Saving money to pay for current and future medical expenses is not on most people’s “things to do” list despite a clear concern on the part of most people about the ability to pay for medical expenses not covered by insurance. One way to save for the medical expense rainy day is through a Health Savings Account (HSA).
For those unfamiliar with HSAs (and as a refresher for more experienced practitioners), here is a little background on HSAs. An HSA is an account, similar to an IRA, to which individuals under age 65 and/or employers may make annual tax-deductible contributions within specified limits. The earnings in the account grow on a tax-free basis, and, if used for qualified medical expenses, may be withdrawn on a tax-free basis. When an individual becomes Medicare-eligible, or in the event of death or disability, amounts in the account may be used for any purpose without incurring a tax penalty (although these amounts must be included in income).
In order to contribute to an HSA, an individual must be covered under a high deductible health plan, and may not participate in any other non-high deductible health plan, subject to certain exceptions.
HSAs commonly are funded by employer and employee contributions. The Tax Relief and Health Care Act of 2006 added new ways that contributions may be made to HSAs – by rolling over funds from a health flexible spending account (FSA), health reimbursement arrangement (HRA), IRA, or Roth IRA. There are special rules that must be followed to receive the favorable tax treatment afforded such rollovers. Those rules, however, are beyond the scope of this article.
There are several reasons that employers might want to permit the rollover to HSAs of unused balances in FSAs or HRAs. The first reason to permit the rollover is to ease the employee’s transition to a high deductible health plan (HDHP). Employers typically save a considerable amount of money on health insurance premiums by switching to HDHP coverage for employees from traditional lower deductible health coverage. HDHPs can be less attractive, however, to employees who have to pay more out of their own pockets for medical expenses. In addition, the transition to an HDHP can be difficult for employees with chronic or ongoing medical problems since they do not have the ability to build up a balance in their HSAs. Allowing an employee to rollover unused money from an FSA or HRA to the employee’s HSA would make money immediately available to the employee to pay for medical expenses that are incurred before the HDHP begins paying benefits. The immediate availability of funds rather than having to build up a balance in the HSA over time is likely to make the transition to an HDHP easier and more palatable for employees with ongoing medical expenses.
A second reason for employers who switch to HDHPs to permit such rollovers is to give employees who have not exhausted their FSA and HRA accounts the ability to use that money in the future. Generally, employees are going to have to give up FSAs or HRAs when an employer switches to an HDHP. Permitting a rollover of any balances remaining in an employee’s FSA or HSA rewards employees for past good medical care spending habits by ensuring that the unused money isn’t lost, but rather is available for future medical expenses.
A third reason is to encourage and support the growth of HSAs for the employee’s future medical expenses. Unlike FSAs, HSAs do not have a “use-it-or-lose-it” rule, so unused HSA account balances are carried forward at the end of a year. FSAs, by design, encourage employees to exhaust all funds in one year. HSAs, on the other hand, encourage individuals to accumulate funds and save for the medical expense rainy day rather than seeking reimbursement for all medical expenses including those that are quite small, such as co-payments. Additionally, unlike HRAs, HSAs belong to the individual and are portable because access to the funds in the HSA account is not tied to any employment relationship. Allowing employees to rollover funds from an FSA or HRA encourages employees to consume medical care wisely with long-term savings in mind.
Individuals are also now permitted a one-time tax-free distribution from an IRA or Roth IRA to the individual’s HSA. This rollover is particularly attractive because the individual will never be taxed on those rolled-over dollars as long as they are used to pay for qualified medical expenses. This result occurs because contributions to IRAs are deducted from income and distributions from HSAs that are used to pay for qualified medical expenses are not taxed. An IRA-to-HSA rollover would be attractive to an individual with adequate retirement savings or to an individual who anticipates a sizable upcoming medical expense.
Planning for future health care expenses is a task that all of us should undertake. HSAs are one option that allows individuals to save money in a tax-favored way for future and current medical expenses. Funding HSAs using rollover contributions is an attractive way to save for the medical expense rainy day in all of our futures.
Jenifer Cromwell is an associate at the employee benefits law firm of Groom Law Group, in Washington, DC, where she is a member of the Health and Welfare practice group.