Health Law Update: Health Savings Account Provisions in the Medicare Prescription Drug Improvement and Modernization Act of 2003

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1 Health Law Update: Health Savings Account Provisions in the Medicare Prescription Drug Improvement and Modernization Act of 2003 This Update summarizes the provisions of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 related to health savings accounts (HSAs). It will be of interest to virtually all employers who offer group health plans to their employees. What are HSAs? The Act creates new health care savings vehicles called HSAs. HSAs are separate and distinct from health flexible spending accounts (Health FSAs) and health reimbursement accounts (HRAs) already permitted under the Internal Revenue Code of 1986, as amended (IRC). The provisions regarding HSAs will be codified as new section 223 of the IRC (current IRC section 223 is redesignated as section 224). An HSA is a tax-exempt trust that is established by an eligible individual, or by an employer for eligible individuals, for the purpose of paying the qualified medical expenses of the eligible individual(s) and his or her eligible dependents. Amounts contributed to HSAs by eligible individuals are generally deductible from income and amounts contributed to HSAs by employers are generally excluded from income. In addition, amounts distributed from HSAs to pay qualified medical expenses are generally excluded from income. Who is eligible to participate in an HSA? Generally, an individual may participate in an HSA if he or she is participating in a high deductible health plan (HDHP) and is not covered under any other health plan that provides the same benefits as the HDHP. However, the individual may maintain certain permitted insurance and/or other coverage in addition to the HDHP coverage (even though such insurance or coverage provides benefits also covered by the HDHP.) Examples of permitted insurance are (i) insurance for which substantially all of the coverage is provided by workers compensation insurance, tort liabilities insurance, or property insurance; (ii) insurance for a specified disease or condition (such as cancer insurance); and (iii) hospital indemnity insurance. Permitted coverage also includes coverage provided for accidents, disability, dental care, vision care or long-term care. Are there any exceptions to eligibility? Yes. The following individuals cannot participate in an HSA: Individuals who may be claimed as tax dependents of another individual;

2 Individuals covered under a spouse s or dependent s employer s health plan; Individuals covered under a comprehensive major medical insurance policy; and Individuals covered under a Health FSA or HRA unless coverage under such HRA or FSA is limited to permitted benefits or specific benefits not provided by the HDHP. In addition, individuals who are eligible for Medicare cannot continue to have contributions made for them and/or make contributions to an HSA on a tax-deductible basis. Medicare-eligible individuals may, however, use funds that were previously contributed to the HSA to pay for qualified medical expenses on a tax-free basis. Thus, individuals can use HSAs during their working lives as a tax-free means of building a nest egg to pay health expenses during retirement. What is an HDHP? An HDHP is a health plan that has an annual deductible of not less than $1,000 for individual coverage, and $2,000 for family coverage. The maximum out-ofpocket expenses under an HDHP cannot exceed $5,000 for individual coverage or $10,000 for family coverage. If the HDHP is a network plan, the plan s annual deductible and out-of-pocket limitations for out-of-network expenses are not considered in determining whether the plan qualifies as an HDHP. A plan will not fail to qualify as a HDHP simply because it does not have a deductible for preventative care. How are amounts contributed to the HSA? HSA contributions must be made in cash and may be made by an individual or his or her employer. HSA contributions must be deposited into a trust that meets the following requirements: (i) the trustee must be a bank, an insurance company, or other person who demonstrates to the satisfaction of the Secretary of the Treasury that the manner in which such person will administer the trust will be consistent with HSA requirements; (ii) no part of the trust may be invested in life insurance contracts; (iii) the assets of the trust may not be commingled with other property except in a common trust fund or common investment fund; and (iv) the interest of an individual in the balance in his or her HSA account must be nonforfeitable. What are the rules regarding contributions to the HSA? An HSA account beneficiary may take an above-the-line deduction for contributions made to an HSA during any month of the individual s taxable year in which such person is HSA-eligible. The permitted annual deduction cannot exceed the sum of the monthly limitations for such months. For 2004, the monthly limitation for any month is 1/12 th of the following amounts (subject to the reductions described below): 2

3 For those with individual coverage on the first day of the month, the lesser of the annual deductible under the HDHP or $2,600; or For those with family coverage on the first day of the month, the lesser of the annual deductible under the HDHP or $5,150. For married individuals, if either spouse has family HDHP coverage then both spouses are treated as having only that family coverage. If both the account beneficiary and the spouse have family coverage, the lowest annual deductible is used for purposes of determining the monthly limitation. Individuals age 55 or older are permitted to make contributions in addition to the contributions described above. Such additional contributions may be made as provided by the following table. Year Additional Contribution Amount 2004 $ $ $ $ $ and after $1,000 The monthly maximum limits described above are reduced by the sum of the following two amounts: The aggregate amount paid to Archer MSAs by an account beneficiary during the taxable year; and The aggregate amount contributed to the account beneficiary s HSA by an account beneficiary s employer(s) (to the extent that such contributions are excluded from income). What if contributions are made in excess of the monthly maximums? Contributions by account beneficiaries are not deductible and employer contributions are not excluded from income to the extent that such contributions exceed the limitations described above or they are made on behalf of an account beneficiary who is not an eligible individual. In addition, such excess contributions are subject to a 6% excise tax unless the excess contributions and any net income attributable to the 3

