Merritt Personal Lines Manual: Tax Rules and Other Details

The tax rules for MSAs are in IRS Publication 969, Medical Savings Accounts. We've attached this publication -- in its complete form -- as an Appendix at the end of this chapter.

A caveat: If am HSA is the first time an insured has gotten an individual (non-group) policy, make sure the insured applies wisely. Applications for individual policies aren't approved automatically, as group-policy applications often are -- and many people aren't even aware that insurance policies are actually underwritten. If an application includes details that raise concerns from the carrier's underwriters, they insured may be rejected. And, since one of the questions on most applications is "Have you ever had an insurance application rejected?" one sloppy mistake can linger with a person for a long time.

If the insured has serious medical problems in the first year, while the HSA account is almost empty, he or she may need to find a lot of money in a hurry to pay the high deductible. But most carriers offer a rider that covers major expenses during the first years of an HSA.

If the attached policy comes with a PPO (a "network" of doctors the insured is required to use), it'll be cheaper. But that network will limit the insured's choices, later, if he or she has serious medical problems. And if the insured chooses a non-network provider, some of their fee -- typically 25% or 50% -- won't count against the yearly deductible... so they'll cost even more!

And insured can spend MSA money on any medical provider or service that the IRS approves. But, even though the insured is paying the provider from the MSA, he or she can only apply the provider's bill against the deductible if the insurer approves the expense.

For example: Your policy has a $1600 deductible and it doesn't cover dentists. You still can spend $1000 at your dentist from your MSA. But you still have to pay another $1600 for expenses that your policy does approve, before your policy will pay a dime.

Amounts that have accumulated in an HSA are intended to be withdrawn and used for actual medical expenses (for a list of the qualified expenses go to page 4 of the IRS Publication 502). If amounts contained in an HSA are not needed for medical purposes, they may, however, be withdrawn penalty-free for other uses after the individual reaches age 65 -- or if death or disability occur.

Otherwise, a 10 percent penalty applies. All non-medical distributions are included in ordinary income for tax purposes. In addition, HSA savings can -- like IRA assets -- be rolled over to another MSA/HSA once every 12 months, but may not be combined with IRA assets.

If an employer contributes on behalf of any employee, a contribution must be made on behalf of all employees having comparable health insurance coverage. A substantial penalty applies if the employer should discriminate by not providing comparable (in amount or percentage) contributions for other employees. There are however, exceptions for part-time employees.

Like an IRA, the assets in an HSA become the property of a named beneficiary upon the accountholder's death, or go to their estate if no beneficiary is name. A spouse beneficiary can treat such assets as their own account, while a non-spouse must include them as ordinary income for taxation purposes.

HSA contributions made by an employer must be reported on an employee's tax return, and reported by the employer to the IRS. (A financial organization through which an employer has set up an MSA or HSA must also provide reports to the IRS.)

The tax year 2003 is the first in which a self-employed taxpayer is eligible to deduct 100% of health insurance premiums!

The family with the "traditional" health plan was well-insured, yet ended in the hole to the tune of over $6 thousand for the year. Meanwhile, the family insured under the MSA Plan was equally well-insured and actually ended up ahead of the game for the year (on the balance sheet).

The family with the MSA cut their insurance premiums dramatically (over $4,000) and actually stashed most of that money into a medical savings account, for which they received a substantial tax savings. They were willing to assume the risk of paying all of their little bills while hedging their bet against the catastrophic loss in a prudent manner.

If we were to re-visit these two families in three years, what would we discover? If they each had the same medical bills for two consecutive years, the "traditional" family would have a net loss of $19,767 ($6,589 x 3 years) while the "MSA" family would have a positive balance of $8,463 in their savings account -- after out-of-pocket expenses had been paid from the account -- plus interest (also tax-free).

The most difficult part of using an HSA is managing the IRS paperwork involved. So, we are including the main IRS document related to HSAs -- Publication 969 -- as an appendix to this chapter.

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