- Recent Amendments to Health Savings Account Provisions
- HSA Contribution Amounts
- Reimbursing Medical Expenses
- Accumulating Tax-Advantaged Savings
- Full Deduction in First Year
- Transfer from IRA to HAS
- Index for 2006
1. Recent Amendments to Health Savings Account Provisions
In one of its last actions before adjourning in early December, Congress passed H.R. 6408, the “Technical Relief and Health Care Act of 2006.” This bill includes several useful changes relating to health savings accounts (HSA’s). Banks should become familiar with these new provisions, to assist customers who are opening and funding HSA’s.
Banks that actively promote HSA’s will benefit from the changes described below, because (1) the more flexible HSA provisions will encourage more consumers to open HSA’s, and (2) many higher-income customers will now be able to build up large HSA balances as a tax shelter—creating a new source of long-term bank deposits.
Following are the most significant changes and their effects:
• Allowable annual contributions to an HSA will no longer be limited to the amount of the “deductible” on the consumer’s related high-deductible health insurance policy. (In 2007, for individual coverage any eligible person under 65 can contribute $2,850 to an HSA, and for family coverage, $5,650. If the individual or covered spouse is at least 55 but under 65, a “catch-up” contribution of $800 for each such person is also allowed.)
• Most people with qualifying high-deductible health insurance can achieve a significant tax benefit by making large enough annual contributions to an HSA to pay not only those expenses that fall within the policy’s deductible, but also any other qualified medical expenses that are eligible to be paid from an HSA (discussed in more detail below). “Bulking up” on contributions to an HSA is a good deal. Money not spent for medical expenses in a particular year carries over to future years.
• For the first time, a full annual contribution to an HSA will be available in the year when a high-deductible health policy is set up. The amount contributed to an HSA in the first year will not be pro-rated or reduced because the calendar year is partially gone.
• With more generous contributions to an HSA now possible, many higher-income consumers will want to use their HSA like a “second IRA.” An individual can make a maximum HSA contribution each year until he is 65, paying all medical expenses out of pocket (if he wishes) instead of from the HSA balance. This turns the HSA into a large, growing investment account—available to pay medical expenses for himself or his spouse in retirement (if needed), or to leave as an inheritance. There are no “required minimum distributions” from an HSA. (Money that goes into an HSA is deductible: it grows tax-free; and it’s also not taxed when it comes out, if used for qualified medical expenses.)
• The new provisions allow a consumer to make a one-time non-taxed direct transfer from an IRA to help fund an HSA. This is a step backward in retirement savings, but it can help a lower-income individual with high-deductible health insurance who is unable to fund a related HSA and who can’t afford to pay medical expenses falling within the HDHP’s deductible. After a one-time transfer from an IRA to create a fully-funded HSA, it may be easier thereafter to maintain a good balance in the HSA.
I will discuss below some tax advantages related to these HSA changes, and also some account-handling details.
1. HSA Contribution Amounts
The recent changes will allow the average HSA accountholder to make (and deduct) substantially larger annual contributions than before. This is an extremely important tax benefit for consumers who can afford to “save” the maximum allowable contribution each year.
Before setting up an HSA or being allowed to make HSA contributions in any year, the HSA accountholder must be under 65, must be covered by a qualifying “high-deductible health plan” (HDHP), and cannot have any other full-purpose health plan. (Specialized coverages for vision, dental, cancer, hospitalization and long-term care are allowed.)
The “minimum and maximum” amounts that will qualify a health insurance policy as an HDHP are adjusted each year for inflation. For 2007 a qualifying HDHP with self-only coverage must have a deductible at least as high as $1,100, but total “out-of-pocket” expenses under such a policy cannot exceed $5,500. A qualifying family-coverage HDHP must have a deductible at least as high as $2,200, but with an “out-of-pocket” expenses limit no higher than $11,000.
Until now, annual HSA contributions could not exceed the amount of the deductible under the individual’s self-only or family-coverage high-deductible health plan (HDHP). For example, if the deductible for an individual HDHP was $1,100, the maximum HSA contribution was also $1,100. In the past, an HSA has not been a very effective vehicle for accumulating unused balances, because there was not much left after paying medical expenses not covered by insurance.
