M—Health Reimbursement Arrangements
Both a Health Savings Account (HSA) and a Health Reimbursement Account (HRA) can help employees afford out-of-pocket medical expenses on a tax-advantaged basis and can help employers minimize the cost through tax incentives. The chart below summarizes some of the
differences between the two types of accounts:
General Differences Between an HSA and HRA | ||
| HSA | HRA |
Owner of Account? | Employee | Employer |
Who funds the plan? | Employee and/or Employer | Employer. Vesting may apply. |
Access to funds in account | Direct access to funds to pay for qualifying medical costs. The funds can be withdrawn after age 65 for any expenses, without penalty, and subject to income tax. | Employee pays out-of-pocket for the qualifying medical cost and requests reimbursement from the account. |
Is the account portable? | Yes | No, but may or may not be used in retirement based on plan. |
Earn “Interest” on Account? | Yes. Part of employee’s account balance. | No, though the employer can invest the funds. |
Taxation | Tax-deductible contributions, tax-free growth and tax-free withdrawals for qualified medical costs. | Employer makes tax-deductible contributions, and employee receives tax-free reimbursements from the account for qualified medical costs. |
Eligibility for plan | Employee must be enrolled in a High Deductible Health Plan (HDHP) to participate in an HSA and must not be enrolled in Medicare. | Employees can participate in an HRA regardless of health plan. |
Covered Medical Costs | Qualifying medical costs, including qualifying long term care insurance, and Medicare Part B, D and Advantage Plan premiums, copays, coinsurance and deductibles. A list of qualifying expenses is updated by IRS annually. | Qualifying medical costs, determined by the employer, can be reimbursed. |
Penalties | Medical costs that do not qualify are subject to 20% penalty and income tax on the amount taken. | Generally, no penalty for the employee unless the reimbursement is not used for a qualifying medical cost. |
Contribution Limits | IRS sets annual maximum contribution limits (total employer and employee contributions must not exceed limit) for HSAs, based on high deductible health plan(HDHP) coverage. A ‘catch-up’ contribution (indexed) for participants age 55 and over is available. No further contributions allowed at age 65. | None |
Under a health reimbursement arrangement, it is possible to pay for the medical expenses of an employee and the employee’s dependents. A health reimbursement arrangement can be provided for the employees of a C corporation, a partnership, or a sole proprietorship. However, the partners of a partnership and the sole proprietor cannot be covered and receive the same tax benefits, as they are not considered “employees.” Only the stockholders of a corporation who are also employees of the corporation can be covered and receive the tax benefits. For this purpose, the stockholder-employees
of an S corporation who own more than 2 percent of the outstanding stock or voting power are treated the same as partners. Sole proprietors and partners can deduct 100 percent of amounts paid during the taxable year for medical insurance for themselves and their dependents. To take the deduction, the individual
must not be eligible to participate in any subsidized health plan maintained by his employer or his spouse’s employer. The deduction is allowable in determining adjusted gross income (but is limited to the amount of the individual’s income from the business for which the plan was established).
MEDICAL EXPENSES include items such as doctor bills, dentist bills, hospital bills, transportation, prescription drugs, dentures, nursing services, eyeglasses, and hearing aids. The ideal plan has the cost of the benefit tax deductible to the employer and not includable in the employee’s income.
SELF-INSURED ARRANGEMENTS will cause highly compensated individuals to be taxed on part or all of any reimbursements, unless the arrangement is nondiscriminatory as to benefits provided and meets one of three eligibility requirements:
- The IRS has found specific eligibility classifications within the arrangement to be nondiscriminatory;
- 70 percent or more of employees benefit from the arrangement; or
- 70 percent or more of all employees are eligible, and at least 80 percent of the 70 percent actually benefit from the arrangement.
Routine physical examinations, blood tests, and X-rays (that are not for a known illness or symptom) are not subject to the nondiscrimination requirements (i.e., the “medical diagnostic procedures” exception). In addition, despite having to include in income reimbursements under a discriminatory self-insured plan, a “highly compensated individual” may be able to claim a portion of his or her reimbursements as an itemized deduction. Medical and dental expenses, prescription drugs, and medical insurance premiums, which in total exceed 10 percent of adjusted gross income, may be deducted if the taxpayer itemizes deductions. This amount is limited to 7.5 percent of AGI for 2017 and 2018 after which it returns to 10 percent. However, because of the elimination of other itemized deductions under the 2017 Tax Act, far fewer taxpayers will itemize deductions and be able to use this deduction.
If a self-insured arrangement does not meet one of the three requirements above, then the highly compensated individuals who will be taxed include:
- Any stockholder who owns more than 10 percent of the stock.
- The five highest paid officers.
- Any employee who is among the 25 percent highest paid of all employees.
These arrangements must also comply with many of the requirements of the Patient Protection and Affordable Care Act (the Health Care Act). Some of the more significant include: (1) prohibition of preexisting condition exclusions; (2) prohibition on excessive waiting periods; (3) no lifetime or annual limits; (4) prohibition on rescissions; (5) coverage of preventive health services; and (6) extension of dependent coverage.
INSURED ARRANGEMENTS cannot be used to provide tax benefits to stockholder-employees or officers by segregating them from other employees. Under the Health Care Act, policies purchased on or after September 23, 2010, will be subject to nondiscrimination requirements (i.e., these arrangements can no longer be used to benefit a select class of employees).
The Patient Protection and Affordable Care Act generally extended the nondiscrimination rules applicable to non-insured plans to insured plans. However, employer-provided health insurance policies in existence on March 23, 2010, were grandfathered and may continue to discriminate in favor of highly compensated employees. Policies purchased after March 23, 2010, and before September 23, 2010, are subject to the nondiscrimination requirements beginning with the first plan year beginning after September 23, 2010. Failure to satisfy the nondiscrimination requirements will subject the employer to a $100 per day/per affected participant excise tax.