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Leslie Bonacum
Neil Allen

Becoming a Tax-savvy Health Care Consumer Can Help Offset Sting of Rising Costs, Says CCH

Flexible Spending Accounts, Other Employer-Sponsored Plans and Allowance for Non-prescription Medications All Add Up to Savings

(RIVERWOODS, ILL., November 5, 2003) – With health insurance premiums continuing to increase at double-digit rates and more employers requiring employees to pay a greater share of their health care costs, many individuals are looking for health savings anywhere they can find them. According to CCH INCORPORATED (CCH), a leading provider of tax and benefits law information and software, one historically often overlooked option has been the tax savings that can be realized by effectively planning and tracking healthcare costs.

"When individuals were shielded from the costs of healthcare by comprehensive, employer-paid programs, there wasn’t a great awareness of the costs or a great incentive to reduce costs," said Glenn Sulzer, JD, a senior CCH pension law analyst. "But now, employees are paying an increasing percentage of their health costs, so, even for a healthy family, their out-of-pocket health care expenses can easily reach several hundred dollars or more each year."

This is why many individuals and employers are taking a second look at employer-sponsored benefit programs, like health care flexible spending accounts. Such cost pressures are also driving efforts by the IRS and Congress to try to expand coverage under existing programs and develop new tax-favored programs.

Health Care Flexible Spending Accounts – Worth a Closer Look

Health care flexible spending accounts (health FSAs) allow employees to pay for unreimbursed medical costs (other than premiums) incurred by themselves, their spouse, and dependents on a pre-tax basis. Contributions to the FSA not only reduce an employee’s taxable income, but are not subject to federal income tax, Social Security tax, or in many parts of the country, state and local income taxes.

Generally, once a year during a company’s open enrollment period, employees can elect to open a health FSA and how much they want to contribute through payroll deductions over the upcoming year.

Participating in a health FSA can have a significant impact on what you pay in taxes. For example, if you’re in the 28-percent tax bracket, by reserving $3,000 for medical expenses in an FSA, you may effectively realize buying power of $3,000. By contrast, if you were to take this $3,000 as income and then buy health care with it, you’d reduce your buying power by 28 percent – or $840. Those just skirting over into a higher tax bracket may even be able to lower their tax bracket, thereby reducing tax obligations even more. There also are tax advantages to employers as they do not have to pay the 7.65 percent Social Security and Medicare tax on employee pre-tax contributions to FSAs.

While most large employers with 1,000 or more employees now offer health FSAs, very few employees take advantage of them.

One of the key deterrents has been that FSAs haven’t really been all that flexible. Currently, employees who over-estimate their costs lose any of the funds unspent at the end of the year. Legislation tied to the hotly debated Medicare bill would allow employees to carry over up to $500 of an FSA to the following year.

On the flipside, while employees currently would lose unspent funds at year-end, they can spend their elected contribution before it’s all put in the account. So, if an employee elects to contribute $1,500 to an FSA, which will be drawn from equal payroll withholdings over the course of the year, they can move forward with a $1,500 qualified medical procedure at any time even though the FSA has yet to be fully funded.

In September 2003, the IRS issued a Revenue Ruling that greatly expands the flexibility of health FSAs by allowing participants to use funds to purchase over-the-counter medications. Previously, only prescription drugs and expenses such as dental and eye care were covered under these accounts.

"Most families spend a lot of money on non-prescription drugs. From cold medicine to bandages and aspirin, it adds up quickly and it’s reoccurring," said Linda Panszczyk, JD, a CCH senior employee benefits law analyst. "Having FSAs cover these makes more people realize their value; it also minimizes the use-it-or-lose it issue because toward the end of the year, employees can deplete unspent funds in their FSAs by shopping for the over-the-counter staples they’ll need for the coming year."

While the IRS is now allowing FSAs to cover some nonprescription medications, there are limits. For example, vitamins or other medications that are merely beneficial for general good health are not reimbursable. Also some employer plans have to be revised in order to allow for the new non-prescription drug expenses and some employers simply may choose not to include this as a qualified expense in their health FSAs.

The paperwork required for reimbursement also has been seen as a hassle. Traditionally, employees pay the expenses from their own pocket, save receipts, fill out and submit claim forms and then wait to get paid. To offset this, more companies are now offering debit cards that not only eliminate the paperwork, but also eliminate the need for employees to pay from their own pockets as the debit comes directly from their accounts.

