Good news!  Health Savings Accounts (HSAs) came into being as part of the 2003 Medicare Act.  Bad news!  The IRS has been issuing guidance on HSAs ever since, making the HSA a moving target.

This article lines up the target for you as it stands today.  And you will like the target.  Thanks to the IRS guidelines, HSAs are now prevalent and the rules clarified.  You can plan with these new rules and you can count on them remaining in place.

True, the IRS will issue more guidance, but, as usual, the new guidance

·         Will deal with parts of the law for which there is yet no guidance

·         Will not change or make obsolete the current guidance.

Generally, additional guidance just piles on more layers of information.

If you are self-employed, the HSA can provide a tax-smart alternative when you cannot get the benefits of a Section 105 medical reimbursement plan.  Also, the HSA is a great alternative when you have really low medical bills, but want catastrophic coverage, and a little nest egg to boot.

How HSAs Work in a Nutshell

First, comparison shop when you buy an HSA.  You have choices.  We did a search on the internet for HSA premiums and deductibles, and found one policy with a monthly premium of $230 with a $2,100 annual deductible.  Other policies, with a similar deductible, sold for monthly premiums ranging from $530 to $650.  Types of coverage also vary.  Thus, shopping for an HSA is just like shopping for regular health insurance.  You need to make comparisons.  That’s rule one.

The typical attributes of an HSA include

·         lower insurance premiums

·         higher deductibles

·         savings account

·         tax benefits

Higher deductible.  Your HSA insurance policy must carry a minimum deductible and a ceiling on the out-of-pocket payout by you.  For 2005,

·         $1,000 is the self-only minimum deductible

·         $2,000 is the family minimum deductible

·         $5,100 is the self-only ceiling on out-of-pocket

·         $10,200 is the family ceiling on out-of-pocket

Savings account.  This element gives the HSA an uptick, because the law

·         gives you a tax deduction for the money you put into the savings account,

·         lets the money in your savings compound tax free,

·         allows tax-free withdrawals from savings to pay medical bills, and

·         grants you the right when you reach Medicare eligibility age, to take the savings subject to income taxes, but without penalty, just like you would take money from an individual retirement account after age 59 ½.

The 2005 ceiling that the law places on your savings account contributions is the lesser of your insurance deductible or

·         $2,650 for self-only coverage

·         $5,250 for family coverage

If you start your HSA in 2005, your limit depends on the month you start, as we discuss later.

Tax benefit 1.  You write off your savings contribution above the line, which means

·         you benefit from the deduction, whether or not you itemize, and

·         your deduction does not suffer the phase-out attack on itemized deductions.

Tax benefit 2.  Because you are self-employed, you write off the HSA insurance premium as a cost of health insurance for the self-employed on the front page of your Form 1040, another tax-favored above-the-line deduction.  Compare your favored self-employment status where you get a 100% deduction to the lowly employee who may realize no tax benefit from his HSA insurance premiums as they undergo the cruel torture of the 7.5% floor on itemized medical deductions.

Tax benefit 3.  Unlike many tax advantaged health plans, the self-employed taxpayer may have an HSA without covering the employees.

Can You Have an HSA?

You qualify to have an HSA when you

• have no disqualifying health coverage as discussed below,
• are not enrolled in Medicare, and
• may not be claimed as a dependent on another taxpayers’ return.

Health coverage that destroys your ability to have an HSA includes any health coverage that is not a high deductible health plan, except insurance to cover

·         Accidents

·         Disability

·         Dental care

·         Vision care

·         Long-term care

·         Liabilities under workers’ compensation laws

·         Tort liabilities

·         Liabilities related to ownership or use of property

·         A specific disease or illness (like cancer insurance)

·         Hospital stays at fixed amounts per day, week, or other period of hospitalization

This means that you can have an HSA and the above coverages too.  Also, the law allows the HSA insurance to provide tax advantaged special coverages for annual checkups and selected preventive care screenings.

When Can You Start Claiming HSA Deductions?