Based on the new changes, in 2007 someone can have an HDHP with the lowest allowable deductible ($1,100 for self-only coverage, or $2,200 for family coverage), while taking the maximum annual HSA contribution. In 2007 an HSA owner below the age of 55 who is covered by a qualifying HDHP can make a deductible HSA contribution of up to $2,850 related to self-only HDHP coverage, or up to $5,650 for family HDHP coverage. (These amounts are indexed annually for inflation.)
Each qualifying HDHP policyholder or covered spouse who is at least 55 (but under 65) can contribute an extra $800 to an HSA in 2007. (In other words, an individual with self-only HDHP coverage who is over 55 (but under 65) can contribute a total of $3,650 in 2007; or two spouses, both covered by a family HDHP, and both at least 55 (but under 65) can make a combined HSA contribution of $7,350 in 2007.) The “catch-up” HSA contribution for each covered person between 55 and 65 will increase to $900 in 2008, and $1,000 for 2009 and later years.
In 2007 a person with self-only HDHP coverage and a $1,100 deductible can contribute to his HSA an amount that is $1,750 larger than his deductible (or $2,550 larger than his $1,100 deductible, if he is over 55 but under 65). For family HDHP coverage, in 2007 someone with a $2,200 deductible can contribute to his HSA $3,450 more than the $2,200 deductible (or $5,050 more than his $2,200 deductible, if both spouses are over 55 and under 65). Someone who makes maximum annual contributions will have a good chance of accumulating substantial funds in an HSA.
But it’s still unlikely that the average HSA owner will contribute more than his “deductible” amount to his HSA. Some people don’t understand the full range of expenses that can be paid from an HSA, and won’t put enough money in an HSA to pay everything that’s eligible. Others will fail to contribute as much as they should to an HSA because they have too many other ways to spend their money.
It will almost always be to an individual’s benefit to deposit as much into an HSA as is reasonably possible in the circumstances. One of the easiest ways to make sure that the customer actually funds his HSA fully and regularly is to help him set up automatic payroll deductions.
When money is deducted directly from an employee’s paycheck, he probably doesn’t miss it, and has no temptation to use it in other ways. Once money is in an HSA, it can be used only for qualified medical expenses–or else the non-qualifying distribution will be included in the individual’s taxable income for the year, with a 10% penalty also imposed.
2. Reimbursing Medical Expenses
No health plan fits everyone’s needs on a “one-size-fits-all” basis. There need to be ways to “tweak” or customize it, to better match an individual’s own situation. A consumer’s newly-authorized ability to make an annual HSA contribution that is larger than the deductible on the related HDHP insurance policy provides a very good method of customizing his health plan, As of year-end 2006, approximately 3,600,000 HSA’s had been established. The recent changes make HDHP coverage and HSA accounts much more “user-friendly,” and will cause this type of health plan to gain even wider acceptance.
Until now, a high-deductible health plan has seemed attractive to some, while unattractive or inflexible to others. HDHP’s perhaps have had least appeal to “older” employees (under 65) with existing medical conditions, who need periodic tests and treatments, and take regular medications. They are almost certain to use up the deductible under any plan, and (in the past) would also have no real chance to “save” any unused portion of the deductible amount in the HSA—one of the “selling points” for HSA’s. For these employees, being covered by an HDHP but unable to make an HSA contribution larger than the deductible has meant that (1) expenses falling within the deductible were almost certain to exhaust the maximum annual HSA contribution, and (2) there was no tax-advantaged way to pay regular medical expenses falling outside of the deductible—such as co-pays on doctor visits, hospitals, prescriptions, dental bills, and vision care.
A “flexible spending arrangement” (also called an FSA or “cafeteria plan”) is an employer arrangement that provides a way to pay miscellaneous medical expenses on a tax-advantaged basis. In the past, many larger companies have offered FSA plans, allowing employees to withhold extra money from their salary (before tax) to reimburse all sorts of medical-related expenses that insurance doesn’t cover (deductibles, co-pays, ineligible procedures and tests, and even over-the-counter medications and medical supplies.) For employees with substantial medical expenses, this has been a very attractive benefit.
However, the HSA rules do not allow someone to have both an FSA and an HSA—and this will not change. Employers switching to HDHP coverage must terminate FSA arrangements—and until now this has left an employee with no tax-advantaged method of reimbursement for medical costs not covered by insurance. (An employee covered by an HSA can only participate in a limited-purpose FSA that mainly reimburses for such items as dental and vision care—but not health-insurance-type expenses.)
