01 Dec Navigating Health Savings Accounts and Other Tax-Favored Plans
Over Thanksgiving I was asked to explain in basic sound bite terms the federal tax implications of the various health savings options. Caught off guard I stammered as eyes glazed over, heads drooped, and relatives closest to me pounced. It was brutal.
“Aren’t you an Enrolled Agent?” … “Licensed by the US Treasury to represent people before the IRS!” … “An expert on this kind of stuff!” … Good thing we love each other.
Afterwords as the Tryptophan wore off I found myself reviewing the Code and the Manual in an effort at redemption. That is what students of the US Tax Code do for entertainment, particularly when called out over the holidays by relatives.
IMHO the most efficient way to break these topics down into plain terms for general understanding is to reformat IRS Publication 969 with sprinkles of the Code to arrive at (hopefully) a more comprehensible rendition of the various options.
*SPECIAL NOTE*
IRS Pub. 969 is NOT a “substantiated authority” but nevertheless a good starting point to grasp the basics.
PM me for substantial authority references or with specific questions.
This post addresses 4 different health savings options; 2 general types of medical savings accounts and 2 general types of arrangements all with reasonably significant differences:
- Health Savings Accounts (HSA) – IRS Form 8889
- Medical Savings Accounts (MSA) – IRS Form 8853
- Flexible Spending Arrangement (FSA)
- Health Reimbursement Arrangement (HRA)
*** After a great deal of analysis and thoughtful consideration my family decided to go with an HRA administered by a third party. HRA’s are addressed at the very end of this post. ***
Health Savings Accounts (HSAs) – 26 U.S. Code § 223
A health savings account (HSA) is a tax-exempt trust or custodial account you set up with a qualified HSA trustee to pay or reimburse certain medical expenses you incur.
For an individual with self-only coverage under a high deductible health plan is $3,350.
For an individual with family coverage under a high deductible health plan is $6,650.
You must be covered under a high deductible health plan (HDHP), defined under § 223(c)(2)(A) as a health plan with an annual deductible that is not less than $1,300 for self-only coverage or $2,600 for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $6,450 for self-only coverage or $12,900 for family coverage.
You must be engaged on the first day of the month and have no other coverage except what is permitted under Other health coverage.
Also you cannot be enrolled in Medicare or be claimed as a dependent on someone else’s tax return.
Any eligible individual can contribute to an HSA.
For an employee’s HSA, the employer may contribute.
For an HSA established by a self-employed (or unemployed) individual, the individual or any other person can contribute on behalf of an eligible individual.
Contributions to an HSA must be made in cash, stock or property are not allowed.
The amount contriuted depends on the type of high deductible health plan HDHP coverage you have, your age, the date you become an eligible individual, and the date you cease to be an eligible individual.
Distributions are intended to be for qualified medical expenses.
Distributions from your HSA for qualified medical expenses are not subject to income tax.
The distribution is nevertheless still reported on IRS Form 8889.
The distribution of an excess contribution taken out after the due date, including extensions, of your return is subject to tax even if used for qualified medical expenses as per the instructions for the form.
Distributions from your HSA for not used for qualified medical expenses are subject to income tax and you may have to pay an additional 20% tax on your taxable distribution.
Year end balances are generally carried over to the next year as excess contributions.
Earnings on amounts in an HSA are not included in your income while held in the HSA.
- Filing Form 8889 – Health Savins Account
You must file IRS Form 8889 with your Form 1040 or Form 1040NR if you (or your spouse, if married filing a joint return) had any activity in your HSA during the year.
You must file even if only your employer or your spouse’s employer made contributions to the HSA.
If you want your employees to be able to have an HSA, they must have an HDHP. You can provide no additional coverage other than those exceptions listed previously under Other health coverage .
You can make contributions to your employees’ HSAs. You deduct the contributions on your business income tax return for the year in which you make the contributions.
If the contribution is allocated to the prior year, you still deduct it in the year the contribution is made.
For more information on employer contributions, see Notice 2008-59, 2008-29 I.R.B. 123, questions 23 through 27, available at www.irs.gov/irb/2008-29_IRB/ar11.html.
Medical Savings Accounts (MSAs)
An Archer MSA is a tax-exempt trust or custodial account that you set up with a U.S. financial institution in which you can save money exclusively for future medical expenses.
- The benefits from having an Archer MSA include:
You can claim a tax deduction for contributions you make even if you do not itemize your deductions on Form 1040 or Form 1040NR.
The interest or other earnings on the assets in your Archer MSA are tax free.
Distributions may be tax free if you pay qualified medical expenses.
The contributions remain in your Archer MSA from year to year until you use them.
