Managing Health Care Costs with Health Reimbursement Arrangements and Health Savings Accounts

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1 Reprinted with permission from the Society of FSP. Reproduction prohibited without publisher's written permission. Managing Health Care Costs with Health Reimbursement Arrangements and Health Savings Accounts by John C. Garner, CEBS, CLU, CFCI, CMC Abstract: Generous insurance benefits with low deductibles and out-of-pocket limits have created a situation in which the health care consumer often has little skin in the game and therefore ignores the cost of care, which drives up health care costs. Account-based plans, such as Health Reimbursement Arrangements (HRAs) and Health Savings Accounts (HSAs), are parts of what is often referred to as consumer-driven health plans (CDHPs). One of the goals of CDHPs is to make patients more aware of the actual costs of medical services and therefore become good consumers. HRAs and HSAs can be effective tools to help convert plan participants into good consumers of health care. The rules associated with HRAs and HSAs are complex and care needs to be taken in implementing these account-based plans. This issue of the Journal went to press in June Copyright 2013, Society of Financial Service Professionals. All rights reserved. Introduction here are many reasons why health care costs are rising so rapidly and because there are many T different reasons, no one action can possibly address all of them. Therefore, it will take a number of different actions to bring health care cost increases into line with overall inflation. One of the reasons for rising health care costs is overinsurance. Low copayments have led many people to have the mistaken idea that it costs less to see a doctor than to have a haircut. Account-based plans, such as Health Reimbursement Arrangements (HRAs) and Health Savings Accounts (HSAs), are parts of what is often referred to as consumer-driven health plans (CDHPs). One of the goals of CDHPs is to make patients more aware of the actual cost of medical services and therefore become good consumers. Consumer-Driven Health Plans CDHPs also referred to as consumer-directed health plans typically link a high-deductible health plan (HDHP) with a tax-favored account, such as an HSA or HRA. The CDHP provides financial protection against catastrophic health care costs, while promoting prudent use of health care services and encouraging a healthier lifestyle. In making a move to a CDHP, an employer typically increases the deductible significantly and then fills in a portion of it by funding an HRA or HSA. The concept is to give employees some money they consider to be their own, which should give them an incentive to be a better consumer. A participant will have his or her own 45

2 money available to cover medical expenses, then (particularly in the first year of participation) there will be a corridor between the amount the employer has placed into an account and the amount of the deductible in the HDHP. Preventive care is covered at 100 percent and is not subject to the deductible. These plans are increasing in popularity, both with employers and employees. The 2012 United Benefit Advisors Health Plan Survey found that over 22.5 percent of all employers offer CDHPs. The percentage of employees enrolled in these plans more than doubled, from 6 percent in 2007 to 15.6 percent in It is not likely that health care reform will slow down growth in CDHPs. Now that the rules on the minimum value test have been published, it is clear that most HDHPs will qualify as providing minimum value. Historically, most people have been better consumers of almost any other product or service than of health care. People who would research various consumer studies before purchasing a car or even a toaster, often would have whatever surgical procedure their doctor recommended or go to whichever hospital the doctor suggested. Part of the reason for this blind faith was that virtually no data were available on the quality of care at different hospitals or the effectiveness of different procedures, let alone the prices that would be charged. All that is changing now, with more price, quality, and patient satisfaction information available on the Internet. There is not nearly enough information available yet, but there is much more information available now than ever before. Some communities are much more advanced than others in making data available and some insurers are further along than others, but the trend is encouraging. Several years ago the idea of encouraging people to become better consumers of health care sounded good, but there were virtually no tools available to them. Now there are a growing number of tools available and health care reform s creation of the Patient-Centered Outcomes Research Institute should provide even more information in the future about the comparative effectiveness of different procedures. When consumers have access to educational, planning, and assessment tools, they do make different decisions about their health care spending once they have the impression that they are spending their own money. This seems to be the case even with HRAs, which do not belong to the consumers themselves, but rather to employers. A study by Health Care Service Corporation found that people who migrated from a non-cdhp to a CDHP spent 24 percent less on inpatient hospital services, reduced health care utilization by more than 12 percent, had a 12 percent decrease in emergency room visits, reduced combined