The recent HSA changes will allow a consumer for the first time to make an HSA contribution larger than the HDHP deductible. The consumer can then use any extra HSA funds to pay any medical expenses, in addition to amounts falling within the deductible, that insurance doesn’t pay—in the same way an FSA could have been used if an HSA had not been set up. But there’s an important difference between an FSA and an HSA. An FSA is “use it or lose it”: Any money put into an FSA and not spent within an insurance plan year to reimburse qualifying expenses is “forfeited” at the end of that year (after a 2 ½-month grace period expires.)
Money put in an HSA is never forfeited at the end of a year. Unused balances can be carried forward indefinitely to reimburse a later year’s medical expenses. Even if the HSA owner ceases to have an HDHP, and therefore cannot make further contributions to an HSA, the remaining balance in the HSA can continue to be used to pay medical expenses until it is used up.
When an employee puts money into an FSA, he is often hesitant to deposit more than he knows he can use by the end of the year—because he will have to forfeit the excess amount. With an HSA, there is no “downside” to making HSA contributions all the way up to the annual maximum, if desired, because that money can always be used at some time in the future. If a person finds that he has contributed more to an HSA than he was able to use in a specific year, and he thinks it’s unnecessary to maintain so large a balance, he can simply stop contributing to the HSA until he uses up the excess amount.
An HSA can pay or reimburse any expense meeting the IRS definition of “qualifying medical expenses.” The category of allowed expenses is quite a bit broader than an insurance company’s definition of covered medical expenses. As one example, an insurance policy always takes a less favorable approach to charges by an out-of-network doctor or hospital, but the IRS does not. Most insurance policies pay the out-of-network provider at best no more than an in-network rate. Some policies also impose a larger co-pay for out-of-network providers, or may even treat the entire charge as ineligible for payment under the policy. Unless the provider agrees to reduce his rates, the patient will still owe the difference between the provider’s standard charges and any amount actually paid by insurance. An HSA can pay this “amount still owed” to an out-of-network provider. The insurance policy, by contrast, will not even count the uninsured portion of the out-of-network bill toward the deductible, nor is this amount included in the policy’s cap on total “out-of-pocket” costs.
In another example, an insurance policy may limit coverage for physical therapy to a maximum of 25 days per year. It makes no difference if the patient has two or more separate surgeries in the same year and genuinely requires more than 25 total days of therapy. (The additional days of therapy are a qualifying medical expense properly payable from the HSA if funds are available; but the insurance policy won’t pay, and won’t count the cost of the additional days as part of the deductible, nor as part of the cap on “out-of-pocket” expenses.)
Additionally, an orthopedic surgeon may tell the patient to buy an “ice machine” to circulate ice water through a pad that’s kept on the joint that was operated on (such as a knee or shoulder), to reduce swelling. Or to restore proper mobility, the doctor may tell the patient to rent a “range of motion” machine that exercises the shoulder or knee after surgery. The HSA can pay these medical expenses. The insurance company usually determines that neither the ice machine nor the range of motion machine is a necessary or covered medical expense under the policy. The expense doesn’t count toward the deductible, either.
The IRS definition of “qualifying medical expenses” extends beyond what most people consider “medical.” For example, most dental expenses and vision-care expenses (such as for glasses, contacts, and eye exams) are “qualifying medical expenses” and can be paid from an HSA. Maybe an employee with self-only coverage under an HDHP (provided by his employer) has no dental or vision insurance. By setting up an HSA, this individual can pay his dental and vision expenses in full from his HSA, on a tax-advantaged basis, provided that he contributes sufficient amounts to the HSA to cover everything. If a person with an HDHP also has dental insurance and/or vision insurance, those expenses will be paid first from any separate insurance that applies, but any amounts not covered can be paid from the HSA.
Other miscellaneous costs are considered by the IRS to be “qualifying medical expenses,” although health insurance typically will not cover them. As some examples, an HSA can pay for over-the-counter (non-prescription) medications for various medical conditions, as well as a range of medical supplies and equipment (if required for a medical condition), such as a wheelchair, crutches, bandages, blood pressure monitor, over-the-counter medical testing kits, and supplies for conditions such as diabetes and allergies.
