Saturday, July 13, 2024

February 2005 Legal Briefs

Explanation of Health Savings Accounts

  1. Background
  2. What is an HDHP?
  3. What’s the Advantage of an HDHP?
  4. What Are the Tax Advantages of an HSA?
  5. Establishing HSA’s at a Bank
  6. Special Limitations on HSA Contributions    
  7. Qualifying Medical Expenses

Explanation of Health Savings Accounts

The OBA has been receiving an increasing number of calls concerning setting up Health Savings Accounts (HSA’s).  (Any bank or other entity currently acting as custodian of IRA’s is automatically approved to accept HSA’s.)

Some banks have decided to offer health savings accounts and are looking for more information on what to do, while other banks are getting inquiries from customers and aren’t sure how to respond, or whether to offer these accounts.

HSA’s are attractive accounts for banks to establish.  They should be stable, long-term deposit accounts, and probably will have continuing balances of decent size.  An HSA is the person’s “nest egg” or “safety net” for paying medical expenses—carried over from year to year if not completely spent, and supplemented each year with new contributions.  Withdrawing HSA funds for non-qualifying purposes results in both income tax liability and a 10% penalty–similar to the treatment of early withdrawals from IRA’s.  Unlike so many checking accounts where the money runs out before the month does, people will probably retain balances in HSA’s, spending cautiously and only as really necessary for medical expenses.  

I will discuss various features of the new health savings accounts, including how they can help to decrease costs of health care, their flexibility in reimbursing medical expenses, their considerable tax advantages, and what banks must do as custodians of these accounts.

1.  Background

One “catch” with a health savings account (HSA) is that it can be set up only in connection with a high-deductible health insurance policy (HDHP) that meets certain requirements.  (A person wanting to set up an HSA must already have an HDHP in place, or must set one up simultaneously.)  An HSA and HDHP are designed to work in combination with each other to pay an individual’s medical expenses on a tax-advantaged and flexible basis.  

 It must also be true that the individual is not covered by medical insurance other than an HDHP.  Money cannot be spent from an HSA to pay expenses potentially covered by other insurance, nor can the individual set up or contribute to an HSA if there is other, disqualifying medical insurance.

Qualifying high-deductible health insurance (an HDHP) can be either (i) group insurance coverage provided by an employer, or (ii) an individual health insurance policy obtained by the person to cover himself or his family; however, there are various guidelines and limitations that the HDHP must comply with.    

HDHP’s and HSA’s did not exist until Congress passed enabling legislation in December 2003.   There then was some delay while insurance companies designed their HDHP health insurance products.  The IRS also needed time to prepare necessary forms to use in connection with HSA’s, and needed to write extensive guidelines (now completed) to clarify various aspects of HDHP’s and HSA’s.  With these steps in place, many details became clearer, and customer interest in HSA’s finally began picking up at the end of 2004.  Now in 2005 these accounts should become much more common.   

Because most employer health insurance plans are set up for a year at a time, many employers will be taking their first serious look at HDHP’s in 2005, whenever the annual date approaches for renewing or replacing their existing employee health insurance coverage.

Obviously, banks will not receive requests to open HSA’s until employers or individuals in the local community start switching their medical insurance to high-deductible HDHP’s.  (And agents providing health insurance coverage to local merchants and individuals must actually offer HDHP’s for sale, before people can buy them.)

Many insurance companies offering HDHP’s are also setting up referral arrangements with an out-of-state bank or a mutual fund, then steering their customers to set up HSA’s with that related company.  A local bank probably should visit with local insurance agents to make them aware that the bank would like to set up HSA’s for the agents’ customers.  (Most employers and individuals would prefer the convenience of making deposits to an HSA at a local bank, if they knew that was available.  The HSA and the HDHP are two different products, and certainly can be obtained through separate providers of the customer’s choice.)

The OBA is also considering how to bring high-deductible health insurance plans (HDHP’s) to banks’ local communities.  (Ideally, the related HSA’s would be set up at banks in those communities.)

