Notice 2004-2 provides guidance for new Health Savings Accounts (HSAs) which, beginning in 2004, may be funded by an “eligible individual” with tax deductible cash contributions which grow tax-free. Tax-free distributions from the account may be made by the taxpayer to pay for “qualified medical expenses.” The confluence of tax deductible contributions, tax-free earnings and tax-free distributions make HSAs extremely attractive from a tax perspective. Nontax requirements, discussed below, are not as inviting. The taxation of HSAs, which resembles that of IRAs, is found in IRC § 223, enacted as part of the Medicare Modernization Act of 2003.
Any “eligible individual” may contribute to an HSA. Family members may also contribute on behalf of other family members. An HSA may pay qualified medical expenses only for a person covered under a high-deductible health plan (HDHP). An HDHP, in turn, must satisfy certain requirements with respect to deductibles and out-of-pocket expenses. For family coverage, an HDHP must have an annual deductible of at least $2,000 and annual out-of-pocket expenses required to be paid not exceeding $10,000. A person covered by an HDHP will be ineligible for an HSA if he is concurrently covered under another health plan. Even so, some types of health coverage, such as (i) worker’s compensation, (ii) insurance for a specific illness, and (iii) hospitalization insurance, will not result in ineligibility.
Any approved IRA custodian qualifies as an HSA custodian. The HSA need not be established at the institution providing the HDHP. In that case, the custodian may require proof of eligibility. However, neither an HSA custodian nor an employer making contributions to an employee’s HSA is required to determine whether HSA distributions are used for qualified medical expenses. The individual should maintain adequate records for this purpose.
The maximum annual contribution to an HSA is determined separately each month based on status, eligibility and health plan coverage as of the first day of the month. For 2004, the maximum monthly contribution for eligible individuals with self-coverage is 1/12 of the lesser of (i) 100% of the annual deductible under the HDHP (minimum of $1,000) and (ii) $2,600. (For eligible individuals with family coverage, the minimum in (i) equals $2,000; and (ii) equals $5,150.)
To illustrate, assume an individual begins self-coverage on June 1, 2004 and is covered under the HDHP for the remainder of the year. The contribution limit is computed each month. If the annual deductible is $5,000 for the HDHP, then the lesser of the annual deductible and $2,600 is $2,600. The monthly contribution limit is $216.67 ($2,600/12). An additional $500 “catch-up” contribution may be made by or on behalf of individuals between 55 and 65 for the calendar year 2004. The catch-up amount will increase in $100 increments, reaching $1,000 in 2009.
Contributions made by an eligible individual (or by a family member on behalf of the eligible individual) may be made any time prior to the time required by law (without extensions) for filing the eligible individual’s tax return. Contributions are deductible by the eligible individual in arriving AGI, thus providing a tax benefit regardless of whether the individual itemizes. Employer contributions are excludible from the employee’s income and are not subject to withholding. Excess contributions are included in gross income, are not deductible, and are subject to an excise tax of 6%. Inside buildup is exempt from tax, unless the account ceases to be an HSA. Rollover contributions from Archer MSAs and other HSAs are permitted, and need not be in cash.
Tax-free distributions may be made at any time to pay qualified medical expenses of the beneficiary, his spouse, or dependents. Distributions are excludible even if the individual would no longer be qualified to make HSA contributions. Qualified medical expenses consist of those paid for medical care as defined in IRC § 213(d) “for the diagnosis, cure, mitigation, treatment, or prevention of disease” to the extent not covered by insurance or otherwise. The expense must be incurred after the HSA has been established. Amounts not used exclusively for qualified medical expenses are includible in income and incur an additional 10% tax. However, distributions made after the account beneficiary’s death, disability, or his attaining age 65 are not subject to tax.
Health insurance premiums are generally not qualified medical expenses; however, qualified long-term care insurance and COBRA insurance are not considered health insurance premiums. In addition, individuals over 65 may pay premiums for Medicare Part A or B and Medicare HMO from an HSA.
Upon death, an account beneficiary’s HSA becomes the property of the named beneficiary. A surviving spouse named as beneficiary is taxed only if distributions are not used to pay her own qualified medical expenses.