medical and pharmacy spending by 11 percent, were 10 percent more likely to use generics, spent 8 percent less on outpatient services, and were 4 percent more likely to take advantage of preventive services. According to a 2011 survey by the consulting firm ACS, 31 percent of account holders are planning health care better throughout the year, 28 percent are shopping for lower priced prescription drugs, 18 percent are engaging in healthier lifestyle choices, and 18 percent are researching preventive care programs. A study by RAND published in 2011 found that patients with HSAs or HRAs reduced their costs even after they initiated care. Overall, the study found about twothirds of the reduction in total health care costs was from patients initiating care less often and the remainder was from a reduction in costs after care was initiated; in other words, plan participants were being better consumers. A study by CIGNA released in 2012 found that more than 1 million employees enrolled in CIGNA s CDHP reduced their health risks and lowered medical costs by an average of $9,700 per employee over 5 years. Aetna has reported results of a study comparing 498,000 members in Aetna s HealthFund plans, which feature a high-deductible policy combined with an HRA or HSA, with 1.8 million members in its standard PPO. HealthFund members spent more on preventive care while using the hospital emergency department less for nonurgent situations. HealthFund members in both types of plans were twice as likely as PPO members to go online to access information about costs, benefits, and health data. Among Aetna s HealthFund plans, HSA plans performed significantly better than HRA plans, yielding 9 percent lower overall medical costs. Logically, HSAs would seem to have the most impact on a participant s behavior because of the rules related to HSAs. Once an employer puts money into an HSA, it is 46

3 the employee s money. HRAs can be funded but usually are only notional accounts, meaning that there is a bookkeeping entry that indicates how much an employee has in his or her account but the employer retains control of the money until the employee files a claim. Also, employers set the rules regarding what happens to money in HRAs upon termination of employment. Typically, employees forfeit all the money in an HRA upon termination, although employers have great latitude in determining what to do with the money and can make it available for a period of time after termination. All account-based plans can reimburse anything that the IRS says is a tax-deductible medical expense under Internal Revenue Code Section 213(d), except for special rules that apply to insurance premiums. Medical care under Section 213(d) is a rather broad category that includes any cost-sharing under a health plan (deductibles, coinsurance, copayments, amounts in excess of reasonable and customary) and many expenses not covered by health plans, such as hearing aids, eyeglasses, etc. Medical care also includes many items not normally covered by health plans, such as Braille books and magazines, capital expenses that may be needed to accommodate a person who finds himself or herself in a wheelchair, such as ramps or wider doorways, or even modifications to a car to turn the brake and accelerator into hand controls. Expenses related to guide dogs, lead-based paint removal, legal fees, and special education can also be covered under certain circumstances. There are a number of medical services that are not tax deductible and therefore cannot be reimbursed by any of these types of accounts. Examples include cosmetic surgery, diaper service, health club dues, household help, and illegal treatments. Over-the-counter drugs (except insulin) can only be reimbursed if prescribed by a physician. Interestingly, the rules do not require the prescription to be written before the drugs are purchased, so participants can get prescriptions after their claims are denied. Health Reimbursement Arrangements 1 An HRA is an arrangement that: 1. Is paid for solely by the employer and not provided pursuant to salary-reduction election or otherwise under a Section 125 cafeteria plan; 2. Reimburses the employee for medical care expenses [as defined by Code Section 213(d)] incurred by the employee or the employee s spouse and dependents (as defined in Code Section 152); and 3. Provides reimbursements up to a maximum dollar amount for a coverage period and any unused portion of the maximum dollar amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods. Coverage and reimbursements of accident and medical care expenses of an employee and the employee s spouse and dependents are generally excludable from the employee s gross income under Code Sections 105 and 106. To qualify for the exclusions under Code Sections 105 and 106, an HRA may only provide benefits that reimburse expenses for medical care as defined in Code Section 213(d). Each medical care expense submitted for reimbursement must be substantiated. An HRA may not reimburse a medical care expense that is attributable to a deduction allowed for any prior taxable year. Additionally, an HRA may neither reimburse a medical care expense that is incurred before the date the HRA is in existence nor reimburse a medical care expense that is incurred before the date an employee first becomes enrolled under the HRA. Reimbursements for insurance covering medical care expenses as defined in Code Section 213(d)(1)(D) are allowable reimbursements under an HRA, including amounts paid for premiums for accident or health coverage for current employees, retirees, and COBRA-qualified beneficiaries. An HRA may not reimburse expenses for qualified long-term care services. An HRA does not qualify for the exclusion under Code Section 105(b) if any person has the right to receive cash or any other taxable or nontaxable benefit under the arrangement other than the reimbursement of medical care expenses. If any person has such a right under an arrangement currently or for any future year, all distributions to all persons made from the arrangement in the current tax year are included in gross income, even amounts paid to reimburse medical care expenses. For example, if an arrangement pays a death benefit without regard to medical care expenses, no amounts paid under the arrangement to any person are reim- 47

