Obtaining Tax Benefits with Health Savings Accounts

By Albert B. Ellentuck, Esq.

The Medicare Prescription drug and Modernization Act of 2003, P.L. 108-173, established health savings accounts (HSAs), which are aimed primarily at self-employed taxpayers, small business owners, and employees of small to medium-sized firms. Eligible individuals can make tax-deductible (as an adjustment to AGI) contributions into HSA accounts. The earnings inside the HSA are free from federal income tax, and funds can be withdrawn tax free to pay health care costs.

Observation: The dual benefit of tax-deductible contributions into and tax-free withdrawals from HSAs (and existing medical savings accounts, or MSAs) is truly unique. No other tax-deferred type of account currently exists that offers such a benefit.

Key Definitions for HSAs

An HSA is a tax-exempt trust or custodial account established exclusively for the purpose of paying qualified medical expenses of the account beneficiary who, for the months for which contributions are made to an HSA, is covered under a high-deductible health plan (HDHP). Consequently, an HSA is not insurance; it is an account, which must be opened with a bank, brokerage firm, or other provider (e.g., insurance company) (Sec. 223(d)(1)). It is therefore different from a flexible spending account in that it involves an outside provider serving as a custodian or trustee.

An HDHP is generally a health plan that satisfies certain requirements for deductibles and out-of-pocket expenses. Specifically, for self-only coverage for 2010, the qualifying HDHP must have (1) an annual deductible of at least $1,200 and (2) an annual limit on total out-of-pocket costs (including the deductible, co-payments, and other amounts, but not premiums) for covered benefits of no more than $5,950. For family coverage, the qualifying insurance must have (1) an annual deductible of at least $2,400 and (2) an annual cap on total out-of-pocket costs of no more than $11,900 (Rev. Proc. 2009-29). These amounts are adjusted for inflation.

For family coverage, a plan is an HDHP only if, under its terms and without regard to which family member or members incur expenses, no amounts are payable from it until the family has incurred annual covered medical expenses in excess of the minimum annual deductible. Higher deductibles for out-of-network services do not count toward the annual deductible limit, and out-of-pocket costs for out-of-network services are not counted toward the HDHP’s annual cap. Finally, it is permissible for the plan to not impose any deductible (or a deductible lower than the HDHP minimum) for preventive care (such as annual checkups). However, except for preventive care, a plan may not provide benefits for any year until the deductible for that year is met (Sec. 223(c) (2)). Notice 2004-23 (and its appendix) provides a safe-harbor list of services considered to be preventive care for purposes of the HDHP rules.

Example 1: T has a plan that provides coverage for her and her family. The plan has a family deductible of $2,400 and provides for the payment of covered medical expenses of any member of T’s family if the member has incurred covered medical expenses during the year in excess of $1,000, even if the family member has not incurred covered medical expenses in excess of $2,400. Therefore, if T’s son J incurred covered medical expenses of $1,500 in a year, the plan would pay $500. Because benefits are potentially available before the family’s (or any one member of the family’s) covered medical expenses exceed $2,400, the plan is not an HDHP.

Example 2: Assume that the plan has a $5,000 family deductible and provides payment for covered medical expenses if any one member of T’s family has incurred covered medical expenses during the year in excess of $2,400. The plan satisfies the requirements for an HDHP with respect to the deductibles.

Eligibility Guidelines

An HSA must be established by an eligible individual (i.e., an individual who with respect to any month has qualifying high-deductible health coverage as of the first day of that month). Generally, individuals are ineligible for any month in which they also have any non-highdeductible health coverage (whether as an individual, spouse, or dependent) that covers any benefit also covered under the high-deductible insurance plan (Sec. 223(c)(1)). If an otherwise eligible individual has family HDHP coverage that includes a dependent with disqualifying, non-HDHP coverage, the individual is still an eligible individual (Notice 200859, Q&A-11). In applying these restrictions, however, the following types of health-related insurance and coverage are ignored (Secs. 223(c)(1)(B) and (c)(3)):

  • Workers’ compensation insurance;
  • Tort liabilities;
  • Liabilities relating to ownership or use of property;
  • Insurance for a specific disease or illness (for example, cancer insurance);
  • Insurance that pays a fixed amount per day or other period of hospitalization;
  • Coverage, whether through insurance or otherwise, for accidents, disability, dental care, vision care, or long-term care.

