Health Savings Accounts Can Help Handle Expenses

The Medicare reform act signed by President Bush last week will give many Americans a new tool for defraying medical costs: “health savings accounts.”

These tax-favored accounts, which will be available after Jan. 1, will be open to any working person with a high-deductible health insurance policy.

The idea is for consumers to use tax-free savings accumulated in the accounts to pay for medical expenses that aren’t covered by health plans.

And unlike some existing health-care savings plans, money left unspent in the new health savings account can be rolled over year after year, providing those who are lucky enough to stay healthy with a pot of cash to cover medical expenses when they’re older.

The accounts will quickly become as ubiquitous as individual retirement accounts and so-called 529 savings plans for college, said Paul S. Devore, chief executive of Financial Management Services, an Encino financial planning firm.

Here’s a look at how the accounts will work:

Question: What are health savings accounts?

Answer: Health savings accounts are a tax-favored savings plan created by the 2003 Medicare act. The accounts work a bit like an individual retirement account: Eligible participants can deposit money in an HSA, and deduct the amount of the deposits from taxable income.

But unlike in the case of IRA assets, which are taxed when withdrawn, withdrawals from health savings accounts will be tax-free when used for qualifying medical expenses.

If money is withdrawn for nonmedical expenses, however, the withdrawal is subject to income tax and a 10% penalty. One exception: Those who are age 65 or older can withdraw money for any purpose without penalty, but they would have to pay income tax on any money withdrawn for a non-qualified purpose.

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Q: Who is eligible to contribute to an HSA?

A: Anyone who is working and covered by a high-deductible health insurance plan. A high-deductible plan is defined as one in which coverage starts after the consumer pays the first $1,000 on individual coverage or the first $2,000 for family coverage.

The insurance plan also must limit the person’s total out-of-pocket costs to no more than $5,000 annually for an individual or $10,000 for a family. However, so-called out-of-network charges don’t count toward the out-of-pocket totals.

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Q: What’s the maximum annual amount that can be contributed to an HSA?

A: The maximum contribution is equal to the deductible on the consumer’s insurance plan, but no more than $2,600 for individuals and $5,150 for families.

Workers age 55 or older can contribute an additional $500 in 2004. The catch-up contribution amount will increase by $100 each year until it reaches $1,000 in 2009, said Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based publisher of tax information.

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Q: What are qualifying medical expenses for HSA purposes?

A: They are generally defined as costs incurred to diagnose, cure, treat or prevent a disease. This would include doctor visits and medications.

The plans allow for payments for laser eye surgery but generally not cosmetic surgery. (There are some exceptions when the cosmetic procedure cures an ailment, such as when rhinoplasty is necessary to fix a breathing problem, or when reconstructive surgery is required after an accident or operation.)

Money in an HSA account also can be used for dental expenses and orthodontia.

What’s more, the money can be used to pay premiums on Medicare coverage, long-term care insurance and so-called COBRA insurance coverage (which provides continuing health insurance for those who are between jobs), Luscombe said.

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Q: What’s the difference between an HSA and the flexible spending account many employers offer at work?

A: Flexible spending accounts are similar plans. They allow workers to save their own money, on a pretax basis, to pay medical expenses that come up during the year.

The biggest difference between flexible accounts and HSAs is that any money left unspent in a flexible account at year-end is lost, whereas money in an HSA can accumulate from year to year.

That also means that consumers may have to decide how to save or invest the money -- for example, in a bank account or a mutual fund.

The money saved in a health savings account can be provided by the employer, the employee or a combination of both. Whoever makes the contribution gets the tax deduction.

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Q: Can I contribute to both a health savings account and a flexible spending account?

A: Yes, Devore said. But you cannot double dip by using funds in both accounts to pay the same expense.

You can, however, pay expenses with the flexible savings account first and, if that money runs out, tap the health savings account.

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Q: What happens if I die with money in an HSA?

A: If you have a surviving spouse, the account can be transferred directly to the survivor, without distribution or immediate tax implications, Devore said.

If the money goes to other heirs it would be subject to income tax but not to the 10% penalty.

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Q: Will HSAs be offered through employers, or can individuals set them up themselves?

A: Both, Devore said. Employers can set them up for workers in concert with a health insurance plan. Or individuals with a high-deductible health plan can set up a health savings account separately.

Because the accounts are new, it may be difficult to find an institution offering them right away, he added.

But wait a few months. Aetna Inc. and UnitedHealth Group Inc. already have announced plans to create HSAs, Devore said.

He expects mutual fund companies and banks to jump into the fray too.

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Kathy M. Kristof can be reached at kathy.kristof@latimes.com.