximum monthly contribution for eligible individuals with self-only coverage under a high deductible health plan is 1/12 of the lesser of 100% of the annual deductible under the high deductible health plan (minimum of $1,000) but not more than $2,600. For eligible individuals with family coverage under a HDHP, the maximum monthly contribution is 1/12 of the lesser of 100% of the annual deductible under the HDHP (minimum of $2,000) but not more than $5,150 for the plan year. In addition to the maximum contribution amount, catch-up contributions may be made by or on behalf of individuals age 55 or older and younger than 65. The additional contribution amount is $500 beginning in 2004, increasing in annual $100 increments, reaching $1,000 in 2009 and thereafter.
Distributions from a HSA used exclusively to pay for qualified medical expenses of the account beneficiary, his or her spouse, or dependents are excludable from gross income. Amounts in a HSA can be used for qualified medical expenses and will be excludable from gross income even if the individual is not currently eligible for contributions to the HSA. Any amount not used exclusively to pay for qualified medical expenses of the account beneficiary, spouse or dependents, is includible in gross income of the account beneficiary and is subject to an additional 10% tax on the amount includible, except in the case of distribution made after the account beneficiary’s death, disability or attainment of age 65.
According to the IRS, ‘qualified medical expenses’ are expenses paid by the account beneficiary, his or her spouse or dependents, for medical care as defined in IRC Section 213(d), but only to the extent the expenses are not covered by insurance. The qualified medical expenses must be incurred only after the HSA has been established.
Generally, health insurance premiums are not qualified medical expenses except for the following: qualified long-term care insurance, COBRA health care continuation coverage, and health care coverage while an individual is receiving unemployment compensation. HSAs are not subject to COBRA continuation coverage. The exclusion of HSA contributions from the requirements of COBRA is justified along policy grounds because the employee can make his or her own contributions to the HSA and pay only 100% of the contributions rather than 102% as would be required under COBRA. The HDHPs that go with HSAs seem to be fully subject to COBRA, however.
For individuals over age 65, premiums for Medicare Part A or B, Medicare+Choice plan premiums, and the employee share of premiums for employer-sponsored health insurance (including premiums for employer-sponsored retiree health insurance) can be paid from an HSA. Premiums for Medigap policies are not qualified medical expenses.
The trustee, custodian, or employer is not required to determine if the distribution is used for qualified medical expenses. Individuals who establish HSAs make that determination and should maintain records of their medical expenses sufficient to show that the distributions have been made exclusively for qualified medical expenses and are therefore excludable from gross income.
HSA Features – Flexibility and Portability
Rollover contributions within HSAs are permitted. Rollover contributions need not be in cash. Rollovers are not subject to the annual contribution limits. Rollovers from an IRA, from a health reimbursement arrangement (HRA), or from a health flexible spending arrangement (FSA) to an HSA are not permitted.
A HSA is portable because the account is established for the benefit of one individual and is owned by that individual and stays with the individual through employment changes. Qualifying individuals can continue to fund his or her own HSA and use it pursuant to the law.
If the account beneficiary’s status changes, rendering the individual ineligible (e.g., the individual is over age 65 and entitled to Medicare benefits, or no longer has a HDHP), distribution used exclusively to pay for qualified medical expenses continue to be excludable from the account beneficiary’s gross income. Upon death, any balance remaining in the account beneficiary’s HSA becomes the property of the individual named in the HSA instrument as the beneficiary of the account. If the account beneficiary’s surviving spouse is the named beneficiary of the HSA, the HSA becomes the HSA of the surviving spouse. The surviving spouse is subject to taxation only to the extent distributions from the HSA are not used for qualified medical expenses.
If, by reason of the death of the account beneficiary, the HSA passes to a person other than the account beneficiary’s surviving spouse, the HSA ceases to be an HSA as of the date of the account beneficiary’s death, and the person is required to include in gross income the fair market value of the HSA assets as of the date of death. For such a person (except the decedent’s estate), the includable amount is reduced by any payments from the HSA made for the decedent’s qualified medical expenses, if paid within one year after death.