2. What is an HDHP?

An individual (or an employer acting on his behalf) cannot set up a health savings account (HSA) unless that person is covered by a qualifying high-deductible health plan (HDHP)—either health insurance for the individual alone, or “family” coverage for the individual and one or more family members).  The HDHP must be in effect as of the first day of the month in which the HSA is established.  (If an HDHP goes into effect after the first day of a month, an HSA cannot be set up before the following month.) Additional contributions can be made to an HSA at later dates, but only while the HSA’s owner continues to be covered by either the same HDHP or a different one.

For a health insurance policy to qualify as an HDHP it must have a deductible of not less than $1,000 (individual coverage), or not less than $2,000 (family coverage).  The maximum deductible that any HDHP can have in 2005 is $2,650 for individual coverage (indexed annually for inflation) and $5,250 for family coverage.  In addition, the “maximum out-of-pocket expenses” under an HDHP cannot exceed $5,100 (individual) or $10,200 (family), indexed for inflation.   

The maximum allowable deductible and the maximum “out-of-pocket expenses” for an HDHP are not the same thing.  Once the deductible is satisfied, insured persons typically are still required to pay a portion of covered medical expenses.  For example, there still may be a $10 co-pay for doctor visits, perhaps a $25 co-pay for prescriptions, and an 80%/20% split for hospital bills within a network.  If a family-coverage HDHP cannot exceed a maximum of $10,200 for out-of-pocket expenses, this means that the total of (1) the deductible, plus (2) the continuing co-pay amounts after the deductible is met, cannot exceed $10,200.  In other words, the policy must pay 100% of covered expenses with no co-pay, after the stated-dollar maximum of $10,200 is met.

So even with these high-deductible policies, there is an absolute cap on the total dollar amount that the individual (or family) can be required to pay in one year for all covered medical expenses.

3.  What’s the Advantage of an HDHP?

Compared to a health insurance policy with a low deductible, such as $200 per person, an HDHP may not sound very attractive at first.  But a high-deductible policy is always substantially cheaper than a full-coverage policy—and in combination with an HSA, an HDHP may be a better way of paying for medical expenses than a low-deductible policy.

If a policy has a low deductible, the health insurance company has almost a certainty of paying out benefits each year—and the premiums are based on that assumption.  As the size of the deductible increases, the insurance company will incur a lower payout for covered medical expenses, and the premium decreases.  If the policy has such a high deductible that the insurance company may not pay out benefits at all in some years, the premiums will be quite a bit smaller than for full-coverage insurance. If, then, the person does not actually have many medical expenses in a particular year, whoever pays the premiums for an HDHP (an employer or the individual) is way ahead by doing so, compared to the cost of a low-deductible policy.  

Of course, no matter how good a person’s health may be, he will never get a partial refund of health insurance premiums at the end of the year.  In a year when a person is quite healthy, paying the smaller medical insurance premium for an HDHP results in savings; and in a year when HDHP premiums plus out-of-pocket medical expenses paid through an HSA do not exceed the cost of a low-deductible policy, there’s still at least a break-even.  

By contrast (depending on the circumstances) a person with chronic medical conditions, who is almost certain to have a lot of medical expenses every year, may get no financial advantage from an HDHP/HSA combination, and might be better off to stick with low-deductible health insurance—if that person can even obtain coverage.

Health insurance premiums have been increasing by 15% or more per year.  Many employers cannot afford these increases, and are looking for alternatives.  The employer that can no longer pay for full coverage could still probably provide health insurance that has a higher deductible and lower premiums.  Also, some employers that have never provided health insurance might be able to provide at least high-deductible coverage, which then qualifies the employee to set up an HSA.

