Health Savings Accounts A Technical Outline Echelon Benefits LLC (March 2007) Section 2101 of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 added Code §223 authorizing Health Savings Accounts (“HSAs”), effective January 1, 2004. The law was expanded under the Health Opportunity Patient Empowerment Act of 2006. The statute and IRS guidance are summarized in this outline. 1. Basic Concept of Code §223. An individual may deduct contributions to an HSA for any period of time the individual is covered by a high deductible health plan (“HDHP”) and no other plan. Earnings accumulate in the HSA tax-free, and amounts can be withdrawn taxfree to pay or reimburse for out-of-pocket qualified medical expenses. Amounts withdrawn for any other purpose are taxed as ordinary income, along with a penalty tax if withdrawn before age 65. 2. Health Savings Account. An HSA is a trust with an IRS-approved trustee (or custodian) established to pay qualified medical expenses, and that accepts only cash contributions that do not exceed (except for rollovers) the annual limits. The trust may not hold life insurance, and the balance in the account must be nonforfeitable to the account holder. Although spouses may not establish joint accounts,1 an individual may have multiple HSAs (though the rules apply as if one HSA were established). Any investment allowed in an IRA is allowed in an HSA, and the IRA prohibited transaction rules apply to an HSA. 3. Qualified Medical Expenses. Generally, qualified medical expenses (“QMEs”) are amounts paid for medical expenses by the HSA with respect to the account holder, spouse or dependent (even if the spouse or dependent are not covered by an HDHP), that are deductible under Code §213(d). Health insurance premiums are not QMEs, unless while receiving unemployment benefits, for COBRA coverage, for deductible qualified long-term care (even if the HSA contributions were made by Code §125 cafeteria plan contributions2), paid by a Medicare-eligible individual for coverage that is not supplemental to Medicare, or paid by a retiree for Medicare premiums.3 4. Contributions a. Limits. Contributions to an HSA by or for4 an eligible individual who is an HSA account holder are deductible by the eligible individual (from adjusted gross income, but not Schedule C or self-employment income5) up to $2,8506 for self-only coverage ($5,650 for family coverage). These are the 2007 limits, and are: (i) (ii) indexed for inflation (as of March 317 of the preceding year), rounded to the nearest $50; determined on a pro rated monthly basis based on the individual’s eligibility as of the beginning of the month (but see Special Rule below);
(iii) increased by $800 in 2007 (and an additional $100 per year through 2009) if the individual will have attained at least age 55 by the end of the year; and (iv) reduced by amounts contributed on behalf of the individual to an Archer MSA, or by an employer to an HSA.
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Special Rule for Individuals Becoming Eligible During Year. An individual who becomes covered by HDHP coverage during the year is treated as being covered for the entire year based on the type of coverage (HDHP or non-HDHP) he or she has as of December of that year. For example, an individual who obtains only HDHP coverage beginning in October 2007 will not be required to prorate the HSA contribution limit described in clause (ii) of this paragraph if he or she has only HDHP coverage as of December. However, the individual must remain HSAeligible for entire succeeding calendar year (unless ineligibilty is caused by death or disability) or he or she will incur taxable income in that succeeding year to the extent contributions were allowed in the prior year under this special rule (plus a penalty tax of 10% of that additional taxable income).8 b. Family Coverage. “Family coverage” is health insurance coverage of an eligible individual other than self-only coverage. If family coverage contains individual (“embedded”) deductibles within family coverage, then the sum of the individual deductibles is the amount of the annual deductible if that sum is less than the overall (“umbrella”) deductible.9 c. Effect of Spouse’s Plan. An individual with HDHP coverage will not become ineligible for HSA contributions merely because that individual’s spouse has either individual nonHDHP coverage or family non-HDHP coverage that does not cover the individual.10 However, a married individual covered by his or her spouse’s non-HDHP will be ineligible for HSA contributions. If both spouses have HSAs and are eligible, the limit is split equally among them, or shared as they may otherwise agree. A married individual not covered by his or her spouse’s non-HDHP plan may nonetheless have family HDHP coverage and contribute the family maximum to an HSA, though none may be contributed to the ineligible spouse’s HSA.11 Non-HDHP coverage of a nonspouse dependent does not affect the contribution limitation available to the individual (e.g., parent) who