Scott E. Vincent
Vincent, Fontg & Chartier LLC
Kansas City

Health Savings Accounts ("HSAs") became available for use January 1, 2004. Created by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, these special savings accounts are tax-exempt trusts or custodial accounts established exclusively for paying the qualified medical expenses of an eligible account beneficiary.

Although HSAs have been available since the beginning of this year, most potential custodians and trustees for the accounts, such as banks, are not yet offering the accounts because of liability concerns relating to the documentation required to establish HSAs and manage the funds. In an effort to relieve these concerns, the Internal Revenue Service recently released proposed model documents that may be used as trust or custodial agreements for HSAs.

Health Savings Accounts

HSAs are tax-exempt trusts or custodial accounts exclusively established to pay qualified medical expenses. Congress designed the accounts to help individuals take more control over how their health care funds are saved and spent. Individuals can make contributions to HSAs on a tax-free basis, and employer contributions to employee-owned HSAs are not subject to employment tax. HSAs' earnings accumulate tax-free.

HSA funds can only be used to pay or reimburse qualified medical expenses of the account owner, his or her spouse and dependents, as defined in Code § 213(d) (tax deductible medical expenses). Withdrawals for qualified health care expenses are tax-free, and the money not spent in one year rolls over to the next year.

Contributions

In 2004, the maximum annual contribution limit for an account owner with single coverage is $2,600, and the annual contribution limit for an account owner with family coverage is $5,150. Individuals who are 55 or older can put an additional $500 in catch-up contributions into their HSA this year. The catch-up amount rises to $600 for 2005, and continues to increase $100 each year until it reaches $1,000 in 2009.

Limited Eligibility

Only individuals covered by a high-deductible health plan ("HDHP") can contribute to an HSA. In 2004, an HDHP for individual coverage has a minimum annual deductible of $1,000, with an annual out-of-pocket maximum of $5,000. The 2004 minimum annual deductible for an HDHP with family coverage is $2,000, with an annual out-of-pocket maximum of $10,000.

HSA-eligible individuals may not be covered by a health plan that is not an HDHP, unless that health plan only offers permitted insurance coverage or preventive care as defined in Code § 223(c)(1)(B). Also, the IRS recently announced transition relief for health plans that are unable to qualify as HDHPs due to state mandates. Under the new guidance, a health plan in effect on January 1, 2004, which would otherwise qualify as an HDHP but fails because it offers benefits required under state law, will nevertheless be treated as an HDHP until January 1, 2006.

Tax Benefits

As noted, HSAs operate much like an IRA account. The contributions to the account are deductible, and the internal earnings accumulate tax-free. In addition, expenditures from the account on qualified medical expenses are also tax-free. Withdrawals from an HSA that are not used for qualified medical expenses are subject to tax and an additional 10 percent penalty.

Employers can make contributions to HSAs that are not taxed to the employee HSA owner, and employers can also deduct the cost of premiums for the HDHP insurance plan.

New Model Forms

The proposed model forms are Form 5305-B, Health Savings Trust Account, and Form 5305-C, Health Savings Custodial Account. The forms can be found as drafts in announcement TDNR JS-1748, or on the IRS website at www.irs.gov.

The forms state that the account owner, not the custodian or trustee, is responsible for compliance with the Code § 223 rules for establishing and maintaining an HSA. For example, the account owner must declare that he or she is:

• Covered by a HDHP and no other non-HDHP plan (with exceptions);

• Not entitled to Medicare benefits;

• Not eligible to be claimed as someone else's dependent; and

• Responsible for determining whether contributions to the HSA have exceeded the maximum annual contribution limit.

If contributions to the HSA exceed the maximum annual contribution limit, the account owner is required to notify the custodian and request withdrawal of the excess contribution and any income attributable to the excess contribution.

The HSA owner is also responsible for substantiating that an HSA distribution is for qualified medical expenses. The individual must maintain sufficient records to show that distributions were tax-free. The model forms specifically state that the custodian or trustee is not required to determine if the disbursements are for qualified medical expenses.

The model forms are not mandatory. Trustees and custodians can use all or part of the model language. Specific instructions may be added to the model document, such as definitions, restrictions on rollover contributions, investment powers, prohibited transactions, and custodial fees, among other items.

An HSA is established once the form is executed by both the account owner and the custodian. The form can be completed at any time during the tax year.

These model forms are on a fast track review and comment process, and the IRS plans to finalize the forms after a brief comment period that ends July 25, 2004. Once finalized, the forms will serve as safe-harbors for banks, financial institutions and other custodians or trustees that manage HSAs, and CCH predicts "an advertising blitz from them that promotes setting up HSAs in 'consultation with a tax advisor.'"

Conclusions

Health Savings Accounts are likely to be very popular, and widely marketed, over the next few months. They provide participants with an IRA-type product for health care costs, with tax deductible contributions that can grow tax-free and roll forward from year to year for future use. From an employer's perspective, HSAs coupled with high deductible insurance should provide significant health insurance cost savings, and perhaps more importantly, give employees an incentive to be cost-conscious in their use of health services. These benefits certainly merit consideration for our clients, and for our own practices, as HSA products develop.