You may ask, “What good is a policy with a deductible so large that it may not pay any medical expenses?”  Actually, just having a policy that could pay for “major medical” or “catastrophic” expenses provides peace of mind and is a lot better than nothing.  Anyway, it’s the HSA (not the high-deductible insurance) that’s designed to pay medical costs falling within the health insurance policy’s deductible amount.  There are tax-advantaged ways to fund an HSA (discussed below), but the person first needs to be eligible for an HSA.  (A person can’t have an HSA at all without first having an HDHP, so even a high-deductible HDHP that rarely pays for the person’s medical bills is still a necessary and very desirable “ticket” allowing access to a tax-advantaged HSA which is what the person really wants and needs.)
But HDHP’s are not “one size fits all,” and they don’t have to have the maximum deductible.  A person with an individual HDHP can have an annual deductible as low as $1,000 (averaging out to $83 per month), and a family-coverage HDHP can have a deductible as low as $2,000 ($167 per month).  

Because an individual’s contributions to an HSA are eliminated from his reportable income for tax purposes (not dependent on whether the individual itemizes deductions), the income tax that otherwise would be paid on the amount of income represented by these contributions is saved.  The employee’s “real” cost of having an HSA (which supplements the HDHP’s coverage) is reduced by income taxes that do not have to be paid on the amount of contributions to the HSA.   It’s always cheaper to make tax-advantaged contributions to an HSA (to pay medical expenses) than to directly pay the same medical expenses out-of-pocket, with no tax deduction.

The real issue is not that the deductible on the HDHP may seem large (the mountain is tall).  The point, instead, is that many medical expenses simply cannot be avoided, and an HDHP combined with an HSA will make it easier to pay those expenses (the mountain is easier to climb).  If the employee’s only other option might be no health insurance and no tax-exempt HSA contributions, and no deductibility for medical expenses, this HDHP/HSA combination looks a lot more attractive.   

Furthermore, employers are allowed to contribute to employees’ HSA accounts (deductible to the employer), in addition to paying for the employee’s HDHP insurance.  If an employer can make at least part of the HSA contributions, the employee’s remaining required amount to fully fund the HSA is reduced.  In addition, anyone at all (such as a relative) can contribute to the individual’s HSA, and the individual can still exempt that contribution amount from his own income tax—except what the employer contributes to the HSA, which is already tax-exempt compensation to the employee, and cannot also be “income excluded” by the employee.

4.  What Are the Tax Advantages of an HSA?

Contributions by an individual to an HSA (in permitted amounts) can be subtracted from the person’s income earned during the applicable tax year.  The amounts in an HSA are free from tax not only (1) when contributed, but also (2) as income is earned from year to year, and finally (3) when any disbursement is made from the HSA (even years later) that pays (or reimburses) qualifying medical expenses for the individual or his family.

Comparing an HSA to a traditional IRA, the IRA allows tax-free contributions and tax-free build-up of earnings over many years, but with an IRA the principal and interest are finally both taxed when amounts are withdrawn in retirement.  An IRA is a tax-deferral vehicle, putting the income tax off until later.  The HSA is also a vehicle that allows funds to build in value over time (if not spent).  But unlike an IRA, the funds in an HSA are never subject to tax, no matter how long they are held, if they are ultimately spent on qualifying medical expenses—even after 10, 20, 30 years or more.  The funds in an HSA also are not required to be disbursed at any specific time (no mandatory distributions after a certain age, like an IRA).

The HSA provisions are also rather unique because there is no phase-out of an individual’s ability to contribute to an HSA as the individual’s income rises.  (On the contrary, the higher the income tax bracket the individual is in, the more these HSA contributions will benefit the individual.) No matter how poor or wealthy, anyone who is not yet enrolled in Medicare and has an HDHP is permitted to make contributions to an HSA.  Nor are these contributions subject to the “alternative minimum tax” as a person’s income rises.  

Two spouses can each have a $2,650 maximum-deductible individual HDHP, and, if they do so, each can deposit $2,650 annually into an HSA.  (For a couple, a family HDHP can have a maximum deductible of $5,250.  The maximum annual HSA contribution relating to that insurance policy would also be $5,250, and can be divided between the husband’s HSA and the wife’s HSA in any manner that they agree, including half-and-half or all to one spouse’s HSA and none to the other spouse.)