covers the dependent under an HDHP policy. d. If Medicare Eligible. An individual is ineligible for any month the individual is enrolled for Medicare coverage (including a government retiree enrolled in Medicare Part B12). Mere eligibility for Medicare, without enrollment, will not preclude an HSA contribution nor the HSA catch-up contribution.13 e. When to Contribute. Contributions for a calendar year must be paid to the trust during the year or by April 15 following the year (front-loading is allowed14). f. Who May Contribute. Any person may contribute to an HSA on behalf of an eligible individual,15 though only the HSA account holder will receive any tax deduction.16 Contributions paid to an HSA by an employer for an employee are generally exempt under Code §106(d). g. Contributing Too Much. An HSA custodian/trustee may not accept more than the maximum deductible amount for the year (including catch-ups). Excess combined and employee and employer contributions to an HSA (along with earnings), that are not corrected by the extended due date of the individual’s tax return, are subject to a 6% excise tax.17 Earnings attributable to the correction of an excess contribution are taxed in the year received.18
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h. Fees. Annual account fees can be paid from non-HSA assets without the payment counting against the limit.19 5. Eligible Individual. An “eligible individual” is determined on a monthly basis to determine the prorated contribution limit, and is any individual who (i) is covered by an HDHP on the first day of the month, (ii) is not covered by a non-HDHP plan while covered under the HDHP plan unless the non-HDHP plan covers only permitted insurance and coverage (see section 6 below) not covered under the HDHP, (iii) is not claimed as a personal exemption on another’s tax return for the year and (iv) is not enrolled in Medicare. An individual will not fail to be an eligible individual merely because the individual (i) is given a choice by his or her employer to be covered under a non-HDHP,20 (ii) was eligible for veteran’s (VA) health benefits, provided no VA health benefits were actually received during the prior 3 months,21 (iii) receives health care services at a discount (e.g., using a pharmacy discount card, which could be viewed as a form of non-HDHP) so long as the individual must pay all the discounted costs up to the HDHP deductible,22 or (iv) is covered by an employee assistance, disease management or wellness program that does not provide significant medical care or treatment23. TRICARE (the military services program) coverage is not HDHP coverage, and will cause an individual to be ineligible.24 Flexible Spending Accounts and Health Reimbursement Arrangements. Coverage under a flexible spending account (“FSA”) or a health reimbursement arrangement (“HRA”), even a spouse’s FSA or HRA, that covers expenses incurred before the minimum deductible under the HDHP will generally cause the individual to be ineligible.25 FSA or HRA coverage solely for dental, vision and preventive care or other co-pay amounts incurred after the HDHP deductible has been satisfied,26 will not affect HSA eligibility or the maximum contribution amount. FSA coverage by reason of the 2½ month grace period allowed under the FSA cafeteria plan rules will generally disqualify an individual for HSA contributions, unless (i) the grace period provides HSA-compatible limited coverage (e.g., dental and vision, or post-deductible coverage)27or (ii) the balance in the FSA as of the close of the Plan Year is either zero or is rolled over to an HSA (see section 9(d)).28 Individuals with an HRA balance that is suspended (i.e., the balance is currently unavailable to pay QMEs other than permitted insurance and coverage) may qualify for an HSA if otherwise available.29 6. Permitted Insurance and Coverage. Insurance and other coverage of the following types (even with no or low deductibles) will not disqualify an individual from HSA eligibility. (i) (ii) (iii) (iv) (v) (vi) (vii) Dental. Vision. Accidents. Disability. Long-term care. Torts.* Workers compensation.*
(viii) Insurance related to ownership or use of property.*
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(ix) (x) (xi)
Insurance for a specified disease or illness (e.g., cancer, diabetes, asthma and congestive heart failure).* Prescription drug coverage is not permitted insurance.30 A fixed daily amount of hospitalization insurance.* Preventive care (as described in §1871 of the Social Security Act, and which must not treat an existing illness or condition, unless otherwise impracticable),31 which could include annual physicals and related tests, routine prenatal and well-child care, immunizations, stop-smoking and obesity weight-loss programs, certain specified screenings such as cancer, heart disease, infectious diseases and other conditions,32 drug costs and medications for conditions not yet manifested, such as cholesterollowering drugs, and tobacco-cessation programs.
