New Health Savings Accounts: How Will They Work?

President Bush signed into law last week the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. Among other things, it includes provisions for health savings accounts (HSAs) starting in 2004. HSAs are accounts, like IRAs, to which individuals can make contributions that may be used to reimburse the individual on a tax-free basis for qualifying medical expenses. HSAs are not subject to the "use-it-or-lose-it" rule ( i.e. unused amounts carry over from year to year) and are portable. As a result, HSAs have advantages over health care flexible spending accounts that many employers offer through a cafeteria plan.

Eligibility. An individual is eligible to have an HSA if he or she is covered by a high deductible plan ($1,000 individual/$2,000 family), is not also covered by another plan without a high deductible, is not yet eligible for Medicare, and cannot be claimed as a dependent on another person's tax return. In addition, the maximum out-of-pocket expenses ( e.g., deductibles, co-payments) must be no more than $5,000 for employee-only coverage and $10,000 for family coverage (as indexed for inflation).

Contributions. Generally, contributions are deductible if made by an eligible individual. There are no income limits for individuals claiming a deduction, and the deduction is an "above-the-line" adjustment to income. Contributions are also excludable from gross income and from wages for employment tax purposes if made through an employer. The Act provides that HSAs can be offered under a cafeteria plan. The maximum annual HSA contribution is the lesser of 100% of the annual deductible or an indexed amount (in 2004, $2,600 for employee-only coverage and $5,150 for family coverage). However, the new law also permits an additional "catch-up" HSA contribution for individuals who will be age 55 or older by the end of the year, starting at $500 in 2004 and increasing by $100 each year until reaching $1,000 in 2009. Special rules apply in the case of married individuals where either spouse has family coverage. In addition, accounts may be rolled over into another HSA.

Funding. An HSA is funded through a tax-exempt trust. The trustee can be a bank, insurance company, or another person designated by the Secretary of the Treasury. HSAs are not taxed on their earnings. An HSA that is funded with pre-tax deferrals or employer contributions generally would be a welfare plan under ERISA subject to the requirements that apply to funded plans.

Distributions . Distributions from an HSA are not includible in gross income if used to pay for "qualified medical expenses," including certain insurance premiums ( e.g. , premiums for COBRA continuation coverage), deductibles, and co-payments under a health plan as well as expenses not covered under the employer's health plan. Distributions not used to pay for qualified medical expenses are includible in gross income and are subject to an additional 10% tax, except in the case of distributions made after the account beneficiary's death, disability, or attainment of Medicare eligibility.