Consumer-driven Health Plans Offer Tax Breaks; More Taxpayers May Meet the Medical Expense Deduction As Health Care Costs Increase

(RIVERWOODS, ILL., January 2008) – With health care costs continuing to increase faster than other expenses, taxpayers are looking at ways to help lower medical costs. The tax code offers a few options, including tax advantaged health spending, health reimbursement and flexible savings accounts, as well as a medical deduction for those with medical expenses exceeding 7.5 percent of their adjusted gross income and planning to itemize deductions, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com).

“Whether you’re considering how to keep a lid on your health care premiums and out-of-pocket expenses over the coming years or trying to figure out how to get a tax break on your 2007 return for medical expenses, there are options available, depending on your employer’s benefits options and if you’re willing to take the time to sort through the alternatives available,” said CCH Health/Welfare Plan Analyst Stephen Huth.

The Alphabet Soup of Consumer-driven Health Plans

Just as employees are being asked to take more control of their retirement planning – from opening IRA accounts to contributing to employer-sponsored 401(k) plans – individuals also are being asked to take more control over their health care. And, just as with retirement plans, tax advantages are available for those willing and able to forge ahead into the world of consumer-driven health plans.

Three programs are most generally categorized as consumer-driven health plans and all offer special tax breaks:

Health Savings Accounts (HSAs);
Health Reimbursement Accounts (HRAs); and
Flexible Spending Accounts (FSAs).

“HSAs are unique in that they offer a triple-tax benefit: you are able to contribute pre-tax dollars into the accounts; your investment grows tax free and there is no tax on any distribution as long as it’s used to pay for medical expenses. HSAs offer the added benefit that they are owned by the individual, not the employer, so you could continue to invest in an HSA, setting aside the funds to supplement Medicare during you retirement if you wanted,” said Huth.

Because HRAs are owned by the employer, they generally are not portable from employer to employer. The advantage to employees is that all of the money comes from employer contributions, and the accounts themselves typically roll over from year to year as long as the individual remains with the employer. HRAs are typically used in conjunction with high-deductible health plans (HDHP), although the law does not require this. Thus, HRAs can be used with health plans that have lower deductibles and lower out-of-pocket maximums.

HSAs in 2008 allow taxpayers to set aside tax free up to $2,900 for those with individual coverage and $5,800 for individuals with family coverage. These figures are adjusted for inflation and in 2007 were $2,850 for individual and $5,650 for family coverage. Individuals over 55 can contribute an additional $900 to an HSA in 2008 ($800 for 2007). All withdrawals from an HSA are tax free if used for qualified medical expenses; otherwise, a 10-percent penalty applies. However, this penalty tax is waived in the case of death, disability or the attainment of Medicare eligibility age.

Starting with 2007, taxpayers also have had the option to do a one-time transfer from an IRA to their HSA account. However, it has to be no more than the maximum allowed for HSA contributions, and any amount contributed from the IRA cannot be deducted from income as an HSA contribution for tax purposes.

“If part of your retirement funds were already earmarked for helping to pay for health care, this provision of the tax code allows you to shift the funds over to an HSA so that when you withdraw them for qualified medical expenses, you will not be taxed on the accumulated interest, as would be the case if you withdrew them from your IRA,” said Huth.

Despite the tax trifecta of HSAs, individuals should recognize that HSAs must be used in conjunction with an HDHP. For 2007 and 2008, an HDHP is defined as a health plan that has at least a $1,100 deductible for an individual and a $2,200 deductible for a family. On the other end of the spectrum, HDHPs limit the amount of out-of-pocket expenses to a maximum for 2008 of $5,650 for individuals and $11,200 for families ($5,500 individual; $11,000 family in 2007).

Although HRAs are tied to employer-provided health care, that is not necessarily true for HSAs. Anyone who is covered by an HDHP can establish and contribute to an HSA, regardless of employer involvement, said Huth.

Flexible spending accounts can be used regardless of the type of health insurance individuals have through their employer, as long as the taxpayer’s employer offers an FSA. These accounts allow taxpayers to set aside pre-tax dollars to pay for medical expenses, including over-the-counter drugs. They also, however, have a catch as any dollars put into them need to be used by a set date. This date used to be year end, however, taxpayers now have a 2.5 month grace period after year end in which to use the funds. Any previous-year funds in an FSA after the March 15 extension are forfeited. The amount an employee is allowed to contribute to an FSA is up to the individual employer and can range from a few hundred to several thousand dollars.

