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MSAs can cover health costs, add to retirement savings

Posted online

by G. Stephen Thoma

for the Business Journal

If you're self-employed or own a small business, there's a good chance that getting or paying for health insurance for you and your employees has been a major headache. If you're in one of these two groups, you may be able to take advantage of an alternative to traditional health insurance that is now available as a result of laws passed by Congress in 1996.

Medical savings accounts (MSAs), which are linked to high-deductible insurance plans, were created to allow the self-employed and employees of businesses with 50 or fewer workers to pay for unreimbursed health care expenses with pre-tax dollars set aside in tax-favored accounts.

They are attractive accounts because contributions grow tax-deferred and distributions are generally tax-exempt if used to pay for qualifying medical expenses. Amounts in an MSA that are not used in any year can be carried over to be used in subsequent years and may even be used to supplement retirement income.

What is an MSA? To qualify as an MSA provider, a company must employ 50 or fewer workers. Individual MSAs are available to people who are self-employed. To participate, an individual must not be covered by any other health insurance, such as a group policy or a spouse's plan.

There are two steps to participation in an MSA. First, the contributor must be covered by a health insurance policy with a high deductible. For individual policies, a high deductible is considered to be in the $1,500-$2,250 range and for families, $3,000-$4,500. A high-deductible policy generally lowers the cost of the premiums.

Second, an MSA must be established at a financial institution that offers these accounts. Into this account, contributions of up to 65 percent of the annual health care deductible (75 percent for families) can be made, provided the account holder is covered by the policy for the entire year.

If, for example, a policy with the highest deductible of $4,500 for family coverage is purchased, and it covers the account holder for a whole year, he or she would be able to contribute up to 75 percent of that deductible, or $3,375.

Either a small employer or its employees can make the annual MSA contributions, but not both. If an employer contributes on behalf of employees, the contributions are excludable from income and wages for payroll-tax purposes.

If employees make the contributions, they are deductible from their federal income taxes.

In an MSA, contributions generally are applied at the account holder's direction to the investments offered within the account. These investments may include stocks, bonds, mutual funds or money-market mutual funds. Any earnings in the account can grow tax-deferred, just as they do in an individual retirement account.

Tax deferral can make a big difference in the compounded growth of an MSA. Interest and dividends on contributions and on any earnings in the account including money that would otherwise have gone to paying taxes accumulate tax-deferred.

The primary tax benefit of an MSA, however, is that withdrawals for any qualifying medical expenses are taken free of federal income tax. Only to the extent that amounts in excess of such expenses are withdrawn is the distribution taxed. Before age 65, there is also a 15 percent penalty tax on taxable withdrawals in the tax year the withdrawal is taken. After age 65, only regular income taxes must be paid on such withdrawals.

Using your MSA. To pay a medical bill, the account holder would use an access method offered with the account, often checks, or a credit or debit card, and then submit the claim to the insurance company. Once the deductible is met, the policy would cover most medical expenses, depending on the terms of the policy.

During the year, the account can be used to cover qualifying medical costs not reimbursed by the health care policy. The account holder also has the option of using funds other than those in the MSA to cover medical costs and allow the MSA assets to accumulate tax-deferred.

Unlike flexible spending accounts, assets in an MSA at the end of a year remain in the account for use the following year. Each year, provided that eligibility requirements continue to be met, additional contributions can be made, regardless of how much money remains in the account.

Upon retirement, if there are any assets remaining in the account, they can be withdrawn in a taxable distribution and used for any purpose. If withdrawals are used for qualifying medical expenses, however, they continue to be free of federal income taxes. Used in this way, the account can work in conjunction with a company's 401(k) plan or other retirement plan to provide supplemental income in retirement.

Shopping for an MSA. If you or your company are uninsured, you should consider purchasing a high-deductible health-insurance plan and opening an MSA, if you qualify. If you already have an insurance plan and this option is available to you, you will want to look at the benefits of a combination high-deductible plan and MSA with an eye toward whether you can reduce your health care costs.

Because MSAs are available from insurers, banks and financial institutions, you'll want to compare accounts. Look for an account that makes withdrawals easy, perhaps with checks or a debit card. In addition, look for a wide array of investment choices, so you can make investments that match your anticipated medical expenses.

Also ask about your choice of insurance carriers. You may want an MSA that permits you to choose your insurer, rather than an MSA linked to a certain insurance provider.

An attractive employee benefit. Offering an MSA can be a great way to attract and retain key employees. These accounts offer not only coverage for short-term health care needs, but may offer a retirement-saving opportunity, as well.

(G. Stephen Thoma is senior vice president and director, group employee services, for Merrill Lynch.)

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