As another advantage, an individual can pay qualifying medical expenses for his spouse and other dependents, as well as for himself, from his HSA—even if he has self-only HDHP coverage. Perhaps an individual has an HDHP and dental care and vision care, covering only himself. He can use his own HSA to pay medical, dental and vision expenses for his wife and other dependents who have no insurance, or for unreimbursed deductible or co-pay amounts.
The limiting factor is that a self-only HDHP allows a maximum annual HSA contribution of $2,850 in 2007—or $3,650 if the individual is at least 55 but under 65. This amount may not be enough to cover expenses falling within the individual’s own deductible, plus all expenses for the rest of the family. Still, there’s an important tax advantage for the individual in stretching as far as possible with the amount that’s allowed—taking the largest permitted HSA contribution in relation to his self-only HDHP, and using those HSA funds as far as they will go in paying qualifying medical expenses for himself and his dependents.
The IRS definition of “dependent” determines whose “qualifying medical expenses” are eligible for reimbursement from an HSA. Dependents covered by health insurance (other than a spouse) must be under 19—or up to 23 if an unmarried full-time college student. By contrast, the IRS rules have no age cut-off in determining “dependent” status. An IRS-recognized dependent should include any relative for whom the taxpayer is providing more than 50% financial support—such as an 80-year-old mother who lives with her adult child’s family. The adult child provides housing and food, and pays a variety of other expenses. An accountant could analyze all of this more precisely, but if this lady actually meets the test for a dependent, her “qualifying medical expenses” can be paid from that child’s HSA—medical, dental, vision, health supplies–anything that Medicare or other insurance doesn’t cover in full.
3. Accumulating Tax-Advantaged Savings
I suggested earlier that a higher-income individual should probably consider making maximum annual HSA contributions just to use the opportunity to reduce taxable income each year, and to create a fund that earns tax-free income. (This is true regardless of whether the individual actually intends to use the money in the HSA at any time in the near future to pay medical expenses not covered by insurance.)
To focus again on the most permissive set of facts, if a husband and wife are both 55 but under 65 and have a family-coverage HDHP, they can contribute up to $7,350 to an HSA in 2007. If this couple were to contribute the maximum amount for ten years, and decided to pay no medical expenses at all from the HSA so as to maximize the tax-free earning capability of this account, the HSA balance would easily be more than $100,000 by the time they are 65. (Someone who is 65 or older can no longer make contributions to an HSA).
It may seem “extreme” to talk about accumulating that much money in an HSA for two people and not using it to pay current medical expenses. However, medical costs will continue to increase, and $100,000 (ten years from now) won’t pay even half of the projected average medical costs of just one person during retirement. (Medicare and insurance supplements will not pay everything. A person who goes into retirement with a decent net worth and wants to preserve something for his heirs should seriously consider any good method of limiting the impact of possibly large future medical expenses.)
Everyone won’t need to go into a nursing home, or an assisted care center, or even require home health care. But costs in these categories will continue to escalate. The average nursing home stay costs almost $150,000 today—and will be substantially more in the future. Many people assume incorrectly that the government will pay for their nursing home care. In reality, only those people who are or have become poor, after exhausting most of their assets, can qualify for government-paid nursing home care. Nor will the government pay for assisted living for the person with substantial assets.
If someone goes into retirement with at least several hundred thousand dollars of net worth, and wants to preserve it as long as possible, or hopes to pass something down to heirs, it’s probably worthwhile to consider buying long-term care (LTC) insurance. (No LTC insurance policy will pay everything; but, depending on the provisions that are selected, LTC insurance can significantly lighten the financial burden if someone becomes feeble or incapacitated.)
Some financial advisors suggest purchasing LTC insurance around age 60. The average person then may have to pay premiums for 20 or 30 years. The earlier this insurance is purchased, the lower the premiums will be. If a person waits until age 70, for example, to buy LTC insurance, the premiums will be substantially higher. It’s also important to buy LTC insurance before medical conditions make it impossible to obtain insurance.
The IRS considers LTC insurance premiums to be “qualifying medical expenses” within certain limits (depending on the person’s age). Within these IRS limits, LTC premiums can be paid from an HSA. For a person who is near age 60 (but still under 65), being able to pay LTC premiums from an HSA is probably sufficient reason by itself for making maximum annual HSA contributions.
