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Employers are searching for new medical plan options to allow them to better manage runaway medical costs, which have in recent years outstripped inflation. Employers are also searching for vehicles that will force employees to become better consumers of medical services and that will permit employees to take some responsibility for their retiree medical costs.

Health Savings Accounts or HSAs are a new vehicle which have the potential to revolutionize employer-provided medical plans. These accounts, which operate partially like flexible spending accounts and partially like IRAs, will, if embraced, allow employers to save money on health care costs by giving employees a real stake in the amount they spend each year. In this Benefits Insight Article we will briefly discuss the options employers had before the advent of HSAs and analyze what HSAs can and cannot deliver for employers and employees.

Health Care Spending Account Programs Prior to 2004

Before 2004, three different types of vehicles existed for employers to utilize in conjunction with their medical coverage offerings. The far most popular vehicle has been the flexible spending account or FSA.

Flexible Spending Accounts. FSAs were introduced in the early 1980s and are offered through so called “cafeteria plans.” Under rules governing FSAs, an employee makes an election to either receive cash or to receive a nontaxable benefit. The nontaxable benefit is treated as if the employee had elected employer-provided health coverage under Section 106 of the Internal Revenue Code (the “Code”). Reimbursements from the FSA are then excluded from the participant's gross income pursuant to the provisions of Section 105(b) of the Code, which exclude from gross income amounts paid under an employer-funded accident or health plan specifically to reimburse the employee for eligible medical care expenses.

In order to receive this favorable tax treatment, the FSA must both qualify as an “accident or health plan” offered under Sections 105(b) and 106 of the Code1 and must satisfy “special requirements” for FSAs. Perhaps the most notable of these is the “uniform coverage” requirement. For the employer, this requires that the maximum amount of reimbursement elected by the participant must be available at all times during the period of coverage. On the employee's side, the risk-shifting feature is reflected in the “use it or lose it” concept, which provides that if a participant has not used the full amount of coverage elected, any additional coverage cannot be carried over to the following year but instead must lapse (i.e., the unclaimed money in the participant's account must be forfeited).

In addition to the uniform coverage rule, an employee is not allowed to change the level of his or her coverage unless the employee has experienced one of several enumerated “change in status” events described in Treasury Regulation section 1.125-4 or for other enumerated reasons.

Employer-funded Health Reimbursement Arrangements. Employer-funded health reimbursement arrangements (“HRAs”) represent one of the newest weapons in an employer's arsenal for ways to manage rising health care costs. HRAs were first officially “blessed” by the Internal Revenue Service in 2002, in Revenue Ruling 2002-41 and IRS Notice 2002-45.5 To a participant, an HRA may look similar to an FSA--both programs use an account balance concept, and participants submit eligible health care expenses for reimbursement against the amount available in their accounts. However, the similarity stops there. Unlike an FSA, an HRA is not part of a cafeteria plan and thus cannot have a “cash opt-out” feature, which is central to the cafeteria plan concept. Instead, an HRA must be funded totally by employer contributions. An HRA may include former employees and retirees as eligible participants. Furthermore, because the contributions are solely employer-generated, there is no FSA “lose it or use it” feature, so the program may permit a carryover of unused amounts to future years. In addition, there is no uniform coverage rule; thus, an employer is better able to control expenditures, since any annual contribution for participants can be “accrued” over time and does not have to be available in full at the beginning of each year.

Archer Medical Savings Accounts. Prior to the time that employers began to explore HRAs as a tool in consumer-driven health care, Congress added Section 220 to the Code in 1996, introducing Archer Medical Savings Accounts, or MSAs. The Archer MSA was a pilot program, which ended in 2003, designed to provide an additional tool for eligible individuals to pay for qualified medical expenses on a tax-free basis. Archer MSAs were more analogous to individual retirement accounts than the traditional FSA. Unlike FSAs or HRAs, the Archer MSA offered a portability feature for covered individuals, but the trade-offs for portability were greater restrictions on eligibility, and contribution and funding limitations. Archer MSAs were limited to self-employed individuals and those employed by employers with 50 or fewer employees. Additionally, individuals would be eligible only if they were covered only by a high deductible health plan (an“HDHP”). For Archer MSAs an HDHP was a plan with an annual deductible of between $1,700 and $2,600 for individual coverage and between $3,450 and $6,300 for family coverage. Eligible employees generally could not have other medical plan coverage.

