As operators struggle with increased costs in many areas, one expense they shouldn't forget about is healthcare costs. These costs have increased every year for the past few years, and there is no reason they will not continue to do so in the future. For many companies, the cost has become so high that they choose not to replace employees when they retire or resign.
It behooves operators to understand their options in paying for healthcare. Operators should ask their CPAs for guidance. While most operators will have at least a few options to consider, this article will address one that has become helpful for many, the Health Savings Account (HSA).
Before getting into the details of the HSA, keep in mind that the federal government has set up programs that blend tax incentives with insurance policies to help reduce the overall cost of healthcare. When considering an alternative healthcare plan that has any tax ramifications, a business person should ask his or her CPA how this option will affect his or her overall healthcare costs.
Self-employed have special options
It is also worth pointing out that self employed individuals, which include a large number of this magazine's readers, can deduct a large amount of their healthcare costs, including those on behalf of their dependents. It is critically important for self-employed individuals to discuss their options with an experienced CPA.
An important tool for companies that offer employees health care benefits is the Health Savings Account (HSA), which the government created in 2003. The government created this entity because the prospects of Medicare and Medicaid existing at current benefit levels in the future are not good. The HSA is a savings plan that allows people to put money away for future medical expenses.
HSA offers tax benefits
An HSA is an IRA-style account owned by an individual. HSA funds can be used to pay for current and future medical expenses on a tax- favored basis. In order to have a tax-favored HSA, the IRS requires you to have health insurance coverage under a high deductible health plan (HDHP).
The HSA is a separate individual custodial savings (ICS) account used for medical expenses. The HSA can be an interest-bearing, ICS account. HSA plans allow a taxpayer to save money with what's known as an "above-the-line income tax deductible contribution." This means that the amount of money the taxpayer can deduct under this plan actually reduces their adjusted gross income, which determines their tax bracket. This benefits the taxpayer more than a "below the line" deduction, which is taken after the tax bracket has been established.
The HSA also provides another very important benefit. The money invested in the plan accumulates interest on a tax-deferred basis. When funds are withdrawn to pay medical expenses, the withdrawal is tax-free.
Because of the tax-deferred nature of the HSA, some employees choose not to use the funds to pay medical costs, provided the costs are not high. The HSA is similar to a retirement plan that the employee's wages are invested in on a tax- deferred basis.
High deductible plan is needed
A high deductible health plan (HDHP) is health insurance with a minimum deductible of $1,000 for a single person and $2,000 for a family. It is important to note that no co-payments are allowed until the deductible is met.
The annual out-of-pocket limit, which includes deductible and co-payments, cannot exceed $5,100 per individual or $10,200 per family in 2005. On a high deductible plan, you pay the whole amount until your deductible is met. Sometimes, for preventive care items, the plan will still cover most of the cost. These include routine physical exams, immunizations, routine mammograms, routine gynecological exams and routine prostate exams.
In addition, a higher out-of-pocket cost is often allowed for out-of- network care.
The way an HSA is designed to work is to switch an individual from a traditional low deductible to a high deductible health plan. The difference in deductible will reduce the premium.
However, real world experience from insurance colleagues of mine have noted that the significant savings do not usually materialize until the deductible reaches $2,500 or more for the individual and $5,000 or better for families, depending upon the existing plan's design.
Who can contribute to a HSA? The employer, the individual or both can make HSA contributions.
Individuals need not itemize
Individuals can make an "above-the-line" deduction (Code section 62(a)(19)) for contributions to the account. The beauty of this feature is that the tax benefit can be achieved even if the person does not itemize his or her deductions.
Individuals can also make contributions to an HSA under a "cafeteria" plan. A "cafeteria" plan is one that allows the employee to choose between cash and some non-taxable benefits (such as group term life insurance, health and accident protection, or child care.) A portion of the employee's salary is deducted from their pay and deposited into the HSA. The individual's salary is reduced by the amount of the deduction. Hence, there is a good chance they will fall into a lower tax bracket.
Employers cannot discriminate
"Cafeteria" plans are designed to provide flexibility in tailoring employee compensation to fit individual needs. However, contributions to an HSA made under a "cafeteria" plan are subject to Section 125 nondiscrimination rules and require a plan document to be in place.
Employer contributions must be comparable for all employees participating in the HSA. Otherwise, the plan is considered discriminatory and the employer is subject to an excise tax equal to 35 percent of the aggregate amount the employer contributed to the employees HSA (Code Section 4980G).
How much can be contributed annually? The maximum amount that can be contributed to an HSA annually is the lesser of:
• Amount of high deductible
• Maximum specified under code section 223
• $2,650 for an individual in 2005
• $5,250 for a family in 2005
For individuals 55 and older, catch-up contributions are allowed. Currently, extra contributions of $600 can be made in 2005, increasing to $1,000 by 2009. Contributions cannot continue once an individual reaches the age of 65 or is enrolled in Medicare.
How can the funds in the HSA be distributed?
Funds in an HSA should be utilized for qualified medical expenses. Internal Revenue Code 213(d) defines a qualified medical expense. There is a wide variety of services and products that the HSA money can be spent on, including insurance deductibles and co-payments.
For a thorough understanding how the HSA funds can be spent without penalties, visit the IRS website (www.IRS.gov) and search for publication 502.
The HSA funds cannot be used for the following types of expenses:
- COBRA payments
- Qualified long-term care insurance, until you reach 65
- Coverage while receiving unemployment compensation
- For individuals who have reached age 65:
- Health insurance premiums and out-of-pocket expenses
- Employee share of premiums for employer-based coverage
- Medigap premiums (This is supplemental insurance to Medicare)
It is important to remember that the account holder will be the one who is responsible to prove to the IRS that money used from the HSA account was for qualified medical expenses. All medical receipts should be kept for documentation.
An advantage of an HSA is that you do not have to use all the money in the account by the end of the year. Money can remain in the account and can accumulate tax-free until withdrawn.
If you change jobs, the HSA account is portable. The employee can continue to contribute to and take distributions from the account even if they change employers or leave the workforce.
At age 65, even though you can no longer contribute to the account, you can take tax-free distributions for medical expenses. You are allowed to withdraw funds for nonmedical purposes without paying a 10 percent penalty tax. The amount withdrawn will be considered income tax.
The benefits are worth considering
A high deductible health plan in conjunction with an HSA is a great tool to help manage current and long term medical expenses.
- It enables the individual to have more control over how they spend their medical dollars.
- It offers an accumulation and portability feature that allows an individual to build a medical "nest egg."
- The tax advantage of being able to fund the account with pretax dollars, have the account grow tax-deferred, and make withdrawals tax-free can help contain the effective cost of medical care.
The biggest concern with using an HSA is that the individual is responsible for all expenses until the deductible is met with the exception of preventive care. The individual will still receive the discounted rate of services and prescriptions by being part of a health maintenance organization (HMO) or preferred provider organization (PPO), but will have to pay the full amount until the deductible is met.
For those who plan ahead, the HSA is a great vehicle that will help them manage their healthcare costs.