CRS Updates Report Comparing Health Care Savings Accounts

Health Savings Accounts (HSAs) are the newest addition to the array of tax-advantaged accounts people can use to pay for unreimbursed medical expenses, such as deductibles, copayments, and services not covered by insurance. First available January 1, 2004, HSAs are likely to replace the similar but more restrictive Archer Medical Savings Accounts (MSAs), which never attracted many participants. In addition to these two accounts, people may have access to two employment-based accounts, Health Reimbursement Accounts (HRAs) and health care Flexible Spending Accounts (FSAs). Collectively, these accounts have some features and objectives in common, but they also differ in important respects. Keeping the accounts straight can be difficult, especially when they are discussed informally using different names.

This report provides brief summaries and background information about the four accounts and then compares them with respect to eligibility, contribution limits, use of funds, and other characteristics for tax year 2005. The report concludes with a brief discussion of equity and several other issues. It will be updated as legislative occurs.

Brief Summaries and Background

Four types of tax-advantaged accounts are permitted under current law for people to pay unreimbursed medical expenses such as deductibles, copayments, and services not covered by insurance: health care Flexible Spending Accounts, Health Reimbursement Accounts, Health Savings Accounts, and Archer Medical Savings Accounts. Brief summaries and background information on the four accounts follow.¹

Health care Flexible Spending Accounts (FSAs) are employer-established arrangements that reimburse employees for medical and dental expenses not covered by insurance or otherwise reimbursable. They usually are funded through salary reduction agreements under which employees receive less pay (for example, $100 less a month) in exchange for equivalent contributions to their accounts (in this case, $1,200 for the year). Employees choose how much to put into their accounts, which can vary from year to year; however, they forfeit unused balances at the end of the year. The entire annual amount must be made available to employees at the beginning of the year. Contributions are not subject to either income or employment taxes (i.e., Social Security and Medicare taxes), unlike the pay employees otherwise would have received.

FSAs funded by salary reductions are governed by Section 125 of the Internal Revenue Code, which allows contributions to be exempt from taxes despite the fact that employees have the choice to receive taxable wages.² However, most rules regarding FSAs are not spelled out in the Code; rather, they were included in proposed regulations that the Internal Revenue Service (IRS) issued in 1984 and 1989. Final rules regarding permissible mid-year election changes were issued in 2000 and 2001. FSAs are available to more than one-fifth of private-sector workers (typically in larger establishments) and nearly half of government workers (including federal employees), though participation rates are substantially lower.³

Health Reimbursement Accounts (HRAs) are also employer-established arrangements to reimburse employees for medical and dental expenses not covered by insurance or otherwise reimbursable. As is the case with FSAs, contributions are not subject to either income or employment taxes. In contrast, however, contributions cannot be made through salary reduction agreements; only employers may contribute. Employers need not actually fund HRAs until employees draw upon them; the accounts may be simply notional. Also unlike FSAs, reimbursements can be limited to amounts previously contributed. Unused balances may be carried over indefinitely, though employers may limit the aggregate carryovers.

HRAs are governed by Section 105 of the Internal Revenue Code, which allows health plan benefits used for medical care to be exempt from taxes, and Section 106 of the Code, which allows employer contributions to those plans to be tax-exempt. Rules regarding HRAs are spelled out in IRS revenue rulings and notices issued in 2002.⁴

Health Savings Accounts (HSAs) are tax-exempt accounts for paying medical and dental expenses not covered by insurance or otherwise reimbursable. They can be established and contributions made only when the owner has qualifying high deductible insurance (a deductible of at least $1,000 for self-only and $2,000 for family coverage, plus other criteria) and no other coverage including Medicare, with some exceptions. Contributions are limited to the lesser of 100% of the deductible or $2,650 for self-only coverage, and generally 100% of the deductible or $5,250 for family coverage; additional contributions are allowed for people age 55 and over. HSAs carry tax advantages that can be significant for some people. Contributions made by employers are exempt from income and employment taxes, while account owners may deduct contributions they make themselves. Withdrawals are not taxed if used for medical expenses; those used for other purposes are taxable and subject to an additional 10% penalty except in cases of disability, death, or attaining age 65. Unused balances may be carried over from year to year without limit. As of March 2005, over 1 million people were covered by HSA -- high deductible health plans.⁵

HSAs were authorized by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA, P.L. 108-173). Most of their statutory rules are in Section 223 of the Internal Revenue Code, though there are important revenue rulings and other notices as well.⁶ The President's FY2006 budget includes several proposals to expand the availability of HSAs.