4 bursements for medical care expenses excluded under Code Section 105(b). Employers must not operate an HRA in a manner intended to subvert the rules. Arrangements outside the HRA that provide for the adjustment of an employee s compensation or an employee s receipt of any other benefit will be considered in determining whether the arrangement is an HRA and whether the benefits are eligible for the exclusions under Code Sections 105(b) and 106. If, for example, in the year an employee retires, the employee receives a bonus and the amount of the bonus is related to that employee s maximum reimbursement amount remaining in an HRA at the time of retirement, no amounts paid under the arrangement are reimbursements for medical care expenses for purposes of Code Section 105(b). Similarly, if an employer provides severance pay only to employees who have reimbursement amounts remaining in a purported HRA at the time of termination of employment, no amounts under the arrangement are reimbursements for medical care expenses for purposes of Code Section 105(b). Medical care expense reimbursements under an HRA are excludable under Code Section 105(b) to the extent the reimbursements are provided to the following individuals: current and former employees (including retired employees), their spouses and dependents, and the spouses and dependents of deceased employees. The term employee does not include a self-employed individual. An HRA may continue to reimburse former employees or retired employees for medical care expenses after termination of employment or retirement (even if the employee does not elect COBRA continuation coverage). For example, an HRA may have a provision that reimburses a former employee for medical care expenses only up to an amount equal to the unused reimbursement amount remaining at retirement or other termination of employment. The plan may also provide that the maximum reimbursement amount available after retirement or other termination of employment is reduced for any administrative costs of continuing such coverage. Additionally, an HRA may or may not provide for an increase in the amount available for reimbursement of medical care expenses after the employee retires or otherwise terminates employment (even if the employee does not elect COBRA continuation coverage). Employer contributions to an HRA may not be attributable to salary reduction or otherwise provided under a cafeteria plan. Accident or health coverage funded pursuant to salary reduction is not an HRA and is subject to the rules under Code Section 125. However, an HRA is not considered to be paid for pursuant to salary reduction merely because it is provided in conjunction with a cafeteria plan. Additionally, if an employer offers employees a choice between employer-provided nontaxable benefits (for example, coverage under an HRA and coverage under an HMO), with no cash or other taxable benefits available to employees, the choice is not an election to which Code Section 125 applies. If an employer provides an HRA only in conjunction with other accident or health plan and that other plan is provided pursuant to a salary-reduction election under a cafeteria plan, then all the facts and circumstances are considered in determining whether the salary reduction is attributable to the HRA. Assuming that the terms of the salary-reduction election indicate that the salary reduction is used only to pay for the specified accident or health plan offered in conjunction with the HRA and not to pay for the HRA itself, the mere fact that an employee may participate in the HRA only if the employee participates in specified accident or health plan funded pursuant to a salary-reduction election does not necessarily result in the salary reduction being attributed to the HRA. Following are two examples. One example illustrates an HRA, and the other describes an arrangement that is not an HRA. Example 1: Assume that an employer offers an HRA and an employee who participates in the HRA must also participate in the corresponding employee-only or family coverage offered in an HDHP. If the COBRA-applicable premium for the high-deductible accident and health coverage would be $1,800 for the employeeonly coverage and $4,500 for family coverage if such coverage were offered separately from the HRA, then the annual maximum allowable salary-reduction election in this case is $1,800 for employee-only coverage and $4,500 for family coverage in order for the salary reduction to be treated as not attributable to the HRA. 48