An Archer MSA is “portable” so it stays with you if you change employers or leave the work force.
- To qualify for an Archer MSA, you must be either:
An employee (or the spouse of an employee) of a small employer that maintains a self-only or family HDHP for you (or your spouse).
A self-employed person (or the spouse of a self-employed person) who maintains a self-only or family HDHP.
- You can have no other health or Medicare coverage except what is permitted under Other health coverage.
- You must be an eligible individual on the first day of a given month to get an Archer MSA deduction.
If you are an employee, your employer may make contributions to your Archer MSA. (You do not pay tax on these contributions.)
If your employer does not make contributions to your Archer MSA, or you are self-employed, you can make your own contributions to your Archer MSA.
Both you and your employer cannot make contributions to your Archer MSA in the same year.
You do not have to make contributions to your Archer MSA every year.
Report all contributions to your Archer MSA on IRS Form 8853 and file it with your Form 1040 or Form 1040NR. You should include all contributions you, or your employer made.
You should receive Form 5498-SA, HSA, Archer MSA, or Medicare Advantage MSA Information, from the trustee showing the amount you (or your employer) contributed during the year.
Your employer’s contributions should be shown in box 12 of Form W-2, Wage and Tax Statement, with code R. Follow the instructions for Form 8853 and complete the worksheet in the instructions.
Report your Archer MSA deduction on Form 1040 or Form 1040NR.
You can receive tax-free distributions from your Archer MSA to pay for qualified medical expenses.
If you receive distributions for other reasons, the amount will be subject to income tax and may be subject to an additional 20% tax as well.
You do not have to make withdrawals from your Archer MSA each year.
If you use a distribution from your Archer MSA for qualified medical expenses, you do not pay tax on the distribution but you have to report the distribution on IRS Form 8853 – Archer MSA.
Follow the instructions for the form and file it with your Form 1040 or Form 1040NR.
If you do not use a distribution from your Archer MSA for qualified medical expenses, you must pay tax on the distribution.
You are permitted to take a distribution from your Archer MSA at any time; however, only those amounts used exclusively to pay for qualified medical expenses are tax free.
Year end balances are generally carried over to the next year as excess contributions.
Earnings on amounts in an Archer MSA are not included in your income while held in the Archer MSA.
Flexible Spending Arrangement FSA
Health FSAs are employer-established benefit plans. These may be offered in conjunction with other employer-provided benefits as part of a cafeteria plan. Employers have complete flexibility to offer various combinations of benefits in designing their plan.
- Self-employed persons are not eligible for an FSA.
You contribute to your FSA by electing an amount to be voluntarily withheld from your pay by your employer. This is sometimes called a salary reduction agreement.
Your employer may also contribute to your FSA if specified in the plan.
You do not pay federal income tax or employment taxes on the salary you contribute or the amounts your employer contributes to the FSA.
However, contributions made by your employer to provide coverage for long-term care insurance must be included in income.
At the beginning of the plan year, you must designate how much you want to contribute. Then, your employer will deduct amounts periodically (generally, every payday) in accordance with your election.
You can change or revoke your election only if there is a change in your employment or family status that is specified by the plan.
Generally, contributed amounts that are not spent by the end of the plan year are forfeited unless excepted.
Base your contribution on an estimate of the qualifying expenses you will have during the year.
Generally, distributions from a health FSA must be paid only to reimburse you for qualified medical expenses you incurred during the period of coverage.
You must be able to receive the maximum amount of reimbursement (the amount you have elected to contribute for the year) at any time during the coverage period, regardless of the amount you have actually contributed.
The maximum amount you can receive tax free is the total amount you elected to contribute to the health FSA for the year.
You must provide the health FSA with a written statement from an independent third party stating that the medical expense has been incurred and the amount of the expense.
You must also provide a written statement that the expense has not been paid or reimbursed under any other health plan coverage.
The FSA cannot make advance reimbursements of future or projected expenses.
Debit cards, credit cards, and stored value cards given to you by your employer can be used to reimburse participants in a health FSA.
If the use of these cards meets certain substantiation methods, you may not have to provide additional information to the health FSA.
For information on these methods, see:
Ruling 2003-43 on page 935 of IRB 2003-21 at www.irs.gov/pub/irs-irbs/irb03-21.pdf,
Notice 2006-69, 2006-31 I.R.B.107 available at www.irs.gov/irb/2006-31_IRB/ar10.html, and
Notice 2007-2, 2007-2 I.R.B. 254 available at www.irs.gov/irb/2007-2_IRB/ar09.html.
Flexible spending accounts are generally “use-it-or-lose-it” plans.
