Jay Savan, CEBS, CLU, ChFC, CFP®
Jay Savan, CEBS, CLU, ChFC, CFP®, is a senior consultant with Towers Watson.
The Patient Protection and Affordable Care Act (PPACA), signed into law in March 2010, creates a need to re-evaluate the structure and delivery of health coverage among employers and individuals. Perhaps unintentionally, the law has also created an unqualified opportunity for young adults to capitalize on the tax-protected savings advantage presented by health savings accounts (HSAs).
HSAs: Savings Opportunity of a Lifetime
An HSA is a tax-advantaged personal trust account that is available only to individuals who enroll in a statutorily defined high-deductible health plan (HDHP) and who are not also enrolled in a non-HDHP. HSAs enable beneficiaries to pay for current qualified health expenses and save for future medical and retiree health expenses on a tax-free basis.
Many banks and other financial institutions offer HSA products, and 31 percent of large employers now offer HSA-compatible HDHPs to their employees and permit them to contribute to an HSA through payroll deduction. According to Towers Watson, approximately 7 percent of large employers now offer an HDHP(s) as the only health plan available to their employees.1
The maximum annual HSA contribution is based on the statutory limit for the level of coverage in which an eligible individual is enrolled. For 2011, self-only HDHP coverage permits a contribution of $3,050; family HDHP coverage (defined as two or more covered members) permits a contribution of $6,150. Eligible individuals age 55 or older during the calendar year can make additional catch-up contributions of up to $1,000 a year. No contributions are permitted once an individual is enrolled in Medicare, although beneficiaries can continue to use the funds in their account.
The tax treatment of HSAs is different from just about any other vehicle authorized under the Internal Revenue Code. Specifically:
- Contributions to an HSA are tax-deductible (or, if made through an employer's IRC Section 125 cafeteria benefit plan, may be made from an employee's pretax wages).
- Earnings on the contributions grow tax-free.
- If distributions from the account are used to reimburse qualified health expenses, they are not subject to taxation.
HSA distributions can be used for non-health expenses, although doing so renders them taxable and, if the beneficiary is under age 65, subject to an additional 20 percent penalty. In this way, an HSA can be viewed as analogous to a traditional deductible IRA.
Perhaps most important, beneficiaries own and control the money in their HSA. They ¾ not a third party or health insurer ¾ decide how to spend the money and how to invest account assets, balancing objectives for growth or principal stability according to their needs.
The triple tax-protection dynamic presented by HSAs is an unequaled opportunity for Americans to direct and accumulate funds for current and future needs. And, while an HSA can be a great opportunity for anyone who is eligible, it's particularly appealing for younger individuals, who can benefit from more years of tax-protected account growth.
It's important to note that there is no time limit on the use of HSA distributions to pay for eligible expenses. The only requirement is that the expenses must have been incurred after the HSA was established, and deferring reimbursement presents another opportunity to benefit from compounding interest and tax-free growth. For example, an individual who is HSA-eligible could contribute $2,000 to an HSA in 2011, incur $300 in expenses that year, but choose to pay those expenses out of pocket. After 10 years, assuming a compound annual 5 percent rate of return, the original investment would have grown to $3,258. The HSA owner could then reimburse himself the $300 from accumulated earnings without disrupting the principal or much of his other earnings.
Adult Dependents and HSAs: A Wealth Creation Opportunity
The PPACA also specifies that if a parent's health plan makes coverage of dependent children available, it must allow coverage of eligible adult children up to age 26. This provision applies to group health plan years beginning on or after September 23, 2010 (i.e., January 1, 2011 for a calendar-year plan). For any children who have not attained age 26, the plan may not deny or restrict coverage based on a child's:
- Financial dependency upon the employee (or any other person)
- Residency with the employee (or any other person)
- Student status
- Marital status
- Employment status
- Any combination of these factors
A special rule applies to "grandfathered" plans that have met certain requirements that permit continuation of existing plan provisions. For calendar-year plans beginning before January 1, 2014, a grandfathered group health plan is not required to provide coverage to an employee's adult child to age 26 if the adult child is eligible to enroll in another employer-sponsored health plan. Thus, coverage is not required to be made available under a grandfathered plan if the employee's adult child is eligible for health coverage from his own ¾ or a spouse's ¾ employer. Beginning in 2014, adult children will be eligible for coverage to age 26 under their parent's employer plan regardless of whether the adult children are eligible to enroll in any other employer-sponsored group health plan, including that of their own employer.
The IRS has issued Notice 2010-38, providing guidance on the tax treatment of healthcare coverage extended to adult children under the PPACA. Among other issues, the Notice clarified that:
- Employer-provided health coverage is excluded from the employee's gross income on child coverage provided through the end of the calendar year in which the child reaches age 26 (although mandatory coverage is required only to the 26th birthday).
- Employer-provided accident and health plans can immediately provide coverage for adult children.
- The coverage can be provided through a cafeteria plan, permitting the parent to pay his portion of the required premium on a pretax basis.
Finally, employers are prohibited from requiring an additional premium contribution based solely on a child's age: An employee cannot be charged a higher contribution to enroll, for example, an eligible 25-year-old child than to enroll a 10-year-old child.