5 Example 2: Assume an employer offers a reimbursement arrangement plus other health plan coverage with the actual cost for family coverage for the specified accident or health plan of $4,500 and salary-reduction election of $2,500 or $3,500 to fund this coverage. An employee who elects family coverage and $2,500 salary reduction receives a $1,000 maximum reimbursement amount under the reimbursement arrangement for the coverage period, and an employee who elects family coverage and $3,500 salary reduction receives a $2,000 maximum reimbursement amount under the reimbursement arrangement for the coverage period. In this case, although the maximum allowable salary reduction is not exceeded, a portion of the salary reduction is attributed to the HRA because the increase in salary-reduction election is related to a larger maximum reimbursement arrangement for the coverage period. This arrangement is not an HRA and is subject to Code Section Because an HRA is paid for solely by the employer and not pursuant to salary reduction, the following restrictions on health Flexible Spending Accounts (FSAs) 3 under Code Section 125 are not applicable to HRAs: 1. The prohibition against a benefit that defers compensation by permitting employees to carry over unused elective contributions or plan benefits from one plan year to another plan year; 2. The requirement that the maximum amount of reimbursement must be available at all times during the coverage period; 3. The mandatory 12-month period of coverage; and 4. Except as otherwise provided, the limitation that medical expenses reimbursed must be incurred during the period of coverage. As a result, the maximum reimbursement amount for a coverage period (not including amounts carried forward from previous coverage periods) need not be available at all times during the coverage period. Also, an HRA may specify a coverage period for a reimbursement amount that is less than a year. Although claims incurred during one coverage period may be reimbursed in a later coverage period, an unreimbursed claim may be reimbursed in a later coverage period only if the individual was covered under the HRA when the claim was incurred. Additionally, the maximum reimbursement amount credited under the HRA in the future (not including amounts carried forward from previous coverage periods) may be increased or decreased. Thus, if an increase in maximum reimbursement amounts in an HRA favors one or more highly compensated individuals, the HRA may violate these nondiscrimination rules. If coverage is provided under both an HRA and a health FSA for the same medical care expenses, amounts available under an HRA must be exhausted before reimbursements may be made from the FSA, except as noted below. However, a health FSA will not violate this rule if coverage is provided under both an HRA and a health FSA and the FSA reimburses a medical care expense that is not reimbursable by the HRA. In no case may an employee be reimbursed for the same medical care expense by both an HRA and a health FSA. Consistent with these rules, before a health FSA plan year begins, the plan document for the HRA may specify that coverage under the HRA is available only after expenses exceeding the dollar amount of the FSA have been paid. For example, if an employer sponsors a health FSA and an HRA, both of which provide coverage for the same medical care expenses, and the HRA plan document includes a provision that the HRA is not available for reimbursements of medical care expenses that are covered by the health FSA until after expenses exceeding the dollar amount of the FSA have been paid, then those medical care expenses may be reimbursed first from the health FSA and then from the HRA when the amount available under the FSA is exhausted. An employer establishes an HRA by adopting a formal plan and distributing a summary plan description (SPD) to all eligible employees. The SPD describes, among other things, the amount of money available in each employee s HRA for the coverage period. As eligible expenses are submitted, the employee s personal account is reduced and paid to him or her on a nontaxable basis. At the end of the HRA coverage period, a new period begins with additional employer funding available. In addition, if the employee has available the funds left over from the prior period, the money is not forfeited. Code Section 105(h) sets forth nondiscrimination 49

6 rules for self-insured medical expense reimbursement plans. To the extent that an HRA is a self-insured medical expense reimbursement plan, the nondiscrimination rules under Code Section 105(h) apply to the HRA. An HRA is a group health plan generally subject to the COBRA continuation coverage requirements. If an individual elects COBRA continuation coverage, an HRA complies with these COBRA requirements by providing for the continuation of the maximum reimbursement amount for an individual at the time of the COBRA qualifying event and by increasing that maximum amount at the same time and by the same increment that it is increased for similarly situated non-cobra beneficiaries (and by decreasing it for claims reimbursed). An HRA complies with the COBRA requirements for calculating the applicable premium if the applicable premium is the same for qualified beneficiaries with different total reimbursement amounts available from the HRA. For example, if the annual additional reimbursement amount credited under an HRA is $1,000 and the maximum reimbursement amount remaining for two similarly situated qualified beneficiaries at the time of their qualifying events is $500 and $5,000, the applicable premium is the same for each individual. The plan rules of an HRA may provide for continued reimbursements after a COBRA qualifying event regardless of whether a qualified beneficiary elects