*These coverages must be provided under an insurance contract (i.e., not self-insured by an employer) unless coverage is required by statute and the health benefit is incidental.33 7. High Deductible Health Plan. An HDHP is a health plan (including a state high-risk plan34 and an employer self-insured plan35) that, either by design or as it applies to the covered person or family36, provides for the following: a. Minimum Deductible. For 2007, the minimum annual deductible is $1,100 ($2,200 for family coverage). The policy may (i) have a reasonable lifetime limit on benefits under the policy37 and (ii) credit, toward the deductible, expenses incurred before a mid-year change by an employer to a new plan (even if old plan is a non-HDHP)38 or from selfonly to family coverage during the year.39 A deductible based on a period of more than 12 months is appropriately adjusted for the longer period to determine whether the minimum is satisfied.40 An individual deductible within family coverage may not be less than the overall minimum deductible for family coverage.41 b. Maximum Out-of-Pocket. For 2007, the maximum annual out-of-pocket amounts (excluding premiums) payable by the individual is $5,50042 ($11,000 for family coverage). However, a plan using a network of providers may have a higher limit for services provided out-of-network (though the in-network deductible determines any prorated contribution limit43). Also, out-of-pocket maximum requirements do not take into account (i) reasonable “UCR” restrictions, (ii) reasonable lifetime limits (e.g., $1 million) and reasonable annual limits or outright exclusions on specific benefits if significant other benefits remain after the limitation or exclusion (e.g., substance abuse, fertility treatments; but a maximum annual benefit of $10,000 for any condition would not be reasonable)44 or (iii) penalties (including a higher copay) for failing to obtain precertification for a specific provider or procedure. Copays not counted toward a deductible (e.g., a copay for preventive care that is not subject to the deductible) are counted toward the out-of-pocket maximum.45 Individual deductibles for each family member will not disqualify the HDHP, provided they cannot cause the out-of-pocket maximum to be exceeded.46 c. Permitted Insurance. Permitted insurance is not substantially all of the coverage under the plan. 8. Taxation. a. Earnings. HSA earnings are not subject to income tax, though unrelated business income tax under Code §511 could apply. Engaging in a prohibited transaction, or pledging the account, will disqualify the HSA resulting in taxable income. -4-
b. Distributions. HSA distributions used exclusively to pay, or reimburse for, QMEs and account maintenance and administration fees47 are not taxable, even if to pay QMEs of a spouse or dependent covered by a non-HDHP plan48, and even if paid when the account holder is ineligible for HSA contributions. Taxable HSA distributions are subject to an additional 10% tax, unless paid on account of disability, death or after having attained Medicare eligibility age. A distribution from an HSA resulting from a mistake of fact due to reasonable cause may be repaid to the HSA without tax effect if repaid by April 15 following the close of the year in which the mistake was, or should have been, discovered.49 Accumulated QMEs. QMEs may provide the basis for an HSA tax-free distribution during any subsequent year, provided (i) the QME was incurred after the establishment of the HSA, was not previously reimbursed, and was not taken as an itemized deduction, and (ii) the distribution was used exclusively to pay or reimburse for the QME. Records must be maintained to support this treatment.50 c. Excess Contributions. Excess HSA contributions are nonrollover contributions that are neither deductible nor excludable (if employer paid) from gross income. Distributions of excess contributions for a year are not taxable if distributed by the extended due of that year’s tax return, along with earnings (which are taxed in the year distributed) computed in the same manner as for IRA excess contributions. d. Rollovers. Rules similar to the IRA rollover rules apply. HSA and Archer MSA distributions may be rolled over tax-free to another HSA within 60 days of the distribution. An individual may roll over an HSA distribution only if no rollover was made during the prior 1-year period. Trustee-to-trustee transfers are not rollovers, and are not subject to the 1-per-year rule. e. Deductions of QMEs. QMEs used to support tax-free HSA distributions are not deductible as medical expenses under Code §213. f. Divorce. HSA transfers incident to a divorce decree are not taxable and will be treated as having established an HSA for the recipient. g. Death Distributions. HSA accounts acquired by a surviving spouse beneficiary are treated as if the spouse is the HSA account holder. Any other account acquisitions on account of death disqualify the HSA and are taxable to the acquiror in the year of death (reduced by any QMEs paid by the HSA within 1 year of death, and with an appropriate deduction allowed for estate taxes under Code §691(c)) or, if the beneficiary of the HSA is the decedent’s estate, in the final taxable year of the decedent. 