According to the Internal Revenue Service, no permission or authorization from the Service is necessary to establish an HSA. Once established, an eligible individual is generally entitled to claim a federal income tax deduction for contributions he or she makes to the HSA, regardless of whether he or she itemizes deductions. Further, contributions to an HSA made by an eligible individual’s employer (including contributions made through a cafeteria plan) will be excluded from the individual’s gross income for federal income tax purposes.

An HSA also serves as a savings account. For example, contributions remain in the account from year to year until they are used, while interest or other earnings on the account’s assets are tax-free. In the case of an employer-established HSA, the account is portable. That is, the individual retains the account, even if he or she terminates employment.

Finally, distributions may be tax-free if used for the purpose of paying qualified medical expenses.

Eligible Individuals

Under the tax law, the term "eligible individual" is defined generally as an individual who: (1) is covered under a high deductible health plan (HDHP) on the first day of the month in question, and (2) is not, while covered under an HDHP, covered under any non-HDHP plan that provides coverage for any benefit which is covered under the HDHP.

An HDHP is a health plan with an annual deductible of at least $1,000 for self-only coverage and $2,000 for family coverage. In addition, for 2005, the sum of the annual deductible and the other annual out-of-pocket expenses required to be paid under the plan (other than for premiums) for covered benefits may not exceed $5,100 for self-only coverage, and $10,200 for family coverage.

An individual generally cannot have any other health coverage that is not an HDHP. However, certain types of non-HDHP "permitted" insurance are allowed, and as are certain other types of coverage in addition to an HDHP. For example, an individual is permitted to have additional insurance covering liabilities incurred under workers’ compensation laws, tort liabilities, or liabilities related to ownership or use of property. An individual may also have insurance related to a specific disease or illness, as well as insurance paying a fixed amount per day (or other period) for hospitalization. An individual may also have other coverage (whether provided through insurance or otherwise) for accidents, disability, dental care, vision care and long-term care. The Internal Revenue Service recommends caution, however, since a plan in which substantially all of the coverage is through permitted insurance or other coverage will not be considered to be an HDHP. For example, if the plan in question provides coverage substantially all of which is for a specific disease or illness, the plan will not be considered to be an HDHP for purposes of establishing an HSA.

In the case of prescription drug plans, special rules are applicable. Generally, an eligible individual can have a prescription drug plan, either as part of the HDHP or a separate plan (or rider), as long as the plan does not provide benefits until the minimum annual deductible of the HDHP has been met. If the benefits are available before the deductible is met, the individual will not be an eligible individual. (However, the Internal Revenue Service has indicated that this rule will not take effect until 2006. Therefore, for 2004 and 2005, an individual can qualify as an eligible individual even though the benefits are available under a separate prescription drug plan (or rider) before the minimum annual deductible of the HDHP is met.)

Beginning with the first month in which an individual is enrolled in Medicare, he or she can no longer contribute to the HSA.

For 2005, the maximum annual deductible contribution (for full-year participation) is generally equal the lesser of the following: (1) the annual deductible under the HDHP (minimum of $1,000 for self-only coverage and $2,000 for family coverage), or (2) $2,650 for self-only coverage and $5,250 for family coverage. Moreover, for 2005, an eligible individual who is age 55 or older may contribute an additional "catch-up" amount of $600.

Dependents are not eligible individuals. An individual can make contributions to an HSA until the due date of his or her return (excluding extensions). This date is generally April 15 of the following year.

In making contributions, care must be exercised, since excess contributions are subject to a six percent excise tax. This tax applies even if excess contributions were made by an employer on behalf of an employee. Moreover, those contributions are taxable as income to the employee. Certain exceptions to the excise tax may apply if the excess contribution and the related earnings are withdrawn on a timely basis.

Distributions

Distributions from an HSA are tax-free if they are made for the purpose of paying or reimbursing qualified medical expenses incurred after the establishment the HSA. Distributions for other purposes are subject to income tax and are subject to an additional ten percent tax. Note, however, that the ten percent tax is not applicable if the distribution is made after the date that the individual becomes Medicare-eligible at age 65 or is made on account of death or disability.

Qualified medical expenses are expenses that would generally qualify for the medical expense deduction under the Internal Revenue Code. According to the Service, expenses must be incurred after the HSA is established, and include amounts paid for doctors’ fees, prescription and non-prescription medicines, and necessary hospital services not paid for by insurance. Qualified medical expenses are those incurred by the eligible individual, as well as his or her spouse or dependents.

Insurance premiums are generally not treated as qualified medical expenses for purposes of an HSA. An exception applies, however, for certain types of insurance. Specifically, qualified medical expenses may include premiums for long-term care coverage, health care coverage while the individual is receiving unemployment benefits, or health care continuation coverage provide pursuant to federal law, such as COBRA. In the case of long-term care insurance, distributions in excess of certain limits, which are based on age and adjusted annually, will be taxable and possibly subject to the ten percent additional tax.

Finally, if an individual is age 65 or older, he or she can treat certain health insurance premiums (other than premiums for a Medicare supplemental policy, such as Medigap) as qualified medical expenses for purposes of an HSA.

Employer-Established Programs

If an employer establishes an HSA for employees, deductible contributions can be made to the HSA account of an employee. Certain rules apply. First, the employee must have an HDHP. Second, the employer generally cannot provide additional coverage (other than those exceptions described above). Finally, the employer must meet the "comparability" requirement (unless the plan is offered as a part of a cafeteria plan). Under this requirement, the employer must make available comparable contributions to all comparable participating employees for each coverage period during the calendar year. The term "comparable contributions" means contributions which are the same amount, or which are the same percentage of the annual deductible limit under the high deductible health plan covering the employees. In the case of an employee who is employed for only a portion of the calendar year, a contribution to the account of the employee is treated as comparable if it prorated as prescribed under the law. The term "comparable participating employees" means all employees who are eligible individuals covered under any high deductible health plan of the employer, and who have the same category of coverage. For this purpose, the categories of coverage are self-only and family coverage. Part-time employees are treated separately. A "part-time employee" is any employee who is customarily employed for fewer than 30 hours per week.

The HSA is a tool that provides many advantages to individuals, as well and employers and employees. However, the rules are complex as they relate to the establishment and maintenance of an HSA. Many of the rules, including those related to compliance and reporting, are beyond the scope of this article. Consequently, in all cases, the advice of competent legal and tax/benefits counsel is highly recommended.