For people who primarily want to maximize the tax advantages, it would apparently be possible for them to pay most of their medical bills from other funds, while making maximum HSA contributions each year.  This would leave those contributions largely intact to continue growing, earning tax-free income all the while.  By retirement age, someone might be able to accumulate more than $100,000 in an HSA, by maximizing the tax benefits, limiting medical expenditures, etc.  After enrolling in Medicare, it’s not possible to make further contributions to an HSA, but the principal in the account can continue to grow indefinitely through earnings, and does not have to be spent or distributed at any specific time while the person remains alive.

Of course, in retirement a person’s medical expenses may be large.  The opportunity to build up a medical “nest egg” for retirement by careful management of HSA contributions could be attractive to many.  In retirement, the accumulated funds in an HSA can be used to pay for any medical expenses not covered by the person’s Medicare, Medicare supplement or other insurance—and (before or after retirement) can be used to pay premiums for long-term-care insurance (up to an annual dollar limit established by the IRS).  Without other insurance coverage, funds in the HSA can be used to pay for long-term care itself, including nursing homes or home health care.

At death, funds in a person’s HSA can be used to pay expenses of the final illness (after the fact).  If anything remains in the HSA, and the surviving spouse is the beneficiary, that remaining amount still is not subject to income tax, and becomes the HSA of the spouse.  The spouse can then use the funds to pay his/her own medical expenses, and the account balance continues earning tax-free income.  (If the beneficiary on the HSA is someone other than the spouse, that non-spouse beneficiary inheriting the HSA would be subject to income tax on the entire lump sum that he/she receives.)  It’s very appealing to be able to preserve HSA balances as a medical “nest egg” until both spouses have died, and then to transfer the remainder (if any) to other heirs.

But the main purpose of the HSA is to provide a tax-advantaged fund from which an individual’s or family’s medical expenses can be paid.  If there is any “left-over” amount that has been contributed to an HSA but not spent in a particular year, that amount can be carried over for use in the future, and in the meanwhile continues to build the balance in the account through earnings.   

As an example, if a head of household contributes $5,250 to an HSA in the first year in connection with a family HDHP, but he only needs to spend $3,500 of that amount to pay medical expenses during the year, there will be $1,750 remaining in the HSA, carried over for possible future use. The next year, as the result of the family’s good health in the prior year, the individual has a very flexible range of options, depending on his financial situation and his goals:

(1)  The HSA owner could decide to take advantage of the family’s good health (and unused balance) in the previous year by contributing to the HSA only an additional $3,500 in the second year (not the allowable $5,250).  Combined with what was carried over from the first year, this still would give the individual an available total of $5,250 in the HSA to cover medical expenses that have to be satisfied (if medical bills are high) before the HDHP’s $5,250 deductible is met in the second year.  (A smaller contribution in the second year still “banks” enough money in the HSA for good protection.)  

(2) Alternatively, with a $1,750 “nest egg” going into the second year, the head of household may have enough “cushion” to face almost any type of medical expense that would arise next, and might decide, instead of making regular lump-sum contributions, to only replenish the amounts that are spent from the HSA as the year goes along.  This could cut some welcome slack in the family budget, in contrast to being required to make steady monthly payments on low-deductible health insurance, for example.  A “wait and see” approach such as this (starting with a reasonable balance in the HSA) has some risk, but it’s a lot better than having no savings and no HSA, being forced to pay each medical bill as it arises.

(3)(a) The HSA owner may have plenty of money to fund the HSA whenever that becomes necessary, but wants to strategize his contributions for maximum tax advantage.  Perhaps he wants to contribute the full allowable amount in a lump sum (equal to the full deductible on the HDHP) as soon as possible in the second year. He may do so, and the contributed funds begin earning tax-free income in the HSA immediately.  