HSAs are devised to offer easy, efficient and transparent claim management. The processing of payments can be provided by several entities – the insurance carrier, a third-party administrator, Blue Cross/Blue Shield or specialty flexible spending account vendors. The duties provided by an HSA administrator and the insuring of the HSA-compatible HDHP are distinct, though some insurance companies, such as Fortis, Humana, and Golden Rule, provide both services. Debit or credit cards or stored value cards may be used by an individual under a HSA to obtain distributions.
How Consumer-Driven Health Care Could Transform Health Care Delivery
Supporters and opponents of using HSAs and other tax advantaged accounts to transform the health care delivery system agree on the factors causing the problem of endemic health care inflation. Underlying these factors is the employer-sponsored health care system, ironically created through the tax code in the 1940s.
Since its inception, third-party insurance has remained lavishly subsidized under the tax law. Prior to the creation of HSAs, the government taxed away almost half of every dollar employers put into savings accounts for employees to pay their own medical expenses directly.
The incentives of the tax code encouraged people to use third-party bureaucracies to pay every medical bill, although it often made more sense for patients to manage discretionary expenses themselves. Paying a third party to provide every single benefit, no matter how trivial, insulates the consumer from the realities of the market place that are encountered in virtually every other common economic activity. Americans use more health care because they think it’s free, or almost free.
In recent years, Americans have enjoyed the glories of falling consumer prices. It’s commonly called the Wal-Mart effect: Huge retailers use their buying power to force suppliers to cut costs, and then the retailers pass some of those savings on to their customers. Forced to stay competitive, other retailers follow suit. The result: prices of newly released high tech retail products fall exponentially in just a few years. When a consumer buys the high tech item, she uses a credit card or cash and she pays with her own money. That causes rational consumers to want to comparison shop for the best deal. When it comes to buying health care, consumers have little incentive to shop around. If they are insured, the premium has already been paid, or the copay or deductible is established ahead of time.
Due to the inflation caused by this model, employers began looking increasingly to managed care to deliver savings during the 1990s. The traditional managed care plan was based on a supply-control model: control costs by limiting the supply of care. This model has spawned a jumble of bureaucratic rules and medical protocols (primary care gatekeepers; prescription drug formularies; outpatient utilization reviews; arbitrary medical necessity mandates, etc.) to the chagrin of providers and the confusion of patients.
Starting in 1998 health costs began growing at an alarming rate, even though managed care has remained a popular choice in the health insurance marketplace. Essentially, managed care is grappling with one fundamental, structural problem: how to face unlimited demand in the absence of individual financial responsibility.
HSAs may lead to new consumer behaviors emphasizing long-term health as well as provider reimbursement strategies emphasizing and rewarding outcomes as opposed to production of services. As the providers of administrative and risk services, health plans will be looked to as the primary product innovators. They will need to adopt changes to improve administrative efficiencies through the use of technology. Health plans will need to achieve a better understanding of how providers are evaluated and included in their networks. This should lead to increased contracting with cost-efficient providers.
Under the current system there is a powerful incentive for individuals to purchase as much health insurance as possible and then consume health care without concern for incremental costs. The amount of health care that an individual purchases is inversely related to the cost of that health care. Additionally, there are no counter incentives that can cause health consumers to address their overall health status, lifestyle and health concerns. A new balance in America’s health tax policy must be fashioned. The federal government currently provides more than $100 billion annually in tax subsidies for job-based health insurance, compared with approximately $25 billion over 10 years for HSAs.
HSAs hold the potential to create incentives that will produce greater involvement of the health care consumer in the health care system, with an improvement in the overall quality of the product. With the health care consumer in control of health care decisions, the health care market will better reflect market demand, and prices will react accordingly. Services not normally allowed by third-party insurance companies, but important to health outcomes, would be available to consumers, such as physical fitness and nutrition programs, alternative treatments, mental health, and substance abuse treatment. Health care consumers will hold completely portable health plans, with no physician gatekeepers, post payment reviews (except for IRS oversight of adherence to tax rules), prescription drug formularies, or interference from corporate and government bureaucrats.
Joe Greenman earned a B.S. in Political Science from Lewis & Clark College in Portland, Oregon. He is currently a third-year law student at the University of Wyoming College of Law. Prior to attending law school, he was Professional Majority Staff for the U.S. House Committee on Energy and Commerce. In that capacity, he planned Congressional oversight of the Medicare program. Joe plans to practice law in Oregon.
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