This is the first of three posts on the primary consumer-driven health care arrangements under the current Internal Revenue Code.
What is Consumer-Driven Health Care?
As with almost all political issues today, there are two factions in the health plan industry constantly in conflict over the best structure for covering the cost of health expenses. On one side is the defined benefit-type philosophy. Under this traditional approach, an individual or combination of employer/employee pays a relatively high premium to receive coverage for most health expenses that the participant might incur during the plan or policy year. This style of coverage typically comes with negligible or non-existent cost-sharing requirements for the participant to access services (e.g., copays for doctor visits, coinsurance, deductibles).
Consumer-driven health care, on the other hand, generally attempts to reduce the cost of health coverage by empowering individuals to control their health expenses. Under this defined contribution-type approach, an individual or employer/employee combination contributes to an account or arrangement that can be used to cover health expenses. The individual therefore has an incentive to limit health expenses that does not exist under traditional health coverage.
In my opinion, the ideal consumer-driven health care vehicle should strive to achieve three main objectives:
- Provide incentive for the individual to spend less on health expenses;
- Maximize the individual’s flexibility in contributions and ownership of all assets contributed; and
- Limit the individual’s financial exposure by including an out-of-pocket maximum.
There are three main forms of consumer-driven health care in operation today: The health FSA, HRA, and HSA paired with HDHP coverage. It’s important to have a basic understanding of what these confusing acronyms mean, how they’re different, and their pros and cons in order to advocate for consumer-driven alternatives to the Obamacare model of health coverage. Far too few politicians today are capable of delivering that message articulately or persuasively.
What is a Health FSA?
A health flexible spending arrangement (health FSA) is an employee benefit offered through a Section 125 cafeteria plan. It is primarily intended as a tax-advantaged way to pay for out-of-pocket costs (e.g., deductibles, copays, coinsurance, or items and services not covered) for health expenses not reimbursed by major medical, dental, or vision coverage. Employees can elect to make salary reduction contributions with pre-tax dollars. Employers can also make non-elective contributions, often referred to as flex credits. Qualifying expenses are then reimbursed on a tax-free basis.
- You choose how much to contribute by salary reduction.
- The reimbursements for qualifying medical expenses are not taxed.
- Most Section 213(d) medical expenses for you, your spouse, and your dependents qualify for reimbursement.
- Uniform coverage: You have access to the full amount of your election from the first day of the plan year. For example, if you elect to contribute $1,200, and you have $1,200 of out-of-pocket medical expenses in the first month of the plan year, the health FSA will reimburse the full $1,200 even though you’ve only contributed $50. And if you terminate employment at that point, you have no obligation to repay the additional $1,150 you received in reimbursement.
- COBRA: If your account is underspent (e.g., you’ve contributed $600 but received reimbursement for only $400), you can continue coverage after terminating employment by making after-tax contributions through the end of the plan year.
- The phrase you never want to hear: “Use-it-or-lose-it.” Any amounts unreimbursed at the end of the plan year (plus any run-out period) do not carry over and cannot be cashed out. In other words, if you don’t incur enough out-of-pocket medical expenses, the unused contributions are forfeited.
- Can you guess what your unreimbursed medical expenses will be for the upcoming year? Nobody can. But the health FSA forces you to to make your election prior to the plan year, and the election is generally irrevocable unless you experience a permitted election change event (as defined under the Section 125 Treasury regulations). Guess too high and you’ve lost the excess contributions forever. Too low and you’ll be paying the expenses after-tax.
- The use-it-or-lose it rule also has the perverse effect of encouraging people to spend more on health expenses to avoid forfeiting contributions.
- The health FSA is technically a self-funded group health plan, so it’s subject to nondiscrimination testing under Section 105 and Section 125 as a cafeteria plan component.
- Because of DOMA, expenses incurred by a same-sex spouse or domestic partner usually are not reimbursable.
- The health FSA is generally functional only as a supplement to pay for for out-of-pocket expenses under other primary coverage.
Obamacare limits employee salary reduction contributions to $2,500 for all plan years beginning 2013 and after. Why? The less you can contribute pre-tax to a health FSA, the more taxes you pay. In other words, it’s a revenue raiser they threw in for CBO scoring purposes.
In the good old days, you could stock up on Aspirin if you had a chunk of money left in the account at that end of the year. Obamacare now prohibits health FSAs from reimbursing over-the-counter medicines or drugs (other than insulin) without a prescription. Now you really have to be clairvoyant before the plan year begins when you make your health FSA election.
The Bottom Line
Health FSAs play a relatively minor role in the scope of consumer-driven health care. However, their role is an important one because employees can use pre-tax dollars to pay for unreimbursed health expenses. Those dollars would otherwise almost certainly be taxed because under Obamcare, you can deduct medical expenses only to the extent they exceed 10% of your AGI.
It’s a shame that the use-it-or-lose it rule makes the health FSA a near impossible guessing game—one that often encourages increased health expenditures to avoid forfeitures. More significantly, it’s a shame that Obamacare has further diminished the health FSA’s usefulness by limiting employee salary reduction contributions and reimbursement of over-the-counter medicines and drugs.