What the New Medicare Law Means to Employers

New health account option and retiree coverage subsidies available to plan sponsors

Health savings accounts, or HSAs, are tax-advantaged U.S. trust accounts that work in conjunction with high-deductible health plans by covering current or future medical expenses below the deductible amount.

HSAs closely resemble Archer Medical Savings Accounts (MSAs), which have been available for several years only to self-employed people or those working for small employers (with 50 or fewer employees). HSAs can be set up by either an employer, an employee, or a combination. They are funded accounts where the amounts are owned by the employee and not subject to vesting requirements or "use it or lose it" or similar rules. (For a table comparing HSAs and other accounts, see table below).

Though there is no regulatory guidance on this point yet, employer-established or funded HSA arrangements would generally seem to be ERISA plans, and thus subject to the fiduciary, disclosure and other rules of ERISA, to the continuation requirements of COBRA, and the privacy and portability requirements of HIPAA.

Only banks or insurance companies or others specifically approved by the IRS can be trustees for HSAs. HSA trust assets cannot be used to buy life insurance and cannot be commingled, except in common trust funds or common investment funds.

Contribution Amounts. Annual cash contributions to an HSA generally are capped at the lesser of the annual deductible under the high-deductible plan, or up to (in 2004) $2,600 when the employee has individual coverage and $5,150 when he or she has family coverage (numbers will be indexed annually for inflation). This contribution limit is reduced by any amount contributed by an employer or employee to an Archer MSA. Once an individual turns 55, there is also an opportunity to make additional "catch-up" contributions. The additional amounts (for both individual and family coverages) are: $500 in 2004; $600 in 2005; $700 in 2006; $800 in 2007; $900 in 2008; and $1,000 in 2009 and later years. So, for example, the maximum contribution amount in 2004 for an individual who is 55 would be $3,100 for individual coverage and $5,650 for family coverage.

High-Deductible Health Plan Required. HSAs can be established only by individuals covered by a "high-deductible health plan" as defined by the Act. These plans have two distinguishing features. They have annual deductibles of at least $1,000 for individual coverage and $2,000 for family coverage. And they limit annual out-of-pocket expenses (including deductibles, but not premiums) to not more than $5,000 for individual coverage or $10,000 for family coverage. Insurers are free to offer plans with deductibles that are higher, or out-of-pocket expense caps that are lower, than these annual standards, but the amount that can be contributed to an HSA is limited as described above.

Eligible Individuals. Individuals covered by high-deductible plans usually will not be able to have other health-related coverage and still use an HSA. Specifically, they cannot have other coverage that is not a high-deductible plan and that covers any benefit that the high-deductible plan also covers. There are some exceptions to this duplicate coverage prohibition. An individual would remain eligible to use an HSA even if he or she had accident, disability, dental, vision or long-term care coverage (whether insured or self-insured). Similarly, eligibility would not be lost if an individual had certain types of "permitted insurance" (such as specified disease, fixed-amount hospitalization, workers compensation or auto coverage).

As of the first of the month in which a person becomes entitled to Medicare benefits (due to age, for instance), he or she would no longer be eligible to contribute to, or have his or her employer contribute to, an HSA. As described below, though, an individual who had enrolled in Medicare and was receiving benefits could still use funds in an HSA to pay for certain expenses.

Qualified Medical Expenses. HSAs can be used to pay "qualified medical expenses"—meaning expenses for "medical care" (under the very broad tax code definition) that are incurred by the employee or his or her spouse and dependents and that are not compensated by insurance or otherwise (e.g., reimbursement under an HRA or FSA). Generally, HSA funds cannot be used to pay insurance premiums, though there are some important exceptions. Most significantly, HSA funds could be used to pay for health coverage, other than Medicare supplemental coverage, once an individual turns 65. HSA funds could also pay for COBRA or long-term care coverage, and for coverage during a period when an individual is getting federal or state unemployment assistance.

Tax Benefit of Contributions. Employer contributions to an HSA are excluded from employee gross income for federal income tax purposes (this includes employee pre-tax payroll deductions through a cafeteria plan, which are considered "employer" contributions under the tax rules). Employer contributions are also excluded from "wages" for employment tax purposes, which will create FICA tax savings for employers.

When an individual contributes to an HSA (and does not do so through an employer-sponsored cafeteria plan), contributions are deductible to the individual in determining his or her gross income. This is true whether or not the individual itemizes other deductions.

Tax Consequences of Distributions. HSA distributions used to pay "qualified medical expenses" for an employee and his or her spouse and dependents are generally excludable from the gross income of the employee. This is generally true even in cases, such as a post-65 retiree who is receiving Medicare benefits, where an individual would not be currently eligible to make contributions.

Distributions for anything other than these qualified expenses (and other limited exceptions described above) do not receive that tax-favored treatment. Such distributions generally will become subject to both regular income tax and a 10% penalty tax. Again, though, there are some important exceptions. Penalty taxes will not apply – though income taxes will – to payments that are made after an account beneficiary is disabled, turns 65, or dies.