To further maximize family tax savings, two-income households also may want to consider having the lower income earner open the FSA when the other spouse’s income exceeds the Social Security ceiling of $87,900 for 2004. This is because amounts contributed to an FSA are not taxed for income, Social Security or Medicare taxes. So, a couple with a low-income earner who opens the FSA will realize a bigger ‘discount’ for using the FSA because all of those funds otherwise would have been subject to Social Security taxes.

Employer Sponsored HRAs and the Expiration of the Small Business MSA

While employees fund their own FSAs through pre-tax salary reductions, employers fund Health Reimbursement Arrangements (HRAs) by contributing a fixed amount to an account for each employee to cover unreimbursed medical costs. As with FSAs, employees are not taxed on the contributions made to their accounts. Unlike FSAs, unused funds can be carried over year to year. Generally, HRAs are offered by employers as a means of lowering their insurance costs. Rather than offering employees high-premium, low-deductible programs, they switch to low-premium, high-deductible plans and use HRAs to help offset the costs of the higher deductibles.

Employers determine the particular coverage offered by their HRA, for example, some may fund just hospitalization or certain other benefits. HRAs also can be used to pay non-prescription drug costs if the employer chooses to do so.

"In deciding whether to participate in an FSA or HRA, it is imperative to check with your employer to see if the plan authorizes coverage of over-the- counter medications, the types of medications for which reimbursement is allowed, whether reimbursable costs are capped or otherwise limited, and the type of substantiation that is required in terms of receipts and records to submit a claim," said Sulzer.

The Archer Medical Saving Account (MSA) was another attempt by the IRS to help offset rising healthcare costs. It started in 1997 as a pilot program available only to employees of a small business or self-employed individuals and allowed them set aside up to 75 percent of their deductible amount in a tax-deferred account. The program was limited to the first 750,000 participants – a limit that has never been reached – and is set to expire at the end of 2003 unless Congress extends the law.

A New Twist to MSAs Tied to Medicare Legislation

Lawmakers have proposed two new health savings programs said to combine the best of FSAs, HRAs and MSAs. Known as the Health Savings Account (HSA) and the Health Savings Security Account (HSSA), both were part of The Health Savings and Affordability Act of 2003 passed by the House of Representatives this summer and attached to the Medicare bill. In late October, the more controversial and considerably more expensive HSSA program was removed from the Medicare bill negotiations.

Similar to MSAs, HSAs allow individuals to make tax-free contributions up to the amount of the deductible for insurance plans with a deductible of at least $1,000 for single coverage and $2,000 for families. There would be no income eligibility requirements for HSAs. Withdrawals could be used for qualified medical expenses and long-term care insurance. The accounts would be portable and unused contributions could be rolled over to future years, until age 65 when individuals could make taxable withdrawals for non-medical purposes. Employees also would be allowed to roll over up to $500 of unused health FSA contributions into an HSA and make contributions.

The proposed HSSA program would have had many of the same features as HSAs, but with a lower deductible and added income eligibility requirements. It also would have allowed tax-free distributions for the uninsured to buy qualified insurance.

Whether HSAs will survive the Medicare bill debate remains to be seen. While costing significantly less in tax revenue loss than HSSAs, there’s still concern that promoting more employee-funded health savings accounts would make it easier for employers to cut back their coverage even further.

"Proposed health savings accounts could offer employees and employers additional choices, but as many organizations are currently in the process of open enrollment for next year, it’s important that they focus on realizing savings where they can from known programs currently available," said Panszczyk. "And, right now, the most significant savings are likely to come from contributing wisely to health FSAs."

Deductible Medical Expenses – Often Out of Reach

One of the last-chance ways to reduce costs is by deducting dental and medical expenses as itemized expenses at tax time. However, these expenses are only deductible when they exceed 7.5 percent of adjusted gross income (AGI). Therefore, a married couple filing jointly with a combined AGI of $90,000 annually, would only be able to deduct medical expenses (for themselves and dependents) after the expenses exceed $4,750. Any expenses reimbursed by a pre-tax FSA or other plan cannot be claimed as an itemized deduction.

Additionally, while many over-the-counter medications are covered under health FSAs and other employer-sponsored health benefit plans, only prescription drugs and insulin can be deducted under the medical expense deduction. Given these restrictions, generally only those with chronic or catastrophic medical problems benefit from this deduction.

The self-employed, though do have a readily available opportunity to deduct a part of their health care costs. Starting with the 2003 tax year, self-employed people can deduct all of their health insurance premiums for themselves, their spouse and dependents. This is not subject to the 7.5 percent AGI limitation.


CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served more than four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, insurance, human resources, health care and small business markets. CCH is a Wolters Kluwer company. The CCH web site can be accessed at The CCH Tax and Accounting web site can be accessed at The CCH Human Resources site can be accessed at

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