Health Savings Accounts Expanded in Year-End Legislation

by William J. Flanagan

Health Savings Accounts (“HSAs”) – tax-favored personal savings accounts established in conjunction with high deductible health plans – have become an increasingly popular tool for providing health benefits through both individual and employment-based health plans. Use of HSAs is likely to increase further under the Tax Relief and Health Care Act of 2006 (“TRHCA”), signed into law by President Bush on December 20, 2006. Although the main purpose of this legislation is to extend certain tax cutting measures previously passed by Congress, the TRHCA includes provisions that significantly liberalize the rules governing the use and funding of HSAs. The new standards increase the amounts that individuals may contribute to HSAs, expand the potential sources of funding for HSAs and encourage employers to make larger contributions to HSAs maintained on behalf of lower income workers.

Specifically, the Act makes five important changes in the rules governing HSAs:

1. Increased Annual HSA Contribution Limits. Current law provides that the high deductible health plan maintained in connection with an HSA must provide for an annual deductible in 2007 of at least $1100 for individuals ($2200 for families) up to a statutory maximum of $2850 for individuals ($5650 for families). Historically, annual contributions to an HSA were limited to the amount of the deductible set in the plan, even if that deductible was below the statutory maximum. The TRHCA eliminates this restriction, and individuals may now make contributions to their HSAs up to the annual statutory maximum regardless of the amount of the deductible under their plan. Because HSA assets accumulate income tax free, can be carried over from year to year if not used, and may ultimately be used for non-medical purposes subject only to limited excise tax liability, this change makes HSAs more attractive not only for health benefit funding purposes, but also from a tax planning prospective.
   
2. Full Annual Contributions for Partial Year Coverage. Prior to the TRHCA, the maximum HSA contribution amount was prorated if the HSA owner became eligible for coverage during the course of a tax year. The TRHCA eliminates this proration requirement and in most cases permits a contribution up to the full statutory maximum for the owner’s first partial year of eligibility. The HSA owner must, however, continue to be covered by the HSA for an additional twelve month period after the end of his or her first partial year of eligibility in order to avoid income and excise tax liability.
   
3. Rollovers from IRAs to HSAs. An HSA owner may now take a one-time tax-free distribution from his or her IRA and roll it over into an HSA. This amount is subject to the statutory maximum and one-year participation rules discussed above. This change provides a convenient way to access IRA assets to defray personal or family medical expenses without incurring excise tax liability.
   
4. Transfers from Health Reimbursement Accounts and Health Flexible Spending Accounts. An HSA owner is also now permitted to transfer funds from an existing health reimbursement account or health flexible spending account into an HSA if the reimbursement or flexible spending account has been amended to permit such a transfer. Such transfers are only permitted through tax-year 2011, and are subject to the same contribution limits and participation rules discussed above.
   
5. Increased Employer Flexibility to Fund HSAs for Lower Paid Employees. Prior to enactment of the TRHCA, employers who contributed to their employees’ HSAs were subject to “comparability rules” which, among other things, required that employer contributions be the same for all employees with the same coverage (individual or family) or the same employment status (full-time or part-time employees). Although these rules were intended to prevent employers from favoring highly compensated employees, the actual effect was to prevent employers from providing greater funding for those employees. The TRHCA contains an exception from the comparability rules that permits employers to make larger contributions to employees who are not “highly compensated employees.”

The TRHCA contains other technical provisions relating to HSAs and these provisions, along with those discussed above, will likely require the review and amendment of existing HSA programs in order for employers and their employees to take full advantage of HSA benefits.