(3)(b) As an opposite example, the HSA owner might want to make as large a contribution to the HSA as possible in the second year (for tax purposes) but may not actually need any more money in the HSA to pay health expenses as they occur.  Provided that the individual has both an HDHP and an HSA in place at the beginning of a tax year (such as January 1, 2005), and those arrangements continue in effect throughout the year, the HSA owner may delay making his HSA contribution for that year until as late as that year’s tax-filing deadline (in other words, a 2005 HSA contribution can be made as late as April 15, 2006)—just like an IRA contribution for a certain year can be made as late as April 15 of the following year.

As another example, assume that an HSA owner made a maximum $5,250 HSA contribution in the first year, in connection with a family HDHP with a $5,250 deductible.  But the family actually paid $6,000 of out-of-pocket medical expenses during the first year ($5,250 of covered expenses, before meeting the HDHP deductible, and $750 of other IRS-qualified medical expenses).  The $750 of additional expenses is eligible for payment from an HSA, but for various reasons they could not be paid by the HDHP.  (They consisted of (i) IRS-qualified medical items (such as dental) that the HDHP doesn’t cover, (ii) co-pays that the family has to pay even after the HDHP deductible is satisfied, and (iii) expenses that exceed the HDHP’s coverage limits–for example, too many days of medically necessary physical therapy).   

In the $6,000 example above, the HSA’s available funds are exhausted (or reduced to $1) at the end of the first year; but the individual still has $750 of additional medical expenses that were paid out-of-pocket during the first year, which the HSA cannot (yet) reimburse.  (It is not permissible for the individual to make an even larger contribution to the HSA in the first year to cover these expenses. A penalty is imposed on excess contributions to an HSA—unless accidental and temporary.  Excess contributions must be removed from the HSA, along with any income earned on the excess contributions.

What can be done in this situation?  

At the beginning of the second year (or later) the individual can make the second year’s contributions to the HSA–up to $5,250 in relation to a family HDHP with a $5,250 deductible.  The second year’s contributions can be used to pay medical expenses incurred in the second year, but can also be applied to  reimburse eligible carry-over medical expenses from any prior year when available HSA funds were not adequate for reimbursement. (Eligible expenses are only those incurred after both the HDHP and the HSA are first set up).

In the example above, $750 of the second year’s contributions can be applied to reimburse to the family the excess (unreimbursed) expenses from the first year.  This leaves $4,500 in the HSA to pay medical expenses in the second year.  But let’s say the second year has $4,750 of its own expenses. So at the end of year two, $250 of eligible expenses gets carried forward for reimbursement to the family in the third year, and so on.

The other way around, if an HSA owner makes the maximum contribution each year but does not use it all for reimbursements, the excess that is built up over time is available for use in any future year, if needed. Building up a carryover balance in an HSA helps to insure that future medical expenses, even if higher than normal, will be reimbursable in the same year when they are incurred.

For example, in the first year an HSA owner contributes $5,250 to the HSA and has $3,500 of reimbursements.  In the second year, $5,250 is again contributed, but expenses are only $3,250.  In the third year, $5,250 is contributed, but expenses are $4,500.  Going into the fourth year, the HSA has a $4,500 cash balance carried over (unused from the first three years); and $5,250 more is contributed in the fourth year, for a total of $9,750 available.  If medical expenses in the fourth year are $9,500 (including the deductible, various non-covered medical, dental and vision expenses, co-pays, and perhaps even some long-term-care insurance premiums), all $9,500 can be paid out of the HSA for those eligible expenses, because funds are available to do so.  

Realistically, the “ordinary” person will more likely be scrambling just to make enough HSA contributions to cover most of his (or his family’s) eligible medical expenses during a year, and will not be worrying about how to “max out” his permitted contributions, or how to build up a surplus in the HSA against the risk of having a future year that may have much higher expenses to reimburse.  Still, the examples explain the flexibility of HSA’s in reimbursing expenses, and the potential tax advantages.