continuation coverage. For example, an HRA might allow reimbursements up to the unused maximum reimbursement amount following termination of employment. In such a situation, an HRA subject to COBRA must still comply with the COBRA continuation coverage requirements. If a qualified beneficiary elects COBRA continuation coverage in addition to the continued reimbursement amount already available, an HRA complies with the COBRA requirements by increasing the maximum reimbursement amount at the same time and by the same increment that it is increased for similarly situated non-cobra beneficiaries (and by decreasing it for claims reimbursed). Accident or health plans that meet the definition of an HRA are subject to a variety of statutory rules and provisions, including: The deduction limitations under Code Sections 419 and 419A (for employer contributions to welfare benefit funds) The application of the nondiscrimination requirements under the Health Insurance Portability and Accountability Act (HIPAA), including the extent to which underwritten individual health insurance policies purchased and reimbursed by an HRA are treated as health insurance coverage offered under a group health plan Other requirements under HIPAA, including the requirement that a group health plan provide certificates of creditable coverage (unless the HRA qualifies as exempt) The requirements for welfare benefit plans under ERISA The nondiscrimination requirements of Code Section 105(h) Health care reform generally prohibits group health plans from imposing annual limits on essential health benefits. Regulations allow the U. S. Department of Health and Human Services to waive the restrictions on annual limits. The U.S. Center for Consumer Information and Insurance Oversight has issued guidance that exempts HRAs that were in effect prior to September 23, 2010 from the need to apply for a waiver. The exemption applies until Some administrators also obtained waivers for new HRAs. Because the exemption for the restrictions on annual limits only applies to HRAs that were in effect prior to September 23, 2010, any new HRAs would have to comply with the rules on annual limits, which makes new stand-alone HRAs impractical unless future guidance allows them. Some administrators obtained waivers from the annual limit rules for new HRAs so they could administer new HRAs. HRAs that are integrated with a health plan that complies with the rules on annual and lifetime limits do not have to comply separately. Also, limited-scope HRAs that only cover dental and vision qualify as excepted benefits 4 and can have annual limits. Retiree HRAs are also exempt from the health care reform rules if they are structured as separate plans that do not cover any active employees. Health care reform includes many new rules and requirements, most of which will not apply to HRAs. The new comparative effectiveness research fee is a major excep- 50

7 tion to this general rule in that a separate fee will apply to self-funded HRAs (most HRAs are self-funded) that are offered in conjunction with fully insured medical plans. Health Savings Accounts 5 An HSA is a tax-exempt trust or custodial account established exclusively for the purpose of paying qualified medical expenses of the account beneficiary who, for the months for which contributions are made to an HSA, is covered under an HDHP. An individual must be an eligible individual to establish an HSA. An eligible individual (with respect to any month) means: An individual who is covered under an HDHP on the first day of such month; An individual who is not also covered by any other health plan that is not an HDHP (with certain exceptions for plans providing certain limited types of coverage); An individual who is not entitled to benefits under Medicare (generally, has not yet reached age 65); or An individual who may not be claimed as a dependent on another person s tax return. For example, a child who is claimed as a dependent by his or her parent(s) is not eligible to have his or her own HSA. Generally, an HDHP for HSA purposes is a health plan that satisfies certain requirements with respect to deductibles and out-of-pocket expenses. Specifically, for self-only coverage, an HDHP has an annual deductible of at least $1,250 for 2013 and 2014, and annual out-ofpocket expenses required to be paid (deductibles, copayments, and other amounts, but not premiums) not exceeding $6,250 in 2013 and $6,350 in For family coverage, an HDHP has an annual deductible of at least $2,500 in 2013 and 2014, and annual out-ofpocket expenses required to be paid not exceeding $12,500 in 2013 and $12,700 in In the case of family coverage, a plan is an HDHP only if, under the terms of the plan and without regard to which family member or members incur expenses, no amounts are payable from the HDHP until the family has incurred annual covered medical expenses in excess of the minimum annual deductible. Amounts are indexed for inflation. A plan does not fail to qualify as an HDHP merely because it does not have a deductible for preventive care (e.g., first-dollar coverage for preventive care). However, except for preventive care, a plan may not provide benefits for any year until the deductible for that year is met. Consider the following examples. Example 1: Alan s employer s plan provides coverage for Alan and his family. The plan provides for the reimbursement of 100 percent of covered medical expenses of any member of Alan s family if the member has incurred covered medical expenses during the year in excess of $1,250, even if