Archer Medical Savings Accounts (MSAs) are also tax-exempt accounts for paying medical and dental expenses not covered by insurance or otherwise reimbursable. Like HSAs, they can be established and contributions made only when account owners have high deductible insurance and no other coverage, with some exceptions. However, the minimum deductible levels are higher and the contribution limits are lower than for HSAs. (For details, see the comparison table that follows). In addition, the account owners must be either self-employed or employees covered by a high deductible plan established by their small employer (50 or fewer employees, on average). Contributions made by employers are exempt from income and employment taxes, while contributions by the account owners (allowed only if the employer does not contribute) are deductible. Withdrawals are not taxed if used for medical expenses; those used for other purposes are taxable and subject to an additional 15% penalty except in cases of disability, death, or attaining age 65. Unused balances may be carried over from year to year without limit.

MSAs were first authorized by the Health Insurance Portability and Accountability Act of 1996 (P.L. 104-191). That legislation also set a deadline for establishing new accounts and generally limited the total number to 750,000 (not counting accounts of owners who were previously uninsured, among others), though for tax year 2003 the IRS estimates there were fewer than 80,000 accounts in total. Later amendments extended the deadline for new accounts to December 31, 2005. However, most MSA owners can now have HSAs, and their MSA balances can be rolled over into the new accounts. Most statutory rules governing MSAs are in Section 220 of the Internal Revenue Code.

Side-by-Side Comparison

The side-by side comparison on the following pages shows the principal features of FSAs, HRAs, HSAs, and MSAs for 2005. Rules are expressed in general terms, and not all details are shown.

 Summary of General Features of FSAs, HRAs, HSAs, and MSAs, 2005

Consumer-Driven Health Care. When the accounts discussed in this report are paired with high deductible insurance, they become what some call "consumer driven health plans" (CDHPs).⁷ One objective of CDHPs is to allow owners to choose health care providers and services themselves, not constrained by managed care restrictions. Another is to give owners a financial incentive to save for future health care expenses in exchange for accepting the greater risk of a higher insurance deductible. In theory, CDHPs will slow health care spending and encourage cost-effective care. The extent to which these objectives will be borne out is not clear, in part because the two accounts most likely to be effective in these respects, HRAs and HSAs, were just authorized recently. In addition, much depends on how high the insurance deductibles are, how much money is put into the accounts and by whom, whether accounts are used to pay for expenditures other than health care (when allowed), and whether people with accounts can make informed choices. Additional key questions are how much competition there is among health care providers and whether prices for health care goods and services are transparent. Some of the complexities of these issues are discussed in another report, CRS Report RL32467, Health Savings Accounts.

Equity. The tax savings associated with tax-advantaged health care accounts depend on the taxpayers' marginal tax rates; these vary from 10% for married couples filing joint returns who have taxable incomes up to $14,600 up to 35% for married couples filing joint returns who have taxable incomes over $326,450. (These figures are for the 2005 tax year; other figures apply to taxpayers with different filing status.) As a consequence, the accounts discussed in this report are more attractive for higher-income taxpayers; indeed, some might consider HSAs more as a vehicle for building retirement income than paying for health care. Critics of these accounts might argue that it is unfair for public health care subsidies (the forgone tax revenue) to flow disproportionately to higher income taxpayers, particularly since they generally have more resources to spend on health care in the first place. However, if the accounts are paired with high deductible insurance, it might be argued that the tax savings are appropriate for taking on more greater financial risk and using less health care (to the extent these actually occur). The latter arguments do not apply to FSAs when taxpayers do not have high deductible insurance; these accounts subsidize first-dollar payments for health care and may increase health care spending. As FSAs are available only through employer plans, they likely appear inequitable to taxpayers who cannot have them.

Targeted Savings Accounts. Current law provides multiple tax-advantaged savings accounts for education and retirement, as well as health care. Some argue that it would be simpler and more effective to have accounts that would be generally available for a variety of expenses, perhaps along the lines of the Retirement Savings Account and the Lifetime Savings Account that President Bush has proposed. Others argue that these proposed accounts would favor higher income taxpayers even more and would make it more difficult to coordinate with benefits provided through government programs.

² Section 125 governs cafeteria plans; it provides an express exception to the constructive receipt rule, which requires taxation of what is normally nontaxable income when taxpayers have the choice of receiving taxable income or nontaxable income.

³ FSA rules are available at 49 Federal Register 19321 and 50733, 54 FR 9460, 65 FR 15548 and 66 FR 1837. Also see IRS Revenue Ruling 2003-102. For data on the use of FSAs, see CRS Report RL32656, Health Care Flexible Spending Accounts, by Chris L. Peterson and Bob Lyke.

⁴ IRS Revenue Ruling 2002-41 and Notice 2002-45.

⁵ See America's Health Insurance Plans (AHIP) website at [http://www.ahip.org].

⁶ For a detailed description and analysis of HSAs, see CRS Report RL32467, Health Savings Accounts, by Bob Lyke, Chris L. Peterson, and Neela Ranade. Relevant revenue rulings and other notices are listed in this report.

⁷ HSA and MSA plans require high deductible insurance when contributions are made, though owners can retain accounts after switching to plans with lower deductibles. There is no legal requirement for HRAs to be associated with high deductible coverage, though they usually are. FSAs do not require high deductible insurance.