Healthcare Spending Accounts

The newest addition to the field of health care account options is the Health Savings Account (“HSA”), added as new Section 223 to the Code under Section 1201 of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003.7 HSAs are basically an expansion and liberalization of Archer MSAs, with the same trust requirements and portability features, but greater availability, increased contribution limits, and less restrictive funding.

Eligibility is limited to individuals covered under qualifying HDHPs (with the same restrictions that Archer MSAs have on other health coverage); however, the definition of an HDHP has been modified to include plans with lower deductibles (and higher out-of-pocket maximums). Under the HSA rules, an HDHP plan is one with an annual deductible of not less than $1,000 for individual coverage (or $2,000 for family coverage) and out-of-pocket maximums (other than for premiums) of $5,000 for individual coverage (or $10,000 for family coverage).

Revenue Ruling 2004-389 further limits eligibility for HSAs. Individuals covered by an HDHP and a separate prescription drug plan or rider are only eligible to contribute to an HSA if the prescription drug plan is part of the HDHP. In other words, the prescription drug plan cannot provide benefits before the HDHP deductible has been met. This rule though is waived for 2004 and 2005. The IRS provided this transition relief in order to give employers time to get their plans in compliance with Rev. Rul. 2004-38.

Under an HSA, the maximum annual contribution that can be funded on an individual's behalf is equal to the lesser of 100 percent of the annual deductible of the HDHP (determined without regard to any deductible for out-of-network services) or $2,600 for individual coverage (or $5,150 for family coverage), with the limits applied on a monthly basis.10 Both the individual and his or her employer can contribute to the account; the limit is determined based on the total amount contributed. Contributions made by an employee or his/her family members to the HSA are deductible from gross income for income tax purposes, and employer contributions are excludible from an employee's gross income. Earnings on amounts held in the HSA grow on a tax-free basis.

Another feature of the HSA is the ability for a qualifying individual to make “catch-up contributions.” Under this rule, an individual (and his or her spouse covered under the HDHP) between ages 55 and 65 may make an additional annual contribution of up to $500 (calculated on a monthly basis) in calendar year 2004. The annual limit for catch-up contributions is scheduled to increase by $100 increments each year, until it reaches a maximum of $1,000 in 2009. After an individual has attained age 65, that individual may no longer make contributions, including catch-up contributions, to his HSA.

Another means of making contributions to an HSA is by making a rollover contribution from an Archer MSA or another HSA. Rollover contribution are not accepted from IRAs, HRAs, or FSAs. If permitted by the employer, an HSA owner can make contributions on a pre-tax basis under a cafeteria plan.

With regard to the tax treatment of distributions from an HSA, so long as the distribution is used for a “qualifying medical expense”, the distribution is tax-free. Also, the HSA may be rolled over to another HSA in the event an individual changes jobs. Other distributions are also permitted but are subject to income tax and a 10% excise tax.12 An HSA may be transferred tax-free to a former spouse in accordance with a court order or a divorce decree.

Issues For Employers

Clearly HSAs offer employers enticing new options in managing health care costs. HSAs may be favored over HRAs, due to the permissibility of employee contributions and ability of employees to roll over unused account balances. HSAs may force employees to make more informed health care choices in the quest to build up a sizable balance in a portable account. This is in stark contrast to the current PPO/HMO environment, where employees who pay nominal co-pays, may remain unaware of the true cost of care and have no real incentives to minimize their health expenditures. On the other hand, currently few employers may wish to offer plans with deductibles and out-of-pocket maximums as high as those mandated by the HSA rules. However, as health care costs continue to increase, more employers may find appeal in the structure of the HSA.

Retiree Medical Coverage and Adverse Selection

HSAs will be most attractive to younger employees with few health expenditures. Employers that are inclined to reduce or eliminate retiree medical coverage, especially for new employees, may implement HSAs as a means of allowing employees to build a retiree medical account throughout their careers. Every year, more companies cut back on retiree benefits, and HSAs may well spur that trend. However, employees with significant medical expenses may not ever build a sufficient account. For these employees, the advent of HSAs may do little good as employers feel they have a suitable retiree medical substitute which is, in fact, not suitable for them.