the family has not incurred covered medical expenses in excess of $2,500. If Alan incurs covered medical expenses of $1,500 in a year, the plan would pay $250. Thus, benefits are potentially available under the plan even if the family s covered medical expenses do not exceed $2,500. Because the plan provides family coverage with an annual deductible of less than $2,500, it is not an HDHP. Example 2: The facts are the same as those in Example 1 above, except that the plan has a $7,000 family deductible and provides payment for covered medical expenses if any member of Alan s family has incurred covered medical expenses during the year in excess of $4,000. The plan satisfies the requirements for an HDHP with respect to the deductibles because the individual deductible exceeds the minimum family deductible. Deductibles and out-of-pocket limits can be higher for out-of-network services. Generally, an individual is ineligible for an HSA if the individual, while covered under an HDHP, is also covered (whether as an individual, a spouse, or a dependent) under a health plan that is not an HDHP. A health FSA and an HRA are health plans and constitute other coverage. Consequently, an individual who is covered by an HDHP and a health FSA or HRA (even a spouse s FSA or HRA) is generally not an eligible individual for the purpose of making contributions to an HSA. An individual is an eligible individual for the purpose of making contributions to an HSA for periods the individual is covered under the following arrangements: 51

8 1. Limited-purpose health FSA or HRA. A limited-purpose health FSA is an FSA that reimburses benefits for permitted coverage, as defined. 6 A limitedpurpose HRA is an HRA that reimburses benefits for permitted insurance, 7 as defined or permitted coverage (but not for long-term care services). In addition, the limited-purpose health FSA or HRA may pay or reimburse preventive care benefits because they can be paid without having to satisfy the deductible. Typically, a limited health FSA or HRA covers only dental and vision expenses. 2. Suspended HRA. A suspended HRA is an HRA that does not reimburse any medical expense incurred during the suspension period except preventive care, permitted insurance, and permitted coverage (if otherwise allowed to be paid or reimbursed by the HRA). When the suspension period ends, the individual is no longer eligible for an HSA. 3. Postdeductible health FSA or HRA. A postdeductible health FSA or HRA is one that does not reimburse any medical expense incurred before the minimum annual deductible is satisfied. 4. Retirement HRA. A retirement HRA is an HRA that reimburses only those medical expenses incurred after retirement. In this case, the individual is an eligible individual for the purpose of making contributions to the HSA before retirement but loses eligibility for coverage periods when the retirement HRA may pay medical expenses. IRS Publication 969 states that coverage during a grace period by a general purpose health FSA is allowed if the balance in the health FSA at the end of its prior year plan is zero. In 2010 the IRS reversed an earlier position originally taken in November A stacked plan is a combination of an HDHP, HRA, FSA, and HSA. For example, an employer could provide an HDHP with a deductible well above the minimum and provide an HRA that offers coverage once the minimum HDHP deductible has been met. Either the employer or employee could then contribute to an HSA. The employer could also offer a limited-scope health FSA that allows for reimbursement of dental and vision expenses. An individual can still be eligible for an HSA if, in addition to an HDHP, the individual has coverage for any benefit provided by permitted insurance. Permitted insurance is insurance under which substantially all of the coverage provided relates to liabilities incurred under workers compensation laws, tort liabilities, liabilities relating to ownership or use of property (e.g., automobile insurance), insurance for a specified disease or illness, and insurance that pays a fixed amount per day (or other period) of hospitalization. In addition to permitted insurance, an individual can be eligible for an HSA if, in addition to an HDHP, the individual has coverage for accidents, disability, dental care, vision care, or long-term care. If a plan that is intended to be an HDHP is one in which substantially all of the coverage of the plan is through permitted insurance or other coverage, as described in this answer, it is not an HDHP. Discount cards, Employee Assistance Programs (EAPs), disease management programs, and wellness programs (if the program does not provide significant benefits in the nature of medical care) are all allowed for people with HSAs. Screening and preventive services are to be disregarded in determining whether a program provides significant benefits. If an EAP provides only assessment and referral, it would not disqualify an individual from having an HSA. If an EAP provides a specified number of visits to a mental health professional, it probably will disqualify someone from having an HSA. The IRS has said that access to free health care or health care at charges below fair market value from an employer s on-site clinic will not disqualify an individual from eligibility for an HSA if the clinic does not provide significant benefits in the nature of medical care. For example, a clinic could provide preventive care, nonprescription pain relievers, and treatment for injuries caused by accidents at work without disqualifying the employee from having an HSA. The clinic could also provide dental and vision care because these benefits do not disqualify anyone from having an HSA. On the other hand, if a hospital provided free care to its employees, the employees would not be eligible to establish HSAs. Any eligible individual may contribute to an HSA. The employee, the employer, or both may contribute to the HSA of the employee. For an HSA established by a self-employed (or unemployed) individual, the individ- 52