Portability of HSA Accounts. The new HSA accounts provide individuals more flexible ways to accumulate savings for health care expenditures. An employee could "roll over" amounts from one employer’s HSA program to another’s, or from an Archer MSA to an HSA. HSA accounts may also be transferred upon divorce or separation, much like retirement plan benefits can be split by means of a QDRO.

Upon the death of an HSA account holder, the tax treatment will depend on who was the named beneficiary under the account. If it was the spouse, the HSA becomes the tax-favored account of the spouse (and that amount may be deducted in computing the decedent’s taxable estate). If the named beneficiary is someone else, the HSA ceases to be a proper HSA and the beneficiary has to include (with certain exceptions) the fair market value of the account assets in his or her gross income.

Key features of some types of health accounts that employers can offer

Standard prescription drug coverage will be introduced to the Medicare program in 2006 through a new Part D that was added by the Act. All Medicare beneficiaries will be eligible. Premiums initially will be set at an estimated $420 per year. Standard Part D coverage will include a $250 deductible and 25% coinsurance on the costs above the deductible and up to $2,250. Beyond the $2,250 level, beneficiaries will pay 100% of the costs until they have reached an out-of-pocket maximum of $3,600 — this maximum would not include either premiums or amounts reimbursed by insurance or otherwise. Once the out-of-pocket maximum was reached, Medicare would provide benefits with only a minor copayment.

Policy Background. Many employers began paring back or eliminating their retiree medical plans even before the Act created the standard Part D coverage, which will give retirees an important coverage option. To encourage employers to retain prescription drug coverage, the Act provides a subsidy to plan sponsors that cover Medicare-eligible retirees who do not enroll in Part D. A sponsor of a “qualified retiree prescription drug plan” would stand to receive a tax-free subsidy based on the amount the plan actually spends on retiree prescription drug costs. This subsidy is available to plan sponsors of ERISA group health plans, federal and state government plans, collectively bargained plans, and church plans. In the case of a plan maintained jointly by an employer and a union where the employer is the primary source of financing, then the employer will be considered the plan’s sponsor for purposes of the subsidy.

Amount of Subsidy. The Act provides an annual subsidy of 28% of the actual cost (net of discounts, chargebacks, and average percentage rebates) that the plan sponsor paid for Part D-covered prescription drugs for each retiree between the thresholds of $250 and $5,000 (amounts will be adjusted annually). Copayments and other amounts paid by retirees themselves or on behalf of the retirees would also be counted. To see how this might work, consider the example of a retiree who had Part D-covered prescription drug expenses of $10,000 in 2004. But, recall that the Act only takes into account costs between $250 and $5,000 — for a maximum of $4,750 in “allowable retiree costs.” The subsidy with respect to this particular retiree would be $1,330 ($4,750 x 0.28). It is important to note that plan sponsors will not be subsidized for administrative fees such as pharmacy benefit management fees.

Qualifying for Subsidy. Plan sponsors would need to clear three hurdles to ensure that their retiree plans are "qualified retiree prescription drug plans" eligible for a subsidy. A sponsor would have to:

1. Provide coverage that is at least "actuarially equivalent" in value to the standard Part D benefit. Plan sponsors will be required to attest to the Department of Health and Human Services (HHS) that their plans satisfy this standard.
2. Retain records that may be audited by HHS and that are sufficient to ensure the adequacy of the coverage and the accuracy of payments made.
3. Tell HHS and Part D eligible individuals whether or not its plan coverage meets the "actuarial equivalence" standard above. This notice is designed to enable participants that want to switch plans based on this news to do so without running afoul of Medicare enrollment rules.

Of these three requirements, the most difficult may well be the actuarial equivalence standard. HHS will set up a process and method for calculating the actuarial value of coverage. Plan sponsors can rely on outside actuarial opinions provided they are certified by independent, qualified actuaries.

Though employer plans would need to be at least actuarially equivalent to qualify for a subsidy, the Act is clear that they need not provide benefits identical to the standard Part D coverage. Of course, the 28% subsidy arrangement described above often provides no incentive for plan sponsors to offer more generous benefits.

Debit Cards. Debit, credit and stored-value cards may become a more attractive for use with FSAs and other employer-sponsored health accounts under another change in the Act. Earlier this year, the IRS approved the use of these cards as a method of payment, but set some pretty stringent conditions on then. One of these conditions was that a Form 1099-MISC would have had to be completed for each year a single provider or retailer was paid $600 or more through an employer’s account-based plan. Recordkeeping firms indicated that this information is not routinely tracked and that this reporting would be difficult. The Act clarifies that this reporting will not have to be done for any payments made after 2002.

Age Discrimination. Notably absent from the Act is an employer-backed amendment to the Age Discrimination and Employment Act ("ADEA"). In 2000, a federal court of appeals ruled that where Medicare-eligible retirees received a lesser benefit than retirees not yet eligible for Medicare, the Medicare-eligible retirees had a valid ADEA age discrimination claim against the plan sponsor. Employers had backed Senate-approved language declaring that coordinating employer plans with Medicare would not violate the ADEA. The conference committee rejected that language, instead including in its report its nonbinding conclusion that the ADEA’s legislative history "clearly articulates the intent of Congress that employers should not be prevented from providing voluntary benefits to retirees only until they become eligible to participate in the Medicare program."