9. Contributions for Employees a. Funding Outside Cafeteria Plan – The Comparability Rule. Employers may contribute to the HSAs of HSA-eligible employees, and those contributions are not taxable to the employee. However, Code §4980G imposes a 35% excise tax on employer contributions to the HSAs of all employees if the contributions do not satisfy the comparability rule. The comparability rule is satisfied only if comparable contributions are provided for all eligible employees in the same category who receive the same category of coverage as provided under the HDHP.51 (1) Comparable Participating Employees. The various groups requiring comparable contributions are self only, self + 1, self + 2 and self + more than 2. Comparable -5-
contributions are provided to a category described above if, during the calendar year, all employees in the category, who are covered under an employer HDHP policy,52 receive either the same dollar amount of employer contributions or the same percentage of the policy’s annual deductible. If the employer contributes to the HSA of an employee who is not covered under the employer’s HDHP (e.g., the employee is covered under a spouse’s HDHP), then the employer must contribute to the HSAs of all comparable employees who are HSA eligible.53 Contributions for any self + 2 category must be at least as great as those for any self + 1 category, and contributions for any self + 3 or more category must be at least as great as for any self + 2 category. Collectively-bargained employees can be disregarded for comparability testing,54 and highly compensated employees can be disregarded for purposes of testing comparability for nonhighly compensated employees.55 An employer will generally fail the comparability rule if it conditions HSA contributions on (for example) health status, age, length of service or eligibility for the additional catch-up contribution.56 An employee who has HDHP coverage other than through the employer (e.g., individually or through a spouse) can be disregarded for this rule, but only if the employer disregards all such employees.57 (2) Categories of HDHP Coverage. There are 3 “categories” of HDHP coverage: (i) current full-time employees, (ii) current part-time employees and (iii) former employees (excluding former employees on COBRA).58 A “full-time” employee is an individual who is customarily employed for at least 30 hours per week. An employee who changes his or her category during the year (e.g., full-time to parttime) is tested for comparability on a monthly basis (e.g., employee who is full-time for 5 months of the year must receive the comparable full-time employer contribution for those 5 months).59 Summary of Categories. The following matrix summarizes the 12 categories of employees who are separately tested for comparability (subject to the rule in (1) above that any “Self +” category may not receive greater contributions than any other Self + category with more dependents). Self Only Full-Time Employees Part-Time Employees Former Employees (4) 1 5 9 Self + 1 2 6 10 Self + 2 3 7 11 Self + 3 or More 4 8 12
(3)
Funding. An employer may fund contributions for comparable employees at any time during the year (e.g., pre-funding at beginning of the year, monthly funding and retroactive funding), provided the method is consistently applied to all comparable employees at the beginning of the year.60 Separately, a funding method must be applied consistently for comparable employees who become eligible after the beginning of the year. If pre-funding results in an overcontribution for an employee who terminates during the year, the employer cannot retrieve the overpayment. An employer will not fail these funding method requirements merely -6-
because an employee delays the setup of his or her HSA preventing timely contributions, provided the employer catches up timely when setup is complete.61 An employer need not make comparable contributions for an employee who fails to set up his or her HSA by year-end. (5) (6) Sole Proprietors and Partners. Contributions to a sole proprietor’s or partner’s HSA need not be comparable because the comparability rule applies only to employees.62 Co-Employee Spouses. A spouse employed by the same employer who has family HDHP coverage from the other spouse need not receive comparable contributions, unless the employer contributes to the HSA of an employee who participates in a nonemployer-sponsored HDHP.63 Match Contributions Generally Not Comparable. In general, an employer will not satisfy the comparability rule by matching employee HSA contributions because comparable employees will receive varying employer contributions.64 (But, match contributions are allowed in connection with a cafeteria plan, as discussed below.) Employee After-Tax Contributions Not Subject to Comparability. Contributions to an HSA made by an employee who chooses to make after-tax contributions (and forego pre-tax cafeterial plan contributions) are not “employer” contributions, and thus not subject to comparability testing.65