9 ual may contribute to the HSA. Family members may also make contributions to an HSA on behalf of another family member as long as that other family member is an eligible individual. The Tax Relief and Health Care Act of 2006 significantly liberalized the rules regarding the amounts that may be contributed to HSAs. The old rules limited contributions to the amount of the deductible under the HDHP and limited contributions for people who were only eligible for part of a year. For calendar year 2013, the maximum contribution for eligible individuals with self-only coverage under an HDHP is $3,250 in 2013 and $3,300 in For eligible individuals with family coverage under an HDHP, the maximum contribution is $6,450 in 2013 and $6,550 in In addition to the maximum contribution amount, catch-up contributions may be made by or on behalf of individuals between ages 55 and 65. The annual limit is decreased by the aggregate contributions to an Archer Medical Savings Account (MSA) 8. The same annual contribution limit applies whether the contributions are made by an employee, an employer, a self-employed person, or a family member. Unlike contributions to Archer MSAs, contributions to an HSA may be made by or on behalf of eligible individuals even if the individuals have no compensation or if the contributions exceed their compensation. If an individual has more than one HSA, the aggregate annual contributions to all the HSAs are subject to the limit. For individuals (and their spouses covered under the HDHP) between ages 55 and 65, the HSA catch-up contribution limit is $1,000. After an individual has attained age 65 (the Medicare eligibility age), contributions, including catch-up contributions, cannot be made to an individual s HSA. Contributions made by an eligible individual to an HSA are deductible by the eligible individual in determining adjusted gross income (i.e., above-the-line ). The contributions are deductible whether or not the eligible individual itemizes deductions. However, the individual cannot also deduct the contributions as medical expense deductions under Code Section 213. Distributions from an HSA used exclusively to pay for qualified medical expenses of the account beneficiary, his or her spouse or dependents, are excludable from gross income. In general, amounts in an HSA can be used for qualified medical expenses and will be excludable from gross income, even if the individual is not currently eligible to contribute to the HSA. However, any amount of the distribution not used exclusively to pay for qualified medical expenses of the account beneficiary, spouse, or dependents is includable in gross income of the account beneficiary and is subject to an additional tax on the amount includible, except in the case of distributions made after the account beneficiary s death, disability, or attaining age 65. The additional tax was originally 10 percent, but health care reform increased it to 20 percent, effective in If the account beneficiary is no longer an eligible individual (e.g., the individual is over age 65 and entitled to Medicare benefits, or no longer has an HDHP), distributions 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 income tax 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 includible amount is reduced by any payments from the HSA made for the decedent s qualified medical expenses, if paid within one year after death. The term qualified medical expenses means expenses paid by the account beneficiary and his or her spouse or dependents for medical care as defined in Code Section 213(d), but only to the extent that the expenses are not covered by insurance or otherwise. (Rev. Rul , I.R.B. 559). The qualified medical expenses must be incurred only after the HSA has 53

10 been established. For purposes of determining the itemized deduction for medical expenses, medical expenses paid or reimbursed by distributions from an HSA are not treated as expenses paid for medical care under Code Section 213. Effective in 2011, health care reform prohibits reimbursing expenses for nonprescription drugs (other than insulin) without a prescription. With few exceptions, IRS Publication 502 makes clear that consumer-driven health plans such as HSAs cannot be used to pay for prescription drugs imported from Canada or other countries. This rule includes drugs ordered and delivered from these countries. Drugs bought and used in another country and drugs categorized by the FDA as legal imports are two exceptions and may be paid for from such a plan with pretax dollars. The FDA has published a letter on its Web site emphasizing this point, and making clear not only the illegality of such imports but also the illegality of paying for them from consumer-driven health care accounts. Generally, health insurance premiums are not qualified medical expenses except for the following: Qualified long-term care insurance COBRA health care continuation coverage Health care coverage while an individual is receiving unemployment compensation In addition, for individuals over age 65, premiums for Medicare Parts