5. Establishing HSA’s at a Bank

In many ways, a bank’s role in establishing and administering health savings accounts for customers is like setting up and administering IRA’s.  There are required forms for use with these accounts (but the bank can modify them somewhat); there are many restrictions on what the customer can do and when; and there are reporting requirements for both the bank and the customer.

The IRS has developed Form 5305-C to be used by banks in opening HSA’s.  (This is a custodial agreement, similar to what’s used to open an IRA.) It would be good to review Form 5305-C with the customer, because it sets out in simple language a lot of restrictions that apply to HSA accounts.  For example, the customer must agree that funds in the account will be used only for “paying or reimbursing qualified medical expenses of the account owner, his or her spouse, and dependents.”  

Once the HSA is set up, the customer has a right to withdraw money from the account with no questions asked.  The bank has no responsibility to determine that money in the account is spent properly.  But the customer must account to the IRS annually (on Form 8889) for any funds distributed from the HSA; and if withdrawn funds are not spent for qualifying medical expenses, the customer will owe both income tax and a 10% penalty on funds spent for non-qualifying purposes. The bank is not required to withhold any taxes or penalties when money is taken out of these accounts.  Instead, the taxpayer must deal with that when he files his annual tax return.  

Every HSA must be an individual account.  It cannot be a joint or P.O.D. account.  But the bank will want to use a “designation of beneficiaries” form, similar to what is used for IRA’s.  A customer can designate both primary (first-in-line) and secondary beneficiaries.   If a spouse is living and is not the person named as the primary beneficiary, the bank should require a spousal consent—just like for an IRA.

In many cases, the HSA owner may want to put a spouse on the account as an authorized signer.  (This should be possible—particularly if the bank uses “power of attorney” language for signers.)  In many cases HSA’s will be NOW accounts (accessible by check), and both the husband and wife will probably want to be able to pay qualifying medical expenses as they visit the doctor, the pharmacy, etc.  Some providers are already issuing debit cards on these accounts, which is also a very convenient way of paying medical providers.

The phrase “health ‘savings’ account” does not imply that these accounts have to be what a bank thinks of as a “savings” account.  HSA’s can be any type of deposit account, and also can be money market or brokerage accounts furnished through a securities broker.  An individual can have more than one HSA (just as a person can have more than one IRA), but, as with IRA’s, all contributions to all such accounts combined must fit within the same dollar-amount restrictions that would apply if everything were in one account.

As substantial balances build up in an individual’s HSA, it will be appropriate to put part of the funds in C.D.’s or maybe an MMDA.  But an HSA owner will probably still need at least one account from which he/she can pay medical bills directly.  For example, if a person attempts to use either a traditional savings account, a C.D. or an MMDA as the primary account for paying medical bills, the bank will be required to enforce the Regulation D limits on the number of permissible transactions per month, and this may not fit the customer’s needs.

Of course, an HSA can reimburse the owner for medical expenses after-the-fact, instead of paying each medical expense directly to providers.  If a customer has other funds from which to pay medical bills, he could pay those bills from his regular checking account, then reimburse himself from the HSA periodically.  Infrequent reimbursements (but in larger amounts) would allow the HSA to be invested in higher-yielding accounts that allow only very limited withdrawals.  However, most people cannot afford to operate this way, and need to access their HSA for lots of individual expenses as they arise.

After HSA’s have been around for a while, transfers and rollovers will become common.  As with IRA’s, a person can withdraw the balance of the funds (not more than once per year) and take that amount to another bank within 60 days to open a new HSA (a rollover).  Unlimited direct bank-to-bank transfers of HSA funds are also permitted.  

After a person signs up for Medicare, or after the person’s HDHP coverage expires, a bank may not set up HSA accounts or accept additional contributions to an existing HSA account.  The exception is a rollover or transfer of an existing HSA from another bank, which does not involve a contribution of new funds, but only moves existing funds to a new bank—and can occur even after the person is on Medicare or no longer has an HDHP.  (A bank can rely on any person’s statement on the Form 5305-C that HDHP coverage is currently in effect.)