Additionally, because younger, healthier employees may embrace HSAs, there is the distinct possibility that if an employer offers an HSA and another type of plan, the cost increases of the other plan may, over time, outstrip those of the HSA as employees with higher medical expenditures choose the non-HSA plan. This “adverse selection” problem may keep HSAs from being chosen by employers other than those who intend to make the HSA the only health plan choice.

Cafeteria Plan Requirements

The necessity of having to comply with cafeteria plan rules is one of several legal issues related to HSAs which are unclear. First, although it is clear that HSAs, unlike FSAs, need not meet those cafeteria plan rules that require level coverage over the coverage period, no guidance has yet been provided regarding whether cafeteria plan rules would apply to an HSA offered within a cafeteria plan. IRS officials have informally proffered that such rules would not apply; however, no real comfort can be had on this issue until guidance is published.

ERISA Applicability

HSAs may be an attractive option for certain employers if the plans are not subject to ERISA. Because HSAs need not be sponsored by employers, employers could offer HSA options in which the only employer involvement might be the collection of employee contributions, with insurance company sponsoring and running the plan. The Department of Labor recently issued Field Assistance Bulletin (“FAB”) 2004-1 on April 7, 2004. This guidance provides that HSAs will not be considered ERISA plans if the employer's involvement is minimal. FAB 2004-1 provides that employer contributions to an HSA do not cause the HSA to become covered by ERISA if the HSA is completely voluntary and the employer does not: (1) limit the liability of eligible individuals to move their funds to another HSA beyond restrictions imposed by the Code; (2) impose conditions on utilization of HSA funds beyond those permitted under the Code; (3) represent that the HSA is an employee welfare benefit plan established or maintained by the employer, and (4) receive any payment or compensation in connection with an HSA. The employer can also sponsor a HDHP along with the HSA and the HSA will maintain its non-ERISA status. Although helpful, this guidance still leaves HSAs open to becoming ERISA plans if the employer imposes additional rules on the HSA. However, the ability of employers to be free of ERISA's provisions make HSAs very attractive to employers. With ERISA applicability arguably comes employer fiduciary responsibility for the HSA's investments. Authority has not been issued to address these HSA fiduciary issues; two such issues would be (i) whether ERISA section 404(c) (which protects plan sponsors of retirement plans for participant-directed investment losses) would apply to HSA accounts and (ii) what level of care must employers exercise in choosing HSA investments to meet ERISA's prudence requirements.

Claims Substantiation

One clear advantage of HSAs over FSAs and HRAs is the fact that substantiation of claims may be performed by the participant and not the employer. Employers likely will be quite pleased to be relieved of that burden. However, it is unclear whether employees will have the ability to make sound decisions about which claims are for valid medical expenditures. On a tax audit, invalid HSA reimbursements could subject employees to back taxes, penalties and interest. It would not be surprising if employee groups request that employers offer some assistance to HSA participants (as is the case with reimbursement under FSAs and HRAs) in determining the validity of reimbursements.

Conclusion

HSAs offer a plan structure that many employers will readily leap to embrace. However, these accounts have both positive and negative attributes. This is clearly not a “one size fits all” solution to the crisis in medical plan funding. In addition, there are several important legal issues that employers may wish to see resolved prior to implementing an HSA. Therefore, employers need to think hard about the ramifications of establishing HSAs before doing so.

For further assistance, please consult one of our attorneys in the Employee Benefits Practice Group.

The complete article with citations in printable PDF format is available at http://www.littler.com/nwsltr/BenefitsInsights_05_04.pdf

You can find the other Insights at http://www.littler.com/nwsltr/index_insight.html

Mr. Steven J. Friedman is the Chair of Littler Mendelson's Employee Benefits Practice Group. He can be reached at 212-583-2687; sfriedman@littler.com

Ms. Susan L. Letney is Of Counsel and member of the Employee Benefits Practice Group and can be reached at 713.951.9400; sletney@littler.com.

Ms. Michelle I. Pretlow is an Associate of Littler Mendelson and member of the Employee Benefits Practice Group and can be reached at 202.842.3400; mpretlow@littler.com.

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