Note: Prescription drug benefit plans are not in the list of permitted coverages for separate non-HDHPs (Rev. Rul. 2004-38).

An individual who is covered by an employer-sponsored health care flexible spending account plan (FSA), health reimbursement arrangement (HRA), or Sec. 105 medical reimbursement plan will typically be ineligible to make HSA contributions. The same is true when a person is covered via his or her spouse’s employment. The reason is that these arrangements are considered health plans under the HSA rules, and they typically provide benefits on a first-dollar basis. Therefore, they violate the rule that an HSA contributor cannot be covered by a health plan that is not an HDHP.

Two exceptions occur when the FSA plan, HRA, or Sec. 105 plan:

  • Pays benefits only after the HDHP’s deductible has been met; or
  • Provides coverage only for those limited types of expenses that are allowed to be covered by an HDHP before the deductible is satisfied (e.g., dental and vision care and certain preventive care).

In these two circumstances, HSA contributions will be allowed if all the other eligibility rules are met. Other exceptions are when the individual is covered only by a suspended HRA (pursuant to an election) or by a retirement HRA that pays or reimburses only for medical expenses incurred after retirement. (See Rev. Ruls. 2004-38 and 2004-45 and Notices 200423, 2004-50, Q&A-33, and 2008-59.)

In Notice 2005-42, the FSA “use-it-orlose-it” rule was relaxed, and employers are now allowed to extend the year-end deadline for employees to spend down FSA balances by providing a grace period following the FSA’s year end for up to 2½ months. An individual participating in a health FSA who is covered by the grace period is generally not eligible to contribute to an HSA until the first day of the first month following the end of the grace period. However, participation in an FSA during the grace period does not disqualify the individual from being an HSA-eligible individual during that grace period if:

  • The balance in the FSA at the end of the prior year is zero; or
  • The individual is making a qualifying rollover distribution of the entire balance in the FSA (Sec. 223(c)(1)(B)(iii)).

Example 3: Assume that T is single with no dependents. She participated in her employer’s calendar-year FSA plan for 2009, which allows a 2½-month grace period (ending March 15, 2010) to spend down her $500 FSA balance remaining at the end of 2009. She does not participate in the FSA for the 2010 calendar plan year. Assuming T has no other disqualifying coverage for 2010, she is HSA eligible on April 1, 2010. While T may contribute the full deductible amount of $3,000 (Sec. 223(b)(8) (A)), she may not use any of those contributions to cover medical expenses incurred in January–March 2010.

No HSA contributions are allowed for a person who can be claimed as a dependent on another person’s federal income tax return for the year in question (Sec. 223(b)(6)). In addition, contributions are not allowed for the month in which an individual becomes eligible for Medicare (age 65 under current law) and for all subsequent months (Sec. 223(b)(7)).

Contributions to HSAs

Contributions to an HSA can be made by, or on behalf of (for example, a family member), any eligible individual and are deductible by the eligible individual above the line in arriving at AGI (Sec. 62(a)(19)). Thus, eligible individuals can benefit whether or not they itemize deductions. However, the individual cannot also deduct the contributions as a medical expense under Sec. 213 (Sec. 223(f)(6)), and the deduction will not reduce a self-employed person’s self-employment tax (Notice 2004-50, Q&A-84). Contributions can also be made by or on behalf of an eligible individual even if the individual has no compensation or if the contributions exceed his or her compensation (Notice 2004-2, Q&A-12).

For 2010, the maximum monthly contribution limit for an individual with self-only coverage is 1⁄12 of $3,050. For family coverage, the monthly limit is 1⁄12 of $6,150 (Rev. Proc. 2009-29).

This case study has been adapted from PPC’s Guide toTax Planning for High Income Individuals, 10th Edition, by Anthony J. DeChellis, Patrick L.Young, James D.Van Grevenhof, and Delia D. Groat, published byThomsonTax & Accounting, Ft.Worth,TX, 2009 ((800) 323-8724; ppc.thomson.com ).


Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.

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