In 2007 someone who is at least 50 but under 60 can treat up to $1,110 of LTC insurance premiums per year as qualifying medical expenses; someone who is at least 60 but under 70 can include $2,950 per year; and someone 70 or older can treat a total of $3,680 per year of LTC insurance premiums as qualifying medical expenses. These amounts adjust annually for inflation.
Although someone who is 65 or older can no longer contribute to an HSA, he can continue to spend the carryover funds in an HSA for medical expenses, including LTC insurance premiums. Most higher-income individuals (because they can afford it) should start “banking” HSA balances before age 60, by making the maximum HSA contribution each year. In retirement, an individual can continue to draw upon that HSA “nest egg” to pay continuing annual LTC premiums, Medicare co-pays, miscellaneous medical expenses and/or home health care or nursing home expenses, for both the individual and eligible dependents, such as an elderly parent.
4. Full Deduction in First Year
Until now, IRS rules have required an individual to pro-rate his HSA contribution in the taxable year when the HSA is set up. Let’s assume that an individual became insured under a self-only HDHP on September 1, 2006, and also established his HSA on that date. His maximum allowable HSA contribution for 2006 (before this year’s changes) would be divided by twelve, and then multiplied by the number of full months (four) remaining in the taxable year after both the HDHP and the HSA are in place. If the individual’s self-only HDHP had a deductible of $1,050 (the smallest deductible allowed in 2006), HSA rules (before the changes) allowed a maximum 2006 HSA contribution equal to the deductible amount multiplied by the appropriate fraction of a year. In this example, only one-third of the calendar year remained when the HSA was set up, so the maximum 2006 HSA contribution would have been $350 (one-third of $1,050).
This approach created a problem in terms of who pays the medical bills, and from what source: As soon as HDHP coverage begins, the individual becomes liable (in the example just given) for the first $1,050 of covered medical expenses, before the insurance policy pays anything. If a person is limited to a $350 HSA contribution in the first calendar year because only four months remain in the year, that individual will not have enough funds in the HSA to pay medical bills up to the $1,050 deductible. (This is especially harsh for a lower-earning employee, who may not have other funds available. An employer often contributes part of the money deposited to an employee’s HSA, but in this case couldn’t contribute more than the $350 allowed in the first four months.)
No one can completely “schedule” medical expenses or spread them out evenly over a year. For the individual living from paycheck-to-paycheck, the risk of having to pay large medical expenses without warning (because of a high deductible), while having only $350 in the HSA, might cause anxiety or actual hardship.
With the new rule changes, the result in 2007 will be far different. Let’s assume that the individual has a self-only HDHP (with an $1,100 deductible) and that an HSA is established on September 1, 2007. Because it’s 2007, the individual can immediately contribute as much as $2,850 to the HSA (or $3,650 if he’s at least 55 but under 65), with no pro-rating. With this approach, the HSA can be well-funded from the beginning, and can pay all medical expenses (not paid by the HDHP) on a tax-advantaged basis.
There is a “catch,” however: The person who makes a “full-year” HSA contribution in 2007 or later—if the HSA is established part-way into the taxable year—will be subject to a “testing period.” The individual’s HDHP coverage must continue in force until at least the end of the taxable year following the taxable year in which the HSA is set up. If the HDHP does not remain in place that long, the “excess” contribution in the first year (the actual contribution minus what the partial-year pro-rated amount would have been under prior law as explained above), will be taxable income and also subject to a 10% penalty.
For example, if an HSA is established on September 1, 2007, the individual has self-only HDHP coverage, and $2,850 is contributed to the HSA at that time, then one-third of that amount (four months’ worth) will be the pro-rated amount (under the old rule) and two-thirds will be the “excess” amount that is subject to the testing period. If the individual’s HDHP coverage terminates before year-end 2008 (in this example), the “excess” two-thirds of $2,850 ($1,900) will be included in the individual’s 2008 income, and a penalty equal to 10% of $1,900 will also be owed.
Employers switching to HDHP coverage will need to leave that coverage in effect for at least two years, so that employees who have made the maximum HSA contribution in the first year will avoid the “testing period” problem. Employees who quit their jobs or are fired too soon after establishing an HSA may also have a “testing period” problem unless they use their COBRA benefits to continue under the former employer’s insurance plan, or else can switch to other HDHP coverage, such as with a new employer. (The testing period does not apply in the case of disability or death.)