Remember, there are two parts to your HSA:

1. Insurance cost
2. Money stashed in savings

You must have your HSA insurance policy in place before you may contribute to your savings stash.  Also, you may not take money out of the savings until you have the HSA insurance policy in place.  To put this another way, the HSA starts on the first day of the first month you put the HSA insurance policy in place.

If your HSA does not start in the first month of the year, your savings contributions are figured on a month-of-eligibility basis.  But you do not have to contribute to your savings then.  You can put off funding your savings contribution for the 2005 tax year until as late as April 17, 2006.

Example. Say in August, 2005, you start a family HSA with a $3,500 deductible.  Your maximum HSA contribution for 2005 tax year is $1,458.  (Divide $3,500 by 12 months to get the monthly amount; multiply the monthly amount by five months).  You can deposit $1,458 into your savings account in the month you start, or you can wait until April 17, 2006.

More Tax-Sheltered Savings If You Are 55 Or Older

Here is a nice bonus.  If you reach 55 or older as of the end of the tax year for which you are making an HSA contribution, you can make a larger pay in.  Similarly, if your spouse is age 55 or older, you get and additional pay in for him or her.  The extras increase your allowable deposits to your savings by

• $600 for 2005;
• $700 for 2006;
• $800 for 2007;
• $900 for 2008; and
• $1,000 for 2009 and beyond.

Example.  You have an HSA for all of 2005, which carries a $3,500 deductible.  On December 31, 2005, you will be age 55.  Presto!  You may contribute an extra $600.  But you are not finished.  On December 31, 2005, your spouse will be age 58.  Presto!  You may contribute an extra $600, because of your spouse.  Thus, you bump up your $3,500 allowance by $600 for you and by $600 for your spouse to a total of $4,700.

Summary and Conclusions

Because you are self-employed, you have the best options for making your medical expenses not only deductible, but deductible in the most tax-favored manner.

The HSA can put a smile on your face when you do not qualify for the Section 105 medical reimbursement plan.  It can make you downright giddy in the proper circumstances.  Say, for example, you are a truly healthy person who desires insurance against a catastrophe and who wants to build a tax-deferred nest egg.

With the savings part of the HSA, keep the time and return rules in mind.  You want to build your tax-deferred and tax-free accounts over the longest period of time with a great rate of return.

Also, keep in mind that the policies vary, just like most insurance policies.  You can buy different coverages and different deductibles, which change policy premiums.  Make comparisons before deciding on your HSA vendor.  This is rule one.

Rule two is put your money away for a long time and get a good rate of return.

HSA Dangers for Prescription Drugs

The most dangerous element in tax law is confusion.  The HSA rules on prescription drugs create confusion because the rule for 2005 is not the rule for 2006.

Don’t worry!  We are about to eliminate all confusion.

2005 rule.  You may have separate coverage for prescription drugs and also have and HSA.  Your HSA may not include coverage of prescription drugs, unless it provides that coverage after you hit your deductible.

2006 rule.  Unlike 2005, you may not have coverage for prescription drugs through an outside plan and also have an HSA.  Like 2005, your HSA may not include coverage of prescription drugs, unless it provides that coverage after you hit your deductible.

The prohibition on insurance for prescription drugs does not apply to prescriptions under the HSA insurance exceptions, like the provisions that allow an HSA to cover obesity weight loss and tobacco cessation.

Example 1.  You have a Section 105 plan that provides no health coverage, but it pays all of your prescription drug costs.  You may have an HSA in 2005, but not in 2006.

Example 2.  Your HSA pays for prescription drugs, but only after you reach your deductible.  Your HSA is a qualified HSA for both 2005 and 2006.

Example 3.  Your HSA pays for prescription drugs related to obesity weight loss as part of its high deductible insurance policy with no regard to the deductibles.  The HSA pays for no other prescription drugs.  Your HSA is a qualified HSA for both 2005 and 2006.

Information provided by Tax Reduction Letter, Volume 14, Number 7