Flexible, Health and Medical Savings and Spending Accounts

Medical savings accounts (MSAs) are a variation of flexible spending arrangements (FSAs). MSAs are similar to IRAs in the sense that each employee can make tax-free contributions to an account. But instead of withdrawing the funds at retirement as you would with an IRA, you withdraw them to pay for certain types of medical care. In effect, you're being allowed to pay some of your medical costs with pre-tax dollars, which is a heck of a lot cheaper than paying for it with post-tax dollars.

FSAs have been around for quite some time. Their main drawback is the fact that if an employee places money into an account one year and doesn't use it for reimbursement of medical expenses in that year or shortly thereafter, he or she loses the money. With an MSA, the money is allowed to accumulate from year to year, to be used in later years when medical expenses are higher or to be saved until retirement.

At present, MSAs that are exempt from federal income taxes are part of a demonstration project that began in 1997 and expired at the end of 2007, although contributions to established accounts can still be made. It was limited to the first 750,000 people who signed up each year and is open only to the self-employed and to businesses with fewer than 50 workers. However, a number of states have MSA laws that permit employers in those states to establish state-tax-exempt MSAs. Health Savings Accounts (HSAs) have replaced MSAs.

How MSAs work. A business may offer its employees, or a self-employed person may purchase, a high-deductible health insurance plan (often referred to as a "catastrophic health plan"). For 2013, the deductible must be a minimum of $2,150 for individual coverage ($2,100 for 2012) and $4,300 for family coverage ($4,200 for 2012), and can be as high as $3,200 for an individual and $6,450 for a family ($3,150 and $6,300 for 2012). For 2013, the out-of-pocket maximum is $4,300 for individual coverage ($4,200 for 2012) and $7,850 for family coverage ($7,650 for 2012). These amounts may be adjusted anually for inflation. The employer and employee may then make tax-free contributions to an MSA. Total annual contributions are limited to 65 percent of the deductible for individuals and 75 percent of the deductible for families.

MSA Contributions. In addition to the high-deductible health policy, each employee opens up a MSA savings/investment account. Contributions to the account by an individual are deductible from adjusted gross income, and contributions made by an individual's employer are excluded from income (unless they're made through a cafeteria plan). Contributions may be made for a tax year at any time until the due date of the return for that year (not including extensions). Employer contributions must be reported on the employee's W-2. Earnings of the fund are not included in taxable income for the current year.

MSA Withdrawals. Funds may then be withdrawn from the MSA, tax-free, to pay for minor medical expenses — routine checkups, dental exams, eyeglasses, even minor surgery. Any funds that are left in the MSA at the end of the year remain in the account, and can be used in succeeding years, or saved until retirement. Thus, unlike flexible spending accounts, there is no "use-it-or-lose-it" requirement.

If you have few medical expenses over a period of years, the account may grow to a tidy sum. If funds are withdrawn for nonmedical purposes, a penalty will be assessed (plus the funds will be taxed as ordinary income). However, after age 65, you may use your MSA monies for any purpose, just like an IRA, and pay only the tax on withdrawn funds.

Health Savings Accounts. Health Savings Accounts (HSAs), approved as part of the Medicare Act of 2003, have replaced MSA programs. HSAs are very similar to MSAs, but they are less restrictive. HSAs are open to all employers, while MSAs are only available to the self-employed or businesses with 50 or fewer employees.

In addition, the deductibles for HSAs are lower than the deductibles for MSAs. For HSAs, a high-deductible plan is one in which the minimum deductible is $1,250 for individuals and $2,500 for a family for 2013 ($1,200 for individuals and $2,400 for a family for 2012). For 2013, the maximum contribution to an HSA is $3,250 for individuals ($3,100 for 2012) or $6,450 for families ($6,250 for 2012). Individuals who reach age 55 by the end of the year can increase their annual contributions by $1,000. For 2013, the maximum annual out-of-pocket amount is $6,250 for individuals ($6,050 for 2012) and $12,500 for families ($12,100 for 2012). These amounts may be adjusted annually for inflation.

Use-it-or-lose-it rule doesn't apply to HSAs. HSAs are not subject to the use-it-or-lose-it regulations of FSAs and unused balances can be rolled over to subsequent years, making them an attractive option. HSAs are not to be confused with Health Care Spending Accounts (HCSAs) or Dependent Care Spending Accounts (DCSAs), both of which are just another form of FSAs. However, the same rule allowing only prescription drugs to be eligible for reimbursement applies to FSAs and HSAs.

Model forms for establishing an HSA. The IRS has issued model forms for establishing HSAs. Form 5305-B, Health Savings Trust Account, and Form 5305-C, Health Savings Custodial Account, are used to establish HSAs and are not to be filed with the IRS. The forms and their instructions are available on the IRS web site.