5. Transfer from IRA to HSA
Initial funding of the HSA can be a hurdle for some people. In particular, lower-earning individuals may be afraid of high-deductible insurance because they don’t have money to pay medical bills falling within such a high deductible. They also don’t have enough money to make an HSA contribution in an amount equal to the deductible, from which medical bills could be paid.
One approach might be for an employer to make a one-time HSA contribution for each employee, equal to perhaps half of the deductible amount; and from there, the employee can use a monthly payroll deduction to the HSA, equal to one-twelfth of the desired ongoing annual contribution amount. With luck and careful planning, an employee may eventually build up an HSA balance equal to the deductible, and hopefully can sustain it at that level in the future.
Some individuals won’t receive any employer contribution to their HSA, and also don’t have any extra money. To help in this situation, new provisions allow a one-time direct transfer from the individual’s IRA (if he has one) to his HSA.
On a one-time basis, the individual can elect to take a “qualified HSA funding distribution” from his IRA. This distribution is tax-free and penalty-free. It must be handled as a direct bank-to-bank transfer, not by making a distribution to the person.
The maximum amount that can be transferred from an IRA to the HSA equals (a) the individual’s maximum allowable HSA contribution for that year (depending on the type of HDHP and the individual’s age), minus (b) any contributions already made to the HSA that year. This transfer from IRA funds is not a deductible contribution to the HSA.
For example, if the person has self-only HDHP insurance, which allows a maximum HSA contribution of $2,850 (in 2007), and that person has already contributed $1,200 earlier this year, the maximum allowable transfer from the IRA would be the difference, or $1,650. If nothing has been contributed yet for the year, then a transfer up to $2,850 is allowed from an IRA in this example. Any transfer from an IRA must be in a lump sum, not installments. If the first transfer is not as large as the individual is eligible to make, he can’t transfer any more from the IRA later.
There is only one exception: If the individual had self-only HDHP coverage when he made his first transfer from his IRA to his HSA, and later he has family HDHP coverage, he will be allowed at that later time to make an additional one-time transfer from his IRA to his HSA. This later transfer must be no larger than the maximum HSA contribution he could make in the later year with respect to a family-coverage HDHP, minus the amount of the first IRA transfer. Any HSA contributions he has already made in the later year will also affect the permitted amount of the transfer.
There is also a “testing period” for a transfer from an IRA to an HSA. HDHP coverage must remain in effect for not less than twelve calendar months following the month in which the IRA transfer occurs. (HDHP coverage must already be in effect for the month when funds are contributed to an HSA, so terminating HDHP coverage at the end of one year of coverage will not be enough to satisfy the testing period.) If HDHP coverage does not remain in place throughout the required testing period, the entire amount transferred from the IRA to the HSA will be included in taxable income, and subject to a 10% penalty—just like an early withdrawal from an IRA.
2. Legal Briefs January-December 2006 Index
Following is a cumulative index of Legal Briefs from January through December 2006
Bank Name, Deceptive Use of…….. July
Check Conversion…….. February
Check Scams…….. April
CIP—Alternative Methods…….. March
Credit Report File Freezes…….. August
Deceptive Use of Bank Name…….. July
Deposit Insurance Reform…….. April
EFT Transactions…….. February
Exploitation of Elderly or Disabled…….. July
FACT Act…….. January
Fair Credit…….. January
FDIC Insurance of IRA’s…….. April
Holding Company Debt Levels…….. March
IRA’s …….. April, November
Late Fee Increase…….. May
Loans to Service Members…….. December
Manufactured Homes/Fixture Filings…….. May
Mechanic’s Lien Changes…….. October
Medical Information/Loan Approval…….. January
Money Services Businesses…….. May
Money Transmitters…….. May
Oil & Gas UCC-1 Filings…….. May
P. O. D. Beneficiaries…….. June
Payroll Cards…….. September
Predatory Lending…….. December
Regulation E Changes…….. February, March, September
Safe Deposit Box “Access on Death”…….. June
Service Members & Dependents…….. December
Small Loan Dollar Adjustments…….. May
UCC-1 Searches…….. May
UCCC Annual Adjustments…….. May