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
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
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
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
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
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
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.
About CCH INCORPORATED
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 cch.com. The CCH
Tax and Accounting web site can be accessed at tax.cchgroup.com.
The CCH Human Resources site can be accessed at hr.cch.com.
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