This means that amounts in the account at the end of the plan year generally cannot be carried over to the next year.
However, the plan can provide for either a grace period or a carryover.
The plan can provide for a grace period of up to 2½ months after the end of the plan year.
If there is a grace period, any qualified medical expenses incurred in that period can be paid from any amounts left in the account at the end of the previous year.
Your employer is not permitted to refund any part of the balance to you.
- Unlike HSAs or Archer MSAs which must be reported on Form 1040 or Form 1040NR, there are no reporting requirements for FSAs on your income tax return.
- For information on the interaction between a health FSA and an HSA, see Other employee health plans
Health Reimbursement Arrangements (HRAs) – IRS Notice 2013-54 – 26 U.S. Code § 105
An HRA is an arrangement that is funded solely by an employer and that reimburses an employee for medical care expenses (as defined under Code § 213(d)) incurred by the employee, or his spouse, dependents, and any children who, as of the end of the taxable year, have not attained age 27, up to a maximum dollar amount for a coverage period.
This reimbursement is excluded from the employee’s income. Amounts that remain at the end of the year generally can be used to reimburse expenses incurred in later years.
- The salient points about HRA’s IMHO include:
HRAs generally are considered to be group health plans within the meaning of Code § 9832(a), § 733(a) of the Employee Retirement Income Security Act of 1974 (ERISA), and § 2791(a) of the Public Health Service Act (PHS Act) and are subject to the rules applicable to group health plans.
A health reimbursement arrangement (HRA) must be funded solely by an employer.
The contribution cannot be paid through a voluntary salary reduction agreement.
Employees are reimbursed tax free for qualified medical expenses up to a maximum dollar amount for a coverage period. An HRA may be offered with other health plans, including FSAs.
Unlike HSAs or Archer MSAs which must be reported on Form 1040 or Form 1040NR, there are no reporting requirements for HRAs on your income tax return.
For information on the interaction between an HRA and an HSA, see Other employee health plans.
- The benefits of having an HRA IMHO include:
Contributions made by your employer can be excluded from your gross income.
Reimbursements may be tax free if you pay qualified medical expenses .
Any unused amounts in the HRA can be carried forward for reimbursements in later years.
HRAs are employer-established benefit plans.
These may be offered in conjunction with other employer-provided health benefits.
Employers have complete flexibility to offer various combinations of benefits in designing their plan.Self-employed persons are not eligible for an HRA.
HRAs are funded solely through employer contributions and may not be funded through employee salary deferrals under a cafeteria plan.
These contributions are not included in the employee’s income.
You do not pay income taxes or employment taxes on amounts your employer contributes to the HRA.
There is no limit on the amount of money your employer can contribute to the accounts.
Additionally, the maximum reimbursement amount credited under the HRA in the future may be increased or decreased by amounts not previously used. Balance in an HRA
Generally, distributions from an HRA must be paid to reimburse you for qualified medical expenses you have incurred.
The expense must have been incurred on or after the date you are enrolled in the HRA. Debit cards, credit cards, and stored value cards given to you by your employer can be used to reimburse participants in an HRA.
If the use of these cards meets certain substantiation methods, you may not have to provide additional information to the HRA.
For information on these methods, see:
Ruling 2003-43 on page 935 of IRB 2003-21 at www.irs.gov/pub/irs-irbs/irb03-21.pdf,
Notice 2006-69, 2006-31 I.R.B. 107 available at www.irs.gov/irb/2006-31_IRB/ar10.html, and
Notice 2007-2, 2007-2 I.R.B. 254 available at www.irs.gov/irb/2007-2_IRB/ar09.html.
If any distribution is, or can be, made for other than the reimbursement of qualified medical expenses, any distribution (including reimbursement of qualified medical expenses) made in the current tax year is included in gross income.
For example, if an unused reimbursement is payable to you in cash at the end of the year, or upon termination of your employment, any distribution from the HRA is included in your income.
This also applies if any unused amount upon your death is payable in cash to your beneficiary or estate, or if the HRA provides an option for you to transfer any unused reimbursement at the end of the year to a retirement plan.
If the plan permits amounts to be paid as medical benefits to a designated beneficiary (other than the employee’s spouse or dependents), any distribution from the HRA is included in income.
Amounts that remain at the end of the year can generally be carried over to the next year.
Your employer is not permitted to refund any part of the balance to you.
These amounts may never be used for anything but reimbursements for qualified medical expenses.
For an HRA to maintain tax-qualified status, employers must comply with certain requirements that apply to other accident and health plans.
Chapters 1 and 2 of IRS Publication 15-B, Employer’s Tax Guide to Fringe Benefits, explain these requirements.