Health Accounts Side-By-Side

Which consumer-driven health plans, if any, and in what combination, makes sense varies on the taxpayer and their particular situation. A ccording to a study by the Kaiser Family Foundation and Health Research and Educational Trust, adoption of some plans has been slow to take off with approximately 3.8 million workers enrolled in HSA or HRA plans in 2007.

“As more taxpayers become involved in consumer-driven health plans, one of the outcomes is greater transparency throughout the health care system. Because individuals are taking on greater responsibility for managing the finances around their health care, they’re also asking more questions about the costs of procedures and alternatives,” said Huth.

Below, CCH compares plan features and tax-saving implications.

	Health Care Flexible Spending Account (FSA)	Health Reimbursement Account (HRA)	Health Savings Account (HSA)
What is it?	Health FSAs allow employees to pay for un-reimbursed medical costs including deductibles, prescription and over-the-counter medicines for themselves, their spouse and dependents on a pre-tax basis. Does not pay for health care premiums. Employers may determine which medical expenses can be reimbursed.	HRAs are employer-funded plans that allow employees to pay for medical expenses for themselves, their spouse and dependents, which are not covered under any other accident and health plan. HRA funds also may be used to pay for premiums for accident and health coverage, including individual health insurance, but may not be used for long-term care insurance. Employers may determine which medical expenses can be reimbursed.	Special savings accounts that provide tax benefits for individuals with high-deductible health plans, including pre-tax contributions and tax-free distributions for qualified medical expenses for themselves, their spouse and dependents, including premiums for long-term care, COBRA and health insurance for those 65 or older or unemployed. Qualified medical expenses include expenses for medical care as defined by IRC Sec. 213 (including expenses for nonprescription drugs) and payment for long-term care services, but only to the extent that those expenses are not covered by insurance. Distributions taken for expenses that are not qualified are treated as taxable income and may also result in a 10-percent excise tax.
Who funds it?	Employee and/or employer	Employer	Employer and/or employee
What is the tax advantage?	Employee contributions reduce an employee’s taxable income and are not subject to federal income tax, Social Security tax, or in many parts of the country, state and local income taxes.	Contributions to and reimbursements from an HRA are excluded from the employee’s gross income.	Contributions by employees are deductible in determining AGI. Contributions by an employer can be made on a pre-tax salary reduction basis and will also generate a deduction for the employer.
What is the maximum contribution?	The employee determines the amount to be contributed to the plan, although an employer can set a limit.	The employer determines the amount of the annual contribution, but typically contributions are set below the annual deductible of the accompanying health plan.	The maximum contribution limit for 2008 is $2,900 for individuals and $5,800 for families ($2,850 and $5,650, respectively, for 2007). Those who reach age 55 by the end of the tax year are eligible for a catch-up contribution of $900 for 2008 ($800 for 2007). Contributions cannot be made after age 65.
Can the account roll over?	No. It must be used in year earmarked or in the 2.5-month grace period afterwards if contributions are still left. Any contributions remaining after this grace period are forfeited.	Yes. The unused portion of the account rolls over from year to year, though an employer may restrict the amount of the carryover.	Contributions to HSAs grow tax-free and roll over from year to year. Those funds not used for qualified medical expenses can be saved for retirement. After age 65, withdrawals for non-medical expenses may be made without the 10 percent additional tax penalty.
Is the account portable?	No. COBRA continuation of coverage may apply in certain situations.	Generally HRAs are not portable unless the employer permits (subject to COBRA provisions).	Yes. HSAs are completely portable, because they are owned by individuals.
Who can establish and participate?	FSAs can be established by employer and participants may include both current and former employees.	Any employer may offer an HRA.	HSAs can be established by any employer or by an individual, and anyone can participate as long as done in conjunction with a high-deductible health care policy. For 2007 and 2008, an HDHP is generally considered one in which the deductible for individuals is at least $1,100 and $2,200 for a family.
How are reimburse-ments made?	Through debit card or proof of receipts submitted with forms for reimbursement.	Through proof of receipts or authorized debit cards.	Reimbursements are handled by HSA trustees and custodians; individual HSA-holders are responsible for documenting that expenses are for medical care.
Can it be used with other types of accounts?	Can have an FSA and an HRA.	Can have an HRA with an FSA.	Can have an HSA with an FSA limited to dental and vision benefits or an HSA that only provides benefits after the HDHP deductible has been met.