A bank should not allow a customer to contribute more to an HSA than the maximum that is allowed for a particular tax year.  But sometimes, due to changing circumstances during the year (such a termination of HDHP coverage or switching to an HDHP with a lower deductible), the customer’s total permitted contributions for the year can decrease.  To avoid penalties, a customer must withdraw excess contributions, after notifying the bank of the situation.  The customer also must withdraw any earnings on excess contributions—which the bank must calculate in the same manner as earnings on excess contributions to IRA’s.

At the end of the year, the bank files a form 1099-SA with the IRS, and sends a copy to the taxpayer.  This form discloses the total amount of distributions made from the HSA during the year. It also states the amount of earnings on any excess contributions.  It is then the customer’s job to account for these distributions to the IRS, as to whether they are taxable or tax-exempt.

Each year the HSA owner must file a Form 8889 with his federal income tax return.  This is the form on which he claims an exclusion from income for any contributions to an HSA during the year.  This is also the form on which he must explain any distributions from an HSA during the year (to match the Forms 1099-SA sent by banks). Rollovers to a different HSA must be indicated, as well as payments for qualifying medical expenses from the HSA.  Any distributions that were not made for qualifying expenses must be included as income on Line 21 on the individual’s Form 1040 tax return, and also are subject to a 10% penalty to be included on Line 62 of Form 1040.

Normal account charges on a deposit account that is an HSA are not considered distributions that must be reported to the individual on Form 1099-SA—but neither are they medical expenses.  (Ideally, an HSA would be a type of account with as few fees as possible.)  As a matter of policy, a bank may want to consider disallowing overdraft protection on a NOW or checking account that is an HSA.  Someone writing insufficient checks on an HSA would incur even more fees that are not medical expenses.  

It may be unavoidable that a bank posts “returned check” charges to an HSA from time to time.  This would result in a negative balance.  Perhaps the individual can make a payment on the side to reimburse such charges to the bank.  However, if the bank pays actual checks into overdraft, these amounts certainly are not service charges.  To reimburse for overdraft checks that are paid by the bank, the individual would have to make additional contributions to the account; but the individual probably cannot legally do so if he has already made his maximum allowable HSA contributions for the year. Since the bank will not want the account to remain in an overdrawn status until the following year (when more funds can be contributed), it may prefer not to allow overdrafts. (The bank might conclude, instead, that the people who make maximum contributions are not finally strapped, and are not likely to be the ones with overdrafts on an HSA.)

6.  Special Limitations on HSA Contributions

There is a cap on annual contributions to an HSA, equal to 100% of the annual deductible on the qualifying HDHP that the person holds.  (If it’s an individual HDHP, the deductible cannot exceed $2,650 for 2005—adjusted annually—and for a family HDHP the deductible for 2005 cannot exceed $5,250.)

The allowable annual contribution must be pro-rated on a monthly basis, dependent on how many months both the HDHP and HSA have been in effect during the tax year.  If a person’s high-deductible health insurance policy and his HSA are both effective beginning July 1, 2005, and the HDHP has a term of one year, there will be only six months during 2005 for which an HSA contribution can be made, and six months in 2006, at which time the policy either will expire or will be renewed or replaced.   If the HDHP is a family policy with the maximum deductible of $5,250, the family’s allowable HSA contributions for 2005 are pro-rated in this example.  Only six months’ worth (6/12) of the $5,250 deductible—which amounts to $2,625–can be contributed to the HSA in 2005 if the HDHP and HSA do not exist until July 1.  

Similarly, with respect to the first six months of 2006 (the second half of the HDHP’s period of coverage under a $5,250 annual deductible), the HSA owner could contribute $2,625 to the HSA.  Let’s assume further that the family switches to a different family-coverage HDHP at July 1, 2006—one that has only a $3,000 annual deductible.  The allowable HSA contribution relating to the second half of 2006 (6/12 of $3,000) would be $1,500.  Total permitted HSA contributions for all of 2006 would be $4,125 in this example ($2,625 plus $1,500).  The person just described could start the year with a $5,250 contribution, as if that will be the HDHP deductible for the full year; but he would have to withdraw part of that contribution (plus interest) if the HDHP deductible decreases as the year goes on.

