Health Savings Accounts
Congress modernized more than Medicare with the passage of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. The act also created Health Savings Accounts (HSAs), a pre-tax savings account employees can use to offset the rising costs of healthcare. HSAs provide a significant new way to lower employer health care benefits costs and reduce employees’ taxes. HSAs are available for individuals as well as for employees.
HSAs offer distinct advantages over the more familiar Flexible Spending Accounts (FSAs). Both accounts allow employees to contribute pre-tax dollars to a savings account for reimbursement of medical expenditures not covered by health insurance. But under FSA rules, any balance left over at the end of a calendar year is forfeited. The new HSAs allow an unused balance to be rolled over to future years. The account balance may also accrue interest with no tax on the earnings as long as the funds are only used to pay for qualified medical expenses. Funds can be withdrawn after retirement for any purpose penalty-free (although not tax free).
HSAs will help reduce the number of uninsured Americans by allowing small businesses more choice in the current small group market. By allowing more flexibility, HSAs afford employers a better opportunity to offer employees health insurance at reasonable rates.
HSAs are similar to consumer-directed health plans, which many employers are trying as an alternative to managed care in their attempts to cut health benefit costs. They give employees the opportunity to control their health care spending and choose a plan where they can manage some of their own health care dollars. If you assume responsibility for managing your own health care dollars you have to think about how you spend them. You don't want to rush off to the emergency room for every little sniffle.
Anyone, including an employer, can make contributions on behalf of the individual. All contributions are aggregated. If the employer contributes, the amount will be excluded from income and the employer gets the benefit of the deduction.
These accounts signal a historic change in the way we look at health care - introducing lower costs, increased control, and the ability to plan for the future. HSAs reduce insurance costs, enabling more employers to begin or retain health insurance benefits for their employees. They give people more control over who they see for health care services. And they encourage saving for future medical expenses, including retiree health expenses
Setting Up HSA Contributions Properly
Employer and employee HSA contributions can be made in one of two ways:
1) Direct Contributions
An employer may make a direct contribution to an employee's HSA on a "pre-tax" basis. This means that the contribution is not subject to federal income tax or FUTA or FICA taxes. An employee may make direct contributions to his or her HSA via payroll deduction or by writing a separate check using post-tax dollars, which also have tax advantages. Employee direct contributions are subject to FICA and FUTA taxes.
2)Contributions Through a Section 125 Cafeteria Plan
Employee contributions to an HSA through a Section 125 Cafeteria Plan are voluntary salary reductions and are not subject to federal income tax or FICA or FUTA taxes. For employee contributions to be treated in this manner, the employer must formally establish a Section 125 Cafeteria Plan. Generally, employee elections to an HSA under a Section 125 plan can be revoked or changed at any time on a prospective basis.
Employers may also make pre-tax contributions to an HSA through a Section 125 Cafeteria Plan, which involves a choice between contributions to the HSA or other employer provided benefits. All Section 125 Cafeteria plans must comply with federal regulations regarding non-discrimination, elections, qualifying events and other requirements. As a result, such plans are often more complex than all but the largest employers may want to contemplate.
S-Corporations and Partnerships
While S Corporation and partnership principals may benefit from the tax advantages of HSAs, they are classified differently because such principals are not considered "employees" for purposes of HSAs. Principals have choices as to how their HSA contributions are treated for tax purposes. They should consult with their tax advisors about the best approach for them. Generally:
- An S corporation is treated as a partnership for purposes of applying tax laws regarding fringe benefits. For any 2-percent (2%) shareholder of an S Corporation (considered a partner of a partnership), an S Corporation can contribute to the 2% shareholder's HSA in consideration for services rendered.
- Partnership contributions to a partner's HSA may be treated as distributions to the partner or as guaranteed payments. These two options have different effects on the taxes for both the partnership and the partner.
HSAs with HRAs or FSAs
Finally, it is important for employers to remember to be eligible to contribute to an HSA an employee must be enrolled in an HSA-compatible High Deductible Health Plan (HDHP) but not, with few exceptions, enrolled in another health plan.
Healthcare Flexible Savings Accounts (FSAs) and Health Reimbursement Arrangements (HRAs) are considered health plans for federal tax purposes. Employees covered under a health care FSA or HRA generally cannot make contributions to an HSA. Employees can, however, make contributions to an HSA while covered under an HDHP and one or more of the following:
- Limited-purpose health FSA or HRA — An FSA or HRA that reimburses qualified medical expenses not typically covered under an HDHP, such as dental expense or eye wear.
- Post-deductible health FSA or HRA — An FSA or HRA that reimburses only qualified medical expenses incurred after the minimum HDHP annual deductible is met.
- Retirement HRA - An HRA that reimburses only medical expenses incurred after an individual retires and is eligible for Medicare benefits, but no longer eligible to make contributions to an HSA.
Because FSAs and HRAs are considered "health plans," employers must make sure to prepare proper plan documents, such as Summary Plan Descriptions or plan summaries, which communicate plan provisions to plan participants. While there are, generally, no formal requirements for preparing HSA communications, it is a good idea to communicate the elements of your HSA program to employees with materials provided by your health plan.
Again, employers should consult their tax advisors for complete information on the above tax-related issues.