In general, HSAs are modeled after Archer MSAs. Thus, an HSA is a trust or custodial account created exclusively for the benefit of the account holder and is subject to rules similar to those that apply to individual retirement arrangements (IRAs). As discussed below, contributions to, and distributions from HSAs receive favorable federal income tax treatment and the funds in an HSA are not subject to federal income tax.

HSAs are available to employees under age 65 covered under a certain type of health plan. For an employee of an eligible employer to be eligible to make HSA contributions (or have employer contributions made on his or her behalf), the employee must be covered under an employer-sponsored "high deductible" (see below) health plan and cannot be covered under any other health plan, other than one providing certain permitted coverage.

In the case of an employee, contributions can be made to an HSA either by the employee or by someone else on his or her behalf, including the employer. Rollover contributions also may be made to an HSA from an Archer MSA. Unlike Archer MSAs, HSA contributions may be made available as an option under a cafeteria plan.

A "high deductible" plan is a health plan with an annual deductible of at least $1,000 for individual coverage, or an annual deductible of at least $2,000 for family coverage. Also, the maximum out-of-pocket expenses with respect to allowed costs, including the deductible, cannot exceed $5,000 for individual coverage and $10,000 for family coverage. These amounts are increased annually for cost-of-living adjustments (COLAs).

Contributions by employees to an HSA are deductible, within limits, "above the line," i.e., in computing adjusted gross income (AGI) for federal income tax purposes. Employer contributions are excludible from employees' gross income within the same limits. Earnings on amounts in an HSA are not currently taxable, nor are distributions from an HSA that are used to pay qualified medical expenses.

The maximum annual contribution to an HSA for 2004 is the lesser of the annual deductible under the high deductible health plan or $2,600 for individual coverage, or $5,150 for family coverage. These amounts also are increased annually for COLAs.

For individuals who have attained age 55 by the end of the taxable year, the annual contribution limit is increased by $500 in 2004, $600 in 2005, $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and thereafter.

All contributions to an Archer MSA and HSA are aggregated for purposes of the maximum annual limit.

Distributions from an HSA to pay the medical expenses of the employee and his or her spouse or dependents are excludible from income. Distributions that are not used to pay medical expenses are subject to income tax. Such distributions also are subject to an additional 10% penalty tax unless the distribution is made after age 65 or on account of death or disability.

HSAs may be established for tax years beginning after December 31, 2003.

HRAs bypass the limitations of health flexible spending accounts (FSAs) and may help employers control health care costs.  An HRA is paid for solely by the employer, with no employee salary reductions and, therefore, escapes the following restrictions on health FSAs:

•  the prohibition to carry over unused elective contributions or plan benefits from one plan year to another;

•  the requirement that the maximum amount of reimbursement must be available at all times during the coverage period;

•  the mandatory 12-month coverage period; and

•  the limitation that medical expenses that are reimbursed must be incurred during the coverage period.

An HRA is an arrangement that:

•  must be funded solely by the employer and not provided pursuant to a salary reduction election or otherwise under a cafeteria plan;

•  reimburses the employee for medical care expenses incurred by the employee and the employee's dependents; and

•  provides reimbursements up to a maximum dollar amount for a coverage period and any unused portion of the maximum dollar amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods.

Coverages and reimbursements under HRAs are excludible from the employee's gross income.

HRAs can only provide benefits that reimburse substantiated expenses for medical care as defined in the Code.  An HRA may not reimburse a medical care expense that is attributable for any prior taxable year. Furthermore, an HRA may neither reimburse a medical care expense that is incurred before the date the HRA is in existence nor reimburse an expense that is incurred before the date an employee first becomes enrolled under the HRA. 

Reimbursements for insurance covering medical care expenses are allowable reimbursements, including amounts paid for premiums for accident or health coverage for current employees, retirees, and qualified beneficiaries under the Consolidated Omnibus Budget Reconciliation Act of 1987 (COBRA).

