Know Your Consumer-Driven Health Care: HSA

This is the third and final post on the primary consumer-driven health care arrangements under the current Internal Revenue Code.

As stated in the prior posts discussing the health FSA and HRA, the ideal consumer-driven health care vehicle should strive to achieve three main objectives:

1) Provide incentive for the individual to spend less on health expenses;

2) Maximize the individual’s flexibility in contributions and ownership of all assets contributed; and

3) Limit the individual’s financial exposure by including an out-of-pocket maximum.

The HSA is the only vehicle to effectively meet all three.

What is an HSA?

The health savings account (HSA) is the closest thing to the holy grail when it comes to applying free market principles and consumerism to modern health coverage.  HSAs are governed by Section 223 of the Internal Revenue Code.  And it’s one powerful Code section.  HSAs are triple tax-advantaged: contributions are made on a pre-tax basis (by payroll deduction) or tax deductible (above the line), funds held in the account grow tax-free, and distributions for qualified medical expenses are tax-free.  That’s as good as it gets.  The HSA is not perfect, but it is a solid foundation for a true consumer-driven model of health reform.

The basic premise of the HSA is to provide a tax-advantaged account to pair with a high deductible health plan (HDHP).  The HDHP is structured to leave a risk corridor that you’re responsible for paying, and the HSA is structured as a way to fund that risk corridor.  The HDHP will pay for some basic preventive services, but everything else will be subject to the high deductible before it’s covered.  If you incur expenses up to the extent of the deductible, you can (but don’t have to) use your HSA reimburse those costs.  The HDHP also has an out-of-pocket maximum to limit your financial liability.

The Good

- Where to start?  How about the fact that you control the contributions.  You can elect to contribute on a pre-tax basis under Section 125 through your employer’s payroll, or you can make above the line tax-deductible contributions on your own.  Your employer can also make tax-free contributions to your HSA.

- Much like an IRA, the HSA is your own personal trust account.  Unlike the health FSA and HRA, which are generally unfunded employer bookkeeping entries, you own all the funds in your HSA.

- Because you own the funds in your HRA, you control the investments (to the extent permitted by the HSA custodian).

- Also like an IRA, there are no capital gains/dividend/interest or any other taxes on the funds while held in the HSA.

- With a traditional IRA, you pay ordinary income taxes on the distributions.  With a Roth IRA, your contributions are after-tax.  With an HSA, it’s the best of both worlds: the contributions and distributions (for qualified medical expenses) are tax-free.

- Most Section 213(d) medical expenses for you, your spouse, and your dependents are qualified medical expenses.

- There’s no use-it-or-lose-it rule and there are no forfeitures with an HSA.  You really own the funds in the account.  This ability to grow your HSA indefinitely provides the strongest incentive to limit your health expenses.

- You can take a tax-free distribution for qualified medical expenses in the year incurred, or you can continue to let the account grow tax-free and take those distributions in any subsequent year (save those receipts!).

- The HDHP coverage that is paired with HSAs has an out-of-pocket limit to cap your financial exposure (in 2013, the maximum limit is $6,250 for self-only coverage and $12,500 for family coverage).  This generally leaves the consumer-driven aspect of the HSA within a reasonable range between the free preventive services and the out-of-pocket limit.

- You can take distributions for non-medical expenses.  That’s not possible with the health FSA or HRA.  If you’re 65 or over, there’s no penalty - you’ll just pay ordinary income tax as if it were an IRA.  If you’re under 65, you’ll also pay a 20% excise tax.

The Bad

- There’s one major flaw with the HSA: It’s so damn hard to be eligible to contribute to one.

- If you want to contribute to an HSA, you must be covered by an HDHP for medical coverage in that year, and ONLY by that HDHP.  You can’t also be covered by a traditional low-deductible health plan.  Even worse, your medical expenses can’t be eligible for reimbursement under a health FSA or HRA in which you or your spouse participate.  A number of other types of coverage (e.g., an employer on-site clinic) may cause you to lose HSA-eligibility, too.  You also can’t be enrolled in Medicare or claimed as a dependent on someone else’s return.

- If your employer doesn’t sponsor a HDHP, you’re basically out of luck.  Sure, you could go on the individual market to purchase HDHP coverage.  But consider the downsides.  You might be subject to preexisting condition exclusions (prior to 2014), you’ll be turning down the employer contribution amount for the employer-sponsored coverage, and you’ll lose the ability to pay the premiums on a pre-tax basis (and those premiums generally won’t be deductible either).

- The HDHP coverage you must have to be HSA-eligible is subject to a number of statutory restrictions.

- There are HSA contribution limits that cap your ability to take advantage of this triple tax-advantaged benefit.  In 2013, the limit is $3,250 for self-only coverage, and $6,450 for family coverage.  If you’re 55 or older, you get to contribute $1,000 extra.

- Some states (including California) do not conform their state income tax code the Internal Revenue Code for HSA purposes.  At least in California, this is likely motivated by the state’s insatiable demand for revenue and its hostility toward the HSA’s consumer-driven approach.

- Except in rare circumstances, premiums for health coverage are not qualified medical expenses.

ObamaCare

- As with health FSAs and HRAs, ObamaCare now prohibits HSAs from reimbursing over-the-counter medicines or drugs (other than insulin) without a prescription.

- ObamaCare also upped the excise tax for distributions that are not for qualified medical expenses (for people under age 65) from 10% to 20% starting in 2012.

- It’s unclear whether the HDHP coverage required to be HSA-eligible will continue to be readily available in the post-2014 landscape.  The future under ObamaCare will be dominated by the very restrictive exchanges and the need to comply with the individual mandate.

The Bottom Line

HSAs offer a compelling tax benefit for individuals while satisfying virtually all important policy considerations for consumer-driven health care.  For those of us who believe that re-introducing market forces to health coverage is the key to driving down costs while preserving quality and accessible care, HSAs present the ideal model to start from.   The key for making HSAs even more prominent will be either de-linking HSA eligibility with the HDHP coverage restrictions, or de-linking the ability to pay premiums for coverage on a pre-tax/deductible basis with the need for employer-sponsored coverage.  As long as HSAs are only truly viable in connection with employer-sponsored HDHP coverage, their growth will be stunted.

Obamacare only magnifies this concern.  At this point, it appears that HDHP coverage will be available after 2014 only if sponsored by employers operating outside of the exchanges.  But by 2017, employers are likely to shift coverage in large numbers to the exchanges.  If we get to that point without a major legislative success that advances consumer-driven health care alternatives to the Obamacare approach, the HSA could quickly become an anachronism.  That would be shame.  We are in dire need a strong conservative/libertarian effort to start building momentum again for consumer-driven alternatives like the HSA.  Otherwise, it may soon be too late.

 
 


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