(7)
(8)
b. Funding Through a Cafeteria Plan. HSA contributions may be made by employees through a cafeteria plan, and an electing employee may prospectively commence or change his or her contribution election anytime.66 HSA contributions through a cafeteria plan are subject to the cafeteria plan nondiscrimination rules.67 Negative elections for HSA cafeteria plan contributions are allowed.68 (1) Matching Contributions. Employer matching contributions paid through a cafeteria plan are not subject to the comparability rule discussed above (e.g., employer may pay $1 of employer contributions for each $1 employee contributes to an HSA, even though some employees will contribute zero and receive zero match).69 Self-Employed Cannot Participate. Self-employed individuals, 2% shareholders of S corporations and partners cannot participate in a cafeteria plan, and thus cannot contribute to an HSA through a cafeteria plan. In general, a partner or 2% shareholder may deduct the partnership’s or S corporation’s HSA contribution made on his or her behalf.70
(2)
c. Employer Duties. To determine eligibility for tax-free HSA contributions, employers must consider only the coverage under the employer’s health plans (and their deductibles) and the employee’s age (for catch-ups) based on the employee’s representations.71 Employer contributions to HSAs are nonforfeitable. Therefore, a front-loaded employer contribution that later becomes an excess contribution (perhaps due to the employee’s termination during the year) cannot be recouped by the employer.72 d. Special FSA/HRA Rollover Rule. A participant in a cafeteria plan flexible spending account (FSA) or a health reimbursement arrangement (HRA) may, if such FSA or HRA provides, roll over from the FSA or HRA account to his or her HSA an amount equal to the lesser of the amount in the FSA or HRA account as of either September 21, 2006, or the date of rollover. The rollover must be made before January 1, 2012, and may be made only once from any particular FSA or HRA. The rollover will be taxable (with a -7-
10% penalty tax) if (and when) the individual is not an HSA eligible individual for the 12 month period beginning with the month of the rollover (other than by reason of disability or death). The rollover will be treated as if it were an employer-paid contribution, but not subject to the comparability rule described in section 9(a) above if all FSA/HSA participants who are eligible individuals may similarly roll over.73 e. Special IRA Direct Transfer Rollover Rule. An individual may elect a tax-free direct transfer from an individual retirement account to an HSA in an amount equal to the annual contribution limit applicable to the individual at the time of the rollover, reduced by any FSA/HRA rollovers previously made by the individual. An IRA to HSA rollover may be elected only once in the lifetime of an individual, unless the individual is family eligible and is electing to rollover an amount equal to the current family eligible limit and reduces that rollover by the amount of a previous IRA rollover that was limited to the self-only amount.74 The rollover will be taxable (with a 10% penalty tax imposed on the amount that would not be tax-free basis recovery in the IRA) if (and when) the individual is not an HSA eligible individual for the 12 month period beginning with the month of the rollover (other than by reason of disability or death). 10. Custodians and Forms. Any life insurance company defined in Code §816, bank described in §408(n) or IRS-approved nonbank trustee or custodian under Treas. Reg. §1.408-2(e) may be an HSA custodian or trustee. HSAs may be established with model Form 5305-B (trust account) and 5305-C (custodial account). 11. ERISA Coverage. In general, an HSA will not be an “employee benefit plan” within the meaning of the Employee Retirement Income Security Act of 1974 (“ERISA”), so long as (i) it is completely voluntary on the part of the employee, (ii) the employer does not limit the employee’s ability to transfer the HSA funds or utilize them as provided in the Code, (iii) the employer does not make or influence the investment decisions of HSA funds, (iv) the employer does not represent that the HSA is an employee benefit plan or (v) the employer does not receive any payment or compensation in connection with the HSA.75 The DOL has interpreted the “completely voluntary” rule principally to mean that an employee may not be required to contribute to an HSA by an employer, and that employer HSA contributions without affirmative employee consent does not itself subject the Plan to ERISA.76 Similarly, the employer may restrict HSA contributions to a single HSA vendor, or pay the employee’s HSA vendor fees, without necessarily creating an ERISA plan.