4 excess contributions are returned to the individual before the last day of the period for filing the individual s tax return. Such returned excess contributions are included in the account beneficiary s gross income. Are HSA contributions subject to any nondiscrimination requirements? Employer contributions to HSAs must meet a nondiscrimination requirement. The nondiscrimination requirement provides that comparable employer contributions must be made for all employees with the same coverage category (e.g., individual or family). The test may be run separately for part-time employees. If the non-discrimination test is not satisfied, an excise tax is imposed equal to 35% of the aggregate amount contributed by the employer to HSAs during that taxable period. Are HSA trusts taxable? Are there any limitations on the types of investments in which HSA s may invest? HSAs are generally non-taxable trusts, meaning that the income and earnings on HSA assets are generally not subject to taxation. The assets in an HSA trust may not be invested in life insurance contracts. Otherwise, there are no limitations on the investments that can be made by an HSA trust. HSA investments are subject, however, to UBIT requirements, as well as the prohibited transaction rules of section 4975 of the Code (in the same manner as that section applies to IRAs). The law does not limit who may have responsibility for investing HSA assets. Trust investments may be participant-directed or made by the trustee or an employer that sponsors the trust. What expenses may HSA contributions be used to pay? Contributions to HSAs may be used to pay for qualified medical expenses. A qualified medical expense is generally a medical care expense under section 213(d) of the IRC, incurred by the account beneficiary, the account beneficiary s legal spouse (in accordance with state law, but consistent with the federal Defense of Marriage Act; thus legal spouses will preclude domestic partners), or the account beneficiary s tax dependents, to the extent such amounts are not reimbursed by insurance or otherwise. Qualified medical expenses generally do not include payments for health insurance premiums. However, qualified medical expenses do include payments for the following premiums: COBRA premiums; Payments for a qualified long-term care insurance contract; Payment for any health plan maintained while the individual is receiving unemployment compensation; or For those age 65 or older, payment for any health insurance other than a Medicare supplemental policy. 4

5 What is the tax treatment of distributions from HSAs? So long as the distribution is used to pay qualified medical expenses, the distribution is excluded from income. If a distribution is made from the HSA other than for a qualified medical expense the distribution is included in the account beneficiary s gross income and is generally subject to an additional 10% tax. The 10% tax does not apply to any distributions from the HSA that are made in the following instances (regular income tax does still apply): What is the rollover option? Payments made following the account beneficiary s death. Payments made after the account beneficiary becomes eligible for Medicare. Payments made after the account beneficiary becomes disabled (as defined under section 72 of the IRC). The return of excess contributions in accordance with the statute s requirements. Rollover contributions (described in more detail below) to the extent the contribution is paid into an HSA within the statutory time frames. Although amounts distributed from an HSA that are not used exclusively for qualified medical expenses are generally includible in gross income and subject to an additional 10% tax, rollover contributions are exempt from this requirement. A rollover contribution is any amount distributed from an HSA to an account beneficiary that is deposited into an HSA for the benefit of that beneficiary within 60 days after the distribution is received. An account beneficiary may rollover his or her account balance only once every 12 months. Rollovers between HSAs are permitted on a tax-free basis and amounts from an Archer MSA may be rolled into an HSA without detrimental tax consequences. May HSAs be transferred from one individual to another? An account beneficiary s interest in an HSA may be transferred under a divorce or separation agreement, and to the individual s spouse upon death, without being subject to taxation or, in the case of death, inclusion in the account beneficiary s estate. However, if the interest is transferred to someone other than the beneficiary s spouse upon death, the HSA ceases to be an HSA and an amount equal to the fair market value of the account assets as of the date of the beneficiary s death is taxable income to the transferee. If there is no named beneficiary of a decedent s HSA, the fair market value of the account assets is includible in the decedent s gross income for the year of the death. 5

6 May HSAs be operated in conjunction with cafeteria plans? One of the fundamental requirements of the IRC section 125 cafeteria plan rules is that a cafeteria plan may not include a benefit that defers the receipt of compensation. This prohibition against benefits that defer compensation would seem to prohibit the inclusion of HSAs in cafeteria plans because contributions made to the HSA can be carried over from year to year; however, the Act amends section 125 of the IRC to allow HSAs to be offered under a cafeteria plan. Therefore, individuals may make contributions to the HSA with pre-tax salary deferrals even though such contributions may be carried over from year to year. The pre-tax salary contributions are treated as employer contributions and may not be deducted by an individual on his or her tax return. What are the reporting and disclosure requirements related to HSAs? The Act provides that the trustee of an HSA may be required to make reports to the Secretary of the Treasury and beneficiaries detailing contributions, distributions, the return of excess contributions, and any such other matters as the Secretary deems appropriate. The Secretary also may require that any person who provides an individual with a HDHP make reports to the Secretary and the beneficiary with respect to such HDHP as the Secretary deems appropriate. In addition, to the extent that an HSA program is established by and contributed to by an employer, the arrangement would be treated as an ERISA-regulated group health plan and would need to satisfy ERISA s reporting and disclosure rules. What are the employer s withholding obligations? Distributions from HSAs attributable to employer contributions are not considered wages for income and employment tax purposes to the extent it was reasonable to believe that such amounts would not be included in gross income. Therefore, generally there is no withholding requirement for distributions from HSAs attributable to employer contributions. Employer contributions to an HSA on behalf of an employee must, however, be reported on the employee s W-2. What is the effective date of the new provisions? The provisions regarding HSAs are effective January 1, For more information, please contact one of the following Hogan & Hartson attorneys, or any other attorney in the firm with whom you have an existing relationship. Evan Miller Washington, D.C. 202/ Emily C. Vitan Washington, D.C. 202/