Tax Management Summary

By the Tax Management Editorial Staff
Washington, D.C.

On November 25, 2003, the Senate passed the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (H.R. 1), which includes the creation of health savings accounts and gives employers a tax break for providing retiree prescription drug coverage. The House approved H.R. 1 on November 22, 2003.

Below is a summary of the tax changes from the Bill.

TITLE XII--TAX INCENTIVES FOR HEALTH AND RETIREMENT SECURITY

The Bill creates health savings accounts ("HSAs") that provide tax-favored treatment for current medical expenses as well as the ability to save on a tax-favored basis for future medical expenses. In general, the Bill describes HSAs as tax-exempt trusts or custodial accounts created exclusively to pay for the qualified medical expenses (as defined in §213(d)) of the account holder and his or her spouse and dependents that are subject to rules similar to those applicable to individual retirement arrangements.

Within limits, contributions to HSAs are deductible if made by or on behalf of an eligible individual and are excludible from gross income and wages for employment tax purposes if made by the employer of an eligible individual. For example, employer contributions to an HSA (including salary contributions made through a §125 cafeteria plan) are excludible from gross income and wages to the extent the contributions would be deductible if made by the employee.

Distributions from HSAs for qualified medical expenses are not includible in gross income. However, distributions that are not for qualified medical expenses are includible in gross income and subject to an additional 10% tax. The additional 10% tax does not apply after death, disability, or after the individual reaches the age of Medicare eligibility (i.e., age 65).

Eligible individuals for HSA purposes are individuals who are covered by a high deductible health plan and no other health plan that is not a high deductible health plan. Individuals entitled to benefits under Medicare are not eligible to make contributions to an HSA. Eligible individuals do not include individuals who may be claimed as a dependent on another person's tax return.

The Bill provides that an individual with other coverage in addition to a high deductible health plan is still eligible for an HSA if such other coverage is certain permitted insurance or permitted coverage.

A high deductible health plan is defined as a health plan that has a deductible that is at least $1,000 for self-only coverage or $2,000 for family coverage and that has an out-of-pocket expense limit that is no more than $5,000 in the case of self-only coverage and $10,000 in the case of family coverage. Special rules apply for network plans.

The maximum annual contribution that can be made to an HSA is the lesser of: (1) 100% of the annual deductible under the high deductible health plan; or (2) the maximum deductible permitted under an Archer Medical Savings Account (MSA) high deductible health plan. For 2004, the amount of the maximum high deductible is $2,600 in the case of self-only coverage and $5,150 in the case of family coverage.

All contributions by or on behalf of an eligible individual are aggregated for purposes of the maximum annual contribution limit. The maximum annual contribution limits for the health accounts are coordinated so that contributions to one type of health account reduce the annual contribution limit for the other type of health account. Thus, contributions to Archer MSAs reduce the annual contribution limit for HSAs.

An excise tax applies to contributions in excess of the maximum contribution amount for the HSA. The excise tax generally is equal to 6% of the cumulative amount of excess contributions that are not distributed from the HSA to the contributor.

The Bill increases the annual contribution limits for individuals who have attained age 55 by the end of the taxable year. For these individuals, the HSA annual contribution limit is greater than the otherwise applicable limit by $500 in 2004, $600 in 2005, $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and thereafter. Contributions, including catch-up contributions, cannot be made once an individual is eligible for Medicare. Also, qualified medical expenses are expanded to include health insurance premiums for individuals eligible for Medicare, other than premiums for Medigap policies. Qualified health insurance premiums include, for example, Medicare Part A and Part B premiums, Medicare HMO premiums, and the employee share of premiums for employer-sponsored health insurance including employer-sponsored retiree health insurance.

Under the Bill, amounts can be rolled over into an HSA from another HSA or from an Archer MSA and are not taken into account under the annual contribution limits.

If an employer makes contributions to employees' HSAs, the employer must make available comparable contributions on behalf of all employees with comparable coverage during the same period. The comparability rule does not apply to rollovers or to contributions made through a cafeteria plan. If employer contributions do not satisfy the comparability rule, the employer is subject to an excise tax equal to 35% of the aggregate amount contributed by the employer to the HSAs.

Employer contributions are required to be reported on the employee's Form W-2.

Upon the death of an account holder, any remaining balance in the account holder's HSA is includible in his or her gross estate. However, if the account holder's surviving spouse is the named beneficiary of the HSA, then the HSA becomes the HSA of the surviving spouse and the surviving spouse is not required to include any amount in gross income as a result of the death. The surviving spouse can exclude from gross income amounts withdrawn from the HSA for expenses incurred by the account holder prior to death, to the extent they otherwise are qualified medical expenses. However, if the HSA passes to a named beneficiary other than the account holder's surviving spouse, the HSA ceases to be an HSA, and the beneficiary is required to include the balance of the HSA in gross income.

HSAs are effective for taxable years beginning after December 31, 2003.

The Bill provides that gross income does not include any special subsidy payment received under §1860D-22 of the Social Security Act. Thus, the 28% employer subsidy for retiree prescription drug coverage is excludible from taxation. Effective for taxable years ending after the date of the enactment of this Bill.

The Bill provides an exception from the generally applicable information reporting provisions for payments for medical care made under either a flexible spending arrangement or a health reimbursement arrangement that is treated as employer-provided coverage. Effective for payments made after December 31, 2002.