Health savings accounts offer tax-preferred option

Congress enacted the Medicare Modernization Act in late 2003. The act allows a new tax-preferred option called a health savings account. Health savings accounts are essentially medical savings accounts, which have been allowed since January 1997, but are now a permanent tax program without many of the restrictions governing the federal Archer MSA program.

Seventy-three percent of the population spends $500 or less on medical expenses per year. Most people will not spend all of the health savings account funds in a year. Based on a yearly contribution of $3,375, with a 4 percent interest rate and no medical expenses paid out, in 30 years, a participant could have $85,305 in a health savings account.

A qualified high-deductible health insurance plan protects the insured against the cost of catastrophic illness or injury. The savings account contains funds that are controlled and owned by the account holder and can be used to pay for smaller, routine health care expenses. The savings balance in the account rolls over each year and accumulates for future health care expenses or retirement.

In January, when a health savings account participant files an income tax return, he or she will have the tax advantages the health savings account program offers. Contributions to the health savings account are 100 percent tax-deductible, just like an Individual Retirement Account. Withdrawals for covered medical expenses are never taxed and interest earnings accumulate tax-deferred and, if used for qualified medical expenses as defined by 213(d) of the IRS Code, are tax-free.

For individual coverage, the qualifying health plan must have a minimum deductible of $1,000, with total annual out-of-pocket expenses limited to $5,000 (deductible plus coinsurance). For family coverage, the minimum deductible is $2,000 with total annual out-of-pocket expenses limited to $10,000. There is no deductible maximum for either individual or family coverage.

Annual contributions to a health savings account of up to 100 percent of the annual insurance plan deductible are allowed. Annual contributions to the account are indexed for inflation. For 2004, contributions are tax-deductible up to the lesser of the qualified annual deductible amount, or $2,600 for individual coverage and $5,150 for family coverage.

Under a special catch-up provision, individuals age 55 or older may contribute more to their health savings account per year. Starting in 2004, an additional $500 contribution is allowed. This additional contribution increases $100 per year, up to $1,000 per year in 2009 and thereafter. These additional contributions also are tax deductible. A married couple can make two catch-up contributions as long as both spouses are at least 55 and are both on the high-deductible health plan. Catch-up contributions will help individuals accumulate assets for retiree health expenses. Health savings account funds can be used to pay premiums for Medicare, long-term care insurance, COBRA continuation coverage or health insurance while unemployed. Medicare supplement premiums are not considered tax-free distributions.

If a withdrawal for nonqualified health care expenses is made, a penalty of 10 percent plus ordinary income taxes will be due on the amount used. Nonqualified expenses include such things as elective cosmetic surgery, over-the-counter drugs and travel for the general improvement of your health, just to name a few. The 10 percent penalty does not apply once the account holder turns 65 years old, becomes disabled or dies.