Late last year, President Bush signed the Medicare Prescription Drug Improvement and Modernization Act into law. Under this new law, any consumer under age 65 is now able to apply for certain "specific deductible" (what some call “high deductible”) major medical insurance policies paired with an income tax-favored health savings account. The law, in effect, morphed Medical Savings Accounts (MSAs) into "Health Savings Accounts." If you already own an MSA, you can continue it without interruption. If you wish to start a Health Savings Account (HSA), now's the time.

HSAs require a person or family to secure a specific deductible health insurance policy, defining specific deductible as $1000 for individuals and $2000 for a family unit. For tax year 2004, the typical annual deductibles offered by the few insurers providing such plans are (for individuals) $1000, $1700 and $2600. For families, the deductibles are $2000, $3450 and $5150. These deductibles are indexed to annual cost of living changes and will be adjusted each year as the cost of living index dictates.

Understanding how HSAs work is relatively easy if you consider the deductibles "self-insurance" on the part of the policyholders. Since policy owners are expected to pay the day-to-day "small stuff" out of pocket, the premiums paid for the health insurance are less than a low deductible plan or an HMO. To provide the cash to take care of the small stuff, the new law provides for the policy owner to set up a dedicated "cash account." The policy holder then adds specified dollars to that account each month and collects interest or other earnings as they accrue. Contributions to the cash account are income tax free and may be used to pay for a long list of health care related expenses, including some items not covered by the health insurance policy.

And unlike Cafeteria plans (under IRS Sec. 125), any unused HSA cash account dollars left at year-end roll over to the next tax year, allowing the account owner to potentially accumulate many thousands of dollars by age 65. Prior to age 65, if the owner spends HSA cash account dollars on non-allowable items, he or she must pay income taxes, plus a penalty tax on the amount spent. However, after age 65, expenditures from the cash account for non-medical expenses are subject to ordinary income tax rates only. Meanwhile, qualified medical expenses can still be paid with the HSA income tax free dollars.

To sum up HSAs, the participant acquires major medical insurance with a specific deductible, establishes an interest-bearing account from which to pay medical expenses (income tax free) and retains each year's net difference between dollars contributed and dollars spent until he or she reaches age 65. Participants benefit from lower premiums required by specific deductible health insurance policies, potential cash accumulation to augment other retirement income dollars, an opportunity to take charge of his or her future health care options and a "stop loss" benefit of each year's medical expenses equal to the deductible on his or her health insurance plan.

If you’re in good health and can meet the selected insurance company's underwriting requirements, you could be a candidate for an HSA. Maintaining specific deductible health insurance as a hedge against future events allows eligible individuals and families to take advantage of the time value of money, allowing the cash account to grow income tax free or income tax deferred, depending on the circumstances. However, if you’re in poor health or have ongoing significant medical conditions, you'd be better off retaining your present health insurance plan.

Like MSAs, HSAs allow you to own specific deductible health insurance without establishing an HSA cash account. However, you may not set up the cash account in the absence of the health insurance policy.

As with any program established under the Income Tax Code, the devil is in the details. See your insurance broker and/or your tax advisor to determine whether or not a Health Savings Account is appropriate for you or your family.

Kenneth L. Smith, CLU, FLMI, of Kenneth L. Smith Insurance
Planning Services, is a charter member of SBRN and can be
contacted at (904) 285-5225 or via Email at kensmith@kensmithhsa.com.