The HSA contributions for a particular year, such as 2006, can be made at any time from January 1, 2006, to April 15, 2007.  The entire contribution for the year can be made as early as the first banking day of the tax year to which the contribution relates.  However, if full contributions are made early in the year and later circumstances reduce the year’s permissible amount of contributions (due to expiration of the HDHP, change in deductible amount, etc.), the year’s contributions must be adjusted to fit within the recalculated maximum.

After a person enrolls in Medicare, he cannot make any more contributions to an HSA.  (If he turns 65 in September, he can make a contribution for the first eight months of the year, only–so his allowable contribution to the HSA will be only 8/12 of a normal year’s contribution.)

 The HSA provisions also allow “catch-up” contributions to an HSA for persons who are 55 or older (but not yet enrolled in Medicare).  These amounts are in addition to the otherwise permitted total contributions to an HSA based on deductibles.  In 2005, persons 55 or older can have a $500 catch-up contribution.  The amount phases up by $100 per year, reaching a total of $1,000 per year in 2009.

The catch-up contributions must be pro-rated by months, just as the regular contributions are.  For example, a person who reaches 55 at mid-year in 2005 will be able to take only 6/12 of the $500 catch-up contribution (or $250) for 2005.  Similarly, if a person “55 or older” has an HDHP that terminates nine months into the year 2005 (not replaced), or the person enrolls for Medicare after nine months of 2005, the individual could take only 9/12 of $500 (or $375) as a “catch-up contribution” in 2005—and if that person was turning 65, the contribution would actually have to be made before the person enrolled for Medicare, not later in the year.   

7.  Qualifying Medical Expenses

The amount of contributions to an HSA (except for catch-up contributions) cannot exceed the deductible amount on an individual HDHP or family HDHP that covers the HSA owner. However, once the allowable HSA contribution is determined, the HSA funds can be spent for a variety of expenses that the HDHP might not cover.

For example, a person may have an individual HDHP (provided by his employer), but no family coverage.  If this individual HDHP has a maximum deductible ($2,650), the employee can put $2,650 per year into his HSA.  (In some cases, employers would make part of the HSA contribution.)  

If the individual wants to spend the HSA funds for qualifying medical expenses for himself (those which count toward his deductible), that’s fine.  If he wants to spend the HSA funds to pay medical expenses for his wife or dependents (who have no medical insurance), he can do that also, on a tax-favored basis. If the wife’s employer provides individual medical insurance coverage for her with a $200 deductible or co-pays, the husband can use his HSA to pay expenses that the wife’s insurance will not reimburse because of a deductible or co-pay.  (The husband’s employer cannot restrict how HSA funds are spent, or for what, or for whom—even if the employer contributed those funds, and even if the employee wants to spend the money improperly.)

It’s permitted to spend HSA funds for anything (without penalty) that is a qualifying medical expense for IRS purposes—including for types of services not covered under the individual’s HDHP.  For example, dental and vision expenses are qualifying medical expenses for IRS purposes, but the normal medical insurance policy does not cover these.  Also, there are procedures or prescriptions that an insurance company declines to pay—perhaps labeling them as “experimental treatment” or “not medically necessary.”  Funds in the HSA can be spent on these treatments and prescriptions, if they are qualifying medical expenses for IRS purposes.

Generally, funds in an HSA cannot be used to pay insurance premiums.  But there are some important exceptions for which an HSA can be used—long-term care insurance (within limits), COBRA coverage, and health insurance premiums paid while the person is receiving unemployment.  Certain Medicare and other health care coverage after age 65 can also be paid from an HSA, except for Medicare supplement insurance.

Next month I will discuss some additional issues regarding HSA’s.