A, B, or D, Medicare HMO, and/or 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. HSA trustees or custodians are not required to determine whether HSA distributions are used for qualified medical expenses. Individuals who establish HSAs make that determination and should maintain sufficient records of their medical expenses documenting that the distributions have been made exclusively for qualified medical expenses and are therefore excludable from gross income. Both an HSA and an HDHP may be offered as options under a cafeteria plan. Thus, an employee may elect to have amounts contributed as employer contributions to an HSA and an HDHP on a salary-reduction basis. Employer contributions to an HSA must be reported on the employee s Form W-2. In addition, information reporting for HSAs will be similar to information reporting for Archer MSAs. The IRS has released forms and instructions, similar to those required for Archer MSAs, on how to report HSA contributions, deductions, and distributions. According to guidance by the Department of Labor (DOL) in April 2004, HSAs do not constitute ERISA plans as long as employers limit their involvement in the administration of the accounts. Since the employees are the owners of the accounts, as long as they have sole control of the funds and how they are spent, and as long as HSA funds are not used to pay insurance premiums, the accounts themselves should not have any ERISA responsibilities. Employers do need to exercise care in drafting accompanying HDHP plan documents so as to exclude any mention of the HSA component, or to state explicitly that the HSA is not an ERISA plan. In early 2006, the DOL issued Field Assistance Bulletin (FAB) , which clarified much more liberal rules for employer involvement. According to the DOL, HSAs are personal health care savings vehicles rather than a form of group health insurance. The bulletin, therefore, allows for an employer to pay HSA fees to open and contribute to an HSA unilaterally, to impose terms and conditions on contributions so as to satisfy tax code requirements, and to limit the providers who may market their HSAs to its employees and the investments offered within those HSAs. The employer may also limit the forwarding of employer or employee contributions through its payroll system to a single HSA provider, but the employer (and provider) may not restrict the utilization of the HSA funds or the ability of employees to move funds to another HSA beyond any restrictions imposed by the Tax Code. The employer cannot receive any payment or compensation in connection with an HSA or influence the investment decisions with respect to funds contributed to an HSA, and may not represent the HSAs as an employee welfare benefit plan established or maintained by the employer, if the employer wishes to avoid ERISA. HSAs are not subject to COBRA continuation coverage. Summary HRAs and HSAs can be effective tools to help convert plan participants into good consumers of health care. The 54

11 rules associated with HRAs and HSAs are complex and care needs to be taken in implementing these account-based plans. Employees will almost always find HSAs to be more attractive than HRAs because money in HRAs may be forfeited, while money in an HSA belongs to the employee. Chief Financial Officers will generally find HRAs more attractive than HSAs for the same reason; no money is disbursed from the company with HRAs until a claim is filed and approved. Employers will need to decide which approach is more advantageous: providing a better benefit or holding on to money longer. Account-based plans can be confusing to the plan participants, particularly if employees and their spouses have different choices available at work that can impact eligibility for certain benefits. Advisors can play an important role in helping their clients understand their choices and the possible ramifications of those choices. John C. Garner, CEBS, CLU, CFCI, CMC, is founding principal of Garner Consulting, a nationally recognized employee benefit consulting firm in Pasadena, California. He has expertise in the area of cost containment, and is an acknowledged expert in compliance. John is the author of Health Insurance Answer Book. He can be reached at john@garnerconsulting.com. (1) HRAs were created by IRS Notice (2) These examples are based on examples in IRS Notice (3) Health FSAs are not discussed as a planning tool in this article because the use-it-or-lose-it rule makes them less attractive as part of a consumer-driven health plan. (4) Excepted benefits are defined by HIPAA and generally include health FSAs (subject to certain rules) limited-scope benefits, such as standalone dental and vision plans and long-term care benefits, and certain types of insurance, including accident insurance, disability insurance, and workers compensation. (5) HSAs were created when Section 223 was added to the Internal Revenue Code in (6) IRC Section 223(c)(1)(B)(ii) defines permitted coverage to include coverage for accidents, disability, dental care, vision care, or long-term care. (7) IRC Section 223(c)(3) defines permitted insurance to include such things as workers compensation, liability insurance, property insurance, specified disease insurance, or insurance paying a fixed amount per day of hospitalization. (8) Archer MSAs, formerly known as Medical Savings Accounts, are not discussed in this article because they were basically replaced by HSAs. Some Archer MSAs still exist. (9) IRC Section 223(f)(4), as amended by PPACA, Pub. L. No , Section 9004(a). 55