If an HRA is an FSA, reimbursable medical care expenses must not include expenses for qualified long-term care services as defined in the Code.

An HRA does not qualify for the exclusion under the Code if any person has the right to receive cash or any other taxable or nontaxable benefit under the arrangement other than the reimbursement of medical care expenses. If any person has such a right, then all HRA distributions—including those for medical care expenses—to all persons in the current tax year will be included in gross income.

Excluding self-employed individuals and sole proprietors, the following individuals are covered under HRAs:

•  current and former employees, including retired employees;

•  their spouses and dependents; and

•  the spouses and dependents of deceased employees.

An HRA may continue to reimburse former employees or retirees for medical care expenses after termination of employment or retirement by:

•  reimbursing a former employee only up to an amount equal to the unused reimbursement amount remaining at either termination or retirement;

•  providing that the maximum reimbursement amount available after termination or retirement is reduced for any administrative costs of continuing HRA coverage; or

•  allowing an increase in the amount available for reimbursement after termination or retirement.

Employer contributions to an HRA cannot be attributed to salary reduction, either directly or indirectly, or otherwise provided under a cafeteria plan. However, an HRA may be offered in conjunction with a cafeteria plan. If an employer offers its employees a choice between employer-provided nontaxable benefits, such as coverage under an HRA or under a health maintenance organization, with no cash or other taxable benefits, the choice is not an election to which the Code applies.

An accident or health plan funded via salary reduction is not an HRA and is subject to the cafeteria plan rules under the Code. However, if an employer provides an HRA only in conjunction with another accident or health plan and that other plan is provided for under a salary reduction cafeteria plan, then the IRS will consider all the facts and circumstances in determining whether the salary reduction is attributable to the HRA. If the terms of the salary reduction election state that the reduction is used only to pay for the specified accident or health plan offered and not for the HRA, then the salary reduction may not be considered as being attributed to the HRA.

If the salary reduction for a coverage period to fund the specified accident or health plan offered in conjunction with the HRA exceeds the actual cost of the specified accident or health plan coverage of that period, then the salary reduction will be attributed to the HRA.

A medical care expense may not be reimbursed from a health FSA if the expense has been reimbursed or is reimbursable under any other accident or health plan.

If coverage is provided under both an HRA and an FSA for the same medical care expenses, then the HRA must be exhausted first. But, an FSA will not violate the rule if coverage is provided under both an HRA and an FSA and the FSA reimburses a medical care expense not reimbursable by the HRA. Under no circumstances can an employee be reimbursed for the same medical care expense under both an HRA and an FSA.

Before the beginning of an FSA plan year, the HRA plan document may specify that coverage under the HRA is available only after the FSA has been spent down.

To the extent that an HRA is a self-insured medical expense reimbursement plan, it is subject to the nondiscrimination requirements under the Code.

Although increases and decreases in an HRA are allowed from year to year, if an increase favors one or more highly compensated individuals, the HRA may violate the nondiscrimination rules.

Because HRAs are group health plans, they are subject to the COBRA continuation coverage requirements.

If an individual elects COBRA continuation coverage, an HRA complies with the COBRA requirements by providing for the continuation of the maximum reimbursement amount for an individual at the time of the COBRA qualifying event and by increasing that maximum amount at the same time and by the same increment that it is increased for similarly situated non-COBRA beneficiaries, as well as by decreasing it for claims reimbursed.

If a qualified beneficiary elects COBRA continuation coverage in addition to the continued reimbursement amount already available, an HRA will comply with the COBRA requirements by increasing the maximum reimbursement amount at the same time and by the same increment that it is increased for similarly situated non-COBRA beneficiaries.

An HRA plan's rules may provide for continued reimbursements after a COBRA qualifying event regardless of whether a qualified beneficiary elects continuation coverage. For example, an HRA may allow reimbursements up to the unused maximum reimbursement amount following the termination of the employee.

I hope that this article has provided you with background informationon on HSA's and HRA's.  As always, please contact us for further information and to determine if one of these is right for you.