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IRS Notice 2004-50, Q&A-63 IRS Notice 2004-50, Q&A-40 3 IRS Notice 2004-50, Q&A-45 4 IRS Notice 2004-2, Q&A-18 5 IRS Notice 2004-50, Q&A-84 6 IRS Rev. Proc. 2004-71 7 Code §223(g), as amended by HOPE Act of 2006 8 Code §223(b)(8), as amended by HOPE Act of 2006 9 IRS Notice 2004-50, Q&A-30 10 IRS Rev. Rule 2005-25 11 IRS Notice 2004-50, Q&A-31 12 IRS Notice 2004-50, Q&A-4 13 IRS Notice 2004-50, Qs&As-2 and 3; IRS Announcement 2004-67 14 IRS Notice 2004-2, Q&A-21 15 IRS Notice 2004-50, Q&A-28
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16 17
IRS Publication 969, p. 2 Code §4973(a)(5) and (g). 18 IRS Notice 2004-2, Q&A-22 19 IRS Notice 2004-50, Q&A-71 20 IRS Notice 2004-50, Q&A-1 21 IRS Notice 2004-50, Q&A-5 22 IRS Notice 2004-50, Q&A-9 23 IRS Notice 2004-50, Q&A-10. Screening and preventive care services are disregarded for purposes of determining whether significant medical care is provided. 24 IRS Notice 2004-50, Q&A-6 25 IRS Notice 2004-50, Q&A-33 26 IRS Rev. Rul. 2004-45 27 IRS Notice 2005-86 28 Code §223(c)(1)(B)(iii) as amended by HOPE Act of 2006 29 IRS Rev. Rul. 2004-45 30 IRS Rev. Rul. 2004-38 31 IRS Notice 2004-50, Q&A-26 32 IRS Notice 2004-23 33 IRS Notice 2004-50, Q&A-8 34 IRS Notice 2004-50, Q&A-13 35 IRS Notice 2004-2, Q&A-7 36 IRS Notice 2004-50, Q&A-20 37 IRS Notice 2004-50, Q&A-14 38 IRS Notice 2004-50, Q&A-22 39 IRS Notice 2004-50, Q&A-23 40 IRS Notice 2004-50, Q&A-24 41 IRS Notice 2004-2, Q&A-3 42 IRS Rev. Proc. 2004-71 43 IRS Notice 2004-2, Q&A-4 44 IRS Notice 2004-50, Q&A-15 & 16 45 IRS Notice 2004-50, Q&A-21 46 IRS Notice 2004-50, Q&A-20 47 IRS Notice 2004-50, Q&A-69 48 IRS Notice 2004-50, Q&A-36 49 IRS Notice 2004-50, Q&A-37 and 76 50 IRS Notice 2004-50, Q&A-39 51 Treasury Reg. §54.4980G-1, Q&A-2 52 Treasury Reg. §54-4980G-3, Q&A-7 53 Treasury Reg. §54-4980G-3, Q&A-7 54 Treasury Reg. §54-4980G-3, Q&A-6 55 Code §4980G(d), as amended by the HOPE Act of 2006 56 Proposed Treasury Reg. §54-4980G-4, Q&A-10&11 57 Proposed Treasury Reg. §54-4980G-3, Q&A-6 58 Treasury Reg. §54-4980G-3, Q&A-5 59 Proposed Treasury Reg. §54-4980G-4, Q&A-2 60 Proposed Treasury Reg. §54-4980G-4, Q&A-3&4 61 Proposed Treasury Reg. §54-4980G-4, Q&A-6 62 Proposed Treasury Reg. §54-4980G-3, Q&A-2&3 63 Treasury Reg. §54-4980G-3, Q&A-8 64 Proposed Treasury Reg. §54-4980G-4, Q&A-8 65 Treasury Reg. §54.4980G-2, Q&A-2 66 IRS Notice 2004-50, Q&A-58 & 59 67 Proposed Treasury Reg. §54-4980G-5, Q&A-2 68 IRS Notice 2004-50, Q&A-61 69 IRS Notice 2004-50, Q&A-47 70 IRS Notice 2005-8
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71 72
IRS Notice 2004-50, Q&A-81 IRS Notice 2004-50, Q&A-82 73 Code §106(e); IRS Notice 2007-22 74 Code §408(d), as amended by the HOPE Act of 2006 75 DOL FAB 2004-01 76 DOL FAB 2006-02
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