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Tax Tidbit 07/10: Health Savings Accounts

Given the ever-escalating cost of providing employee health care benefits, we would like to advise you of a more cost-effective method of providing these benefits; namely, a health savings account (HSA). For eligible individuals, HSAs offer a tax-favorable way to set aside funds (or have their employer do so) to meet future medical needs. Here are the key tax-related elements:

• Contributions you make to an HSA are deductible, with limits,
• Contributions your employer makes are not taxed to you,
• Earnings on the funds within the HSA are not taxed, and
• Distributions from the HSA to cover qualified medical expenses are not taxed.

Who is eligible? To be eligible for an HSA, you must be covered by a “high deductible health plan” (discussed below). You must also not be covered by a plan which (1) is not a high deductible health plan, and (2) provides coverage for any benefit covered by your high deductible plan.

For 2010, a “high deductible health plan” is a plan with an annual deductible of at least $1,200 for self-only coverage, or at least $2,400 for family coverage. For self-only coverage, the 2010 limit on deductible contributions is $3,050. For family coverage, the 2010 limit on deductible contributions is $6,150. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits cannot exceed $5,950 for self-only coverage or $11,900 for family coverage.

An individual (and the individual's covered spouse as well) who has reached age 55 before the close of the tax year (and is an eligible HSA contributor) may make additional “catch-up” contributions for 2010 of up to $1,000.

Deduction limits. You can deduct contributions to an HSA for the year up to the total of your monthly limitations for the months you were eligible (1/12 of $3,050 for self-only coverage and 1/12 of $6,150 for family coverage). Also, taxpayers who are eligible individuals during the last month of the tax year are treated as having been eligible individuals for the entire year for purposes of computing the annual HSA contribution.

Rollovers from IRAs, FSAs, and HRAs. For a limited period (beginning Dec. 20, 2006, and ending December 31, 2011) an eligible individual can make a one-time transfer of amounts from a health flexible spending arrangement (health FSA) or health reimbursement arrangement (HRA) to an HSA. Similarly, on a once-only basis, taxpayers can withdraw funds from an IRA, and transfer them tax-free to an HSA. The amount so transferred is excluded from the taxpayer's gross income, and is not subject to the 10% early withdrawal penalty.

Employer contributions. If you are an eligible individual, and your employer contributes to your HSA, the employer's contribution is treated as employer-provided coverage for medical expenses under an accident or health plan and is excludable from your gross income up to the deduction limitation, as described above. Further, the employer contributions are not subject to withholding from wages for income tax or subject to FICA or FUTA. The eligible individual cannot deduct employer contributions on his federal income tax return as HSA contributions or as medical expense deductions.

Earnings. If the HSA is set up properly, it is generally exempt from taxation, and there is no tax on earnings. However, taxes may apply if contribution limitations are exceeded, required reports are not provided, or prohibited transactions occur.

Distributions. Distributions from the HSA to cover an eligible individual's qualified medical expenses, or those of his spouse or dependents, are not taxed. Qualified medical expenses for these purposes generally mean those that would qualify for the medical expense itemized deduction. If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 10% tax (20% for distributions made after Dec. 31, 2010) will apply to the withdrawal, unless it is made after reaching age 65, or in the event of death or disability.

As you can see, HSAs offer a very flexible option for providing health care coverage, but the rules are somewhat involved.  If you would like any additional information regarding health savings accounts, please contact Andrew D. Ross, CPA of Bedard, Kurowicki & Co., CPA's, PC (908) 782-7900 x 113, adr@bkc-cpa.com, or visit www.bkc-cpa.com.