Deducting Medical Expenses

Certain dental and medical expenses that are not reimbursed by insurance can be deducted from income, helping a taxpayer to lower taxes owed, but only after they exceed 7.5 percent of adjusted gross income (AGI) and their overall allowable deductions exceed the standard deduction, which for 2008 is $10,900 for joint filers ($10,700 in 2007) and $5,450 for single filers ($5,350 in 2007). In addition to medical expenses, other itemized deductions can include mortgage interest, taxes and charitable contributions. When the combination of these deductions exceeds the standard deduction, it is generally wisest to itemize.

“The combination of good health care coverage, generally good health and a middle-class income, precludes a lot of individuals from ever reaching the 7.5-percent threshold, but eliminate any one of these factors, whether it be job loss, an interruption in insurance or a catastrophic health issue and the availability of this tax deduction becomes very important,” said Huth.

For example, a married couple with an AGI of $50,000 and unreimbursed medical expenses of $15,500 for the year for doctor and hospital visits, as well as prescription and over-the-counter drugs, would be eligible for a medical deduction of $11,750.

Doctor	$5,600
Hospital	$8,200
Prescription drugs	$1,500
Over-the-counter medicines	$ 200
Total medical expenses	$15,500
Less 7.5% of $50,000 AGI	$3,750
Allowable medical deduction	$11,750

Bunching expenses in a single year also is an approach taxpayers can sometimes take to get the advantage of the medical deduction, according to Huth. For example, someone who has an elective surgery pending, but also knows they’re going to need a more serious type of surgery that is not covered by their insurance, may want to consider having both procedures in the same year if this would allow the taxpayer to reach the eligibility level for medical deductions.

What’s Deductible?

A variety of medical related expenses are deductible, from medical and dental to modifying a home.

Among the unreimbursed medical deductions that can add up and taxpayers should keep track of, include the following:

Alcoholism and drug-addiction treatments (including meals and lodging);
Dental treatments and dentures, bridges and implants;
Drugs if medically prescribed, and insulin, but not over-the-counter drugs;
Eye exams, glasses, contact lenses and supplies to clean and maintain them;
Health insurance premiums, deductibles and co-payments;
Hearing aids, telephone equipment and television modification for the hearing-impaired;
Medicare Part B premiums deducted from Social Security checks, and Part A premiums for those not eligible for Social Security but voluntarily enrolled in Medicare;
Hospital services, including room and board for inpatients;
Medical services of physicians, surgeons, specialists or other medical practitioners such as osteopaths and podiatrists;
Stop-smoking programs and prescription drugs but not over-the-counter skin patches or nicotine gum;
Surgery, even elective, as long as it is legal and not purely for cosmetic reasons;
Therapy treatments, such as physical, occupational or speech therapy;
Weight-loss programs (that are medically prescribed); and
Wheelchairs, crutches, walkers, canes, etc.

Additionally, home modifications that do not increase the value of an individual’s home and are medically necessary are deductible. These costs may include adding entrance or exit ramps; widening doorways or hallways; installing railings, support bars or other modifications to bathrooms; lowering or modifying kitchen cabinets or equipment; moving or modifying electrical outlets or fixtures; modifying stairways; installing handrails or grab bars; modifying hardware; or grading ground or making other modifications outside doorways. Certain home modifications that are made for medical reasons that increase the value of a home, for example, an elevator or air conditioning unit, would not be fully deductible. The amount deductible would be the cost of the modification that exceeds any increase in the value of the home.

“Modifications to a home can add up, so you should hang on to invoices for the changes as well as any other out-of-pocket expenses so that you can assure that once you reach the 7.5 percent medical deduction threshold all subsequent expenses are tax deductible,” said Huth.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CorpSystem™, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.

Wolters Kluwer is a leading global information services and publishing company. The company provides products and services for professionals in the health, tax, accounting, corporate, financial services, legal and regulatory sectors. Wolters Kluwer has 2006 annual revenues of €3.4 billion, employs approximately 18,450 people worldwide and maintains operations across Europe, North America, and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, visit www.wolterskluwer.com.

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