For purposes of this discussion, we will assume a parent-child relationship where the parent covers his adult dependent child, who has not yet attained age 26 and is eligible for coverage, under a family-level HDHP offered through his employer. Further, the child in this example cannot be claimed as a dependent on the parent's (or anyone else's) tax return ¾ a key element of HSA contribution eligibility.
In this circumstance, the adult child is eligible to establish his own HSA and contribute up to the allowed maximum family contribution amount, assuming he is eligible to contribute to an HSA (e.g., he is not enrolled in any other a non-HDHP, which would disqualify his HSA eligibility). In addition, the parent is entitled to contribute to his own HSA, up to the statutory family maximum contribution, plus any allowable catch-up contributions. Thus, for example, a married HSA-eligible couple could contribute up to $6,150 (in 2011) to one or more HSAs, plus any allowable catch-up contributions.
An important restriction stipulates that the parents and child cannot use their respective HSA distributions on a tax-free basis to pay out-of-pocket medical expenses incurred by the other party. However, it is permissible for any party to contribute to any HSA-eligible individual's account; thus, the parent (or a grandparent, or other well-meaning party) could fund part or all of the child's HSA contribution without any impact to his or her own tax situation. We'll discuss this further, below.
By virtue of his enrollment in a family-level HDHP, the child can make a family-level tax-free HSA contribution. What's more, the entire family's claims will accumulate toward meeting the HDHP deductible and out-of-pocket limit. Both the parents' and children's respective HSAs are protected by the fact that they're enrolled in a sole HDHP, where they share exposure, while the law permits them to double-dip on the allowable HSA contribution. While this likely presents a particular opportunity for the child, whose claims are likely to be less than his parents', the mutual cost sharing also spreads the out-of-pocket risk among more parties and thus protects the parents' HSA, as well.
For example, let's assume both parents are over age 55, and one parent's employer offers an HDHP with the following features:
- Family deductible: $3,000
- Coinsurance beyond deductible: 80 percent
- Out-of-pocket maximum (including deductible): $4,000
Further assuming the deductible and out-of-pocket limit are structured so that all covered members' claims can accrue to satisfy them, as is common, the family is essentially able to contribute a combined $14,300* into HSAs in 2011, with a maximum depletion of $4,000, leaving $10,300 to accumulate ¾ tax-free ¾ for future needs. If the parents covered a second adult child under the same HDHP, the total would be $20,450.
*The parents are entitled to contribute a combined $6,150 to their respective HSAs, plus $1,000 in catch-up contributions to each HSA; the adult child is entitled to contribute $6,150 to his separate HSA, for a combined $14,300. The second adult dependent child's maximum $6,150 contribution brings the total contributions to $20,450.
This represented spread of risk within the HDHP inherently helps all parties and protects their respective HSAs from withdrawals in favor of continued accumulation. The key point, however, is that this anomaly presented by the PPACA offers young adults an opportunity to "jump-start" their HSA accumulation. Ordinarily, if such an individual is unmarried, he would be limited to the single-level HSA contribution. A married adult child and his HSA-eligible spouse could make a family-level HSA contribution, but that contribution would still be no more than 50 percent of the allowable aggregated contribution he enjoys if enrolled in his parents' plan.
Assume the adult dependent gains an additional three years of family-level HSA contribution through this arrangement, starting at age 23, and that:
- He maximizes his allowable HSA contribution each of these three years.
- The maximum contribution remains at the 2011 level ($6,150.)
- All his contributions are deposited on January 1 of the respective year and grow tax-free at an annually compounded 5 percent rate, until he begins distributions at age 65.
In this case, the three years of front-loaded HSA contribution will grow to just over $124,190 by the child's 65th birthday.
Comparable Opportunity for Domestic Partners
A similar dynamic exists for domestic partners (DPs) covered under a sole, family-level HDHP. In this case, DP 1 (who is not the tax dependent of DP 2) can contribute an amount up to the family maximum HSA limit if he is covered by DP 2's family HDHP and is eligible to contribute to an HSA. The same rule regarding HSA distributions applies, however, in that DP 1 cannot use his tax-free HSA distributions to cover DP 2's otherwise-eligible expenses, or vice versa.
According to Towers Watson data, 366 of 682 large employers surveyed (54 percent) extend medical plan eligibility to same and/or opposite-gender domestic partners. So, while this situation is not as pervasive as the PPACA-mandated extension of coverage to adult dependent children, this opportunity is one for domestic partner couples to consider.
Financial Planning Considerations
Unless Congress acts to modify the estate tax exemption amount, it will reduce from essentially unlimited to $1 million on January 1, 2011. Simultaneously, the estate tax will be reinstated at a 55 percent rate.
For federal estate tax purposes, the gross estate includes all real property such as real estate, investments, business interests and personal property owned at the time of death. It also includes one-half interest in community property, annuities, pensions, profit-sharing plans and the decedent's share of any jointly owned property. Finally, estate tax can also apply to the proceeds from life insurance coverage. All told, it's easier than one might think to breach the $1 million estate threshold.
Family members (e.g., parents, grandparents) who are interested in reducing their potential estate tax liability often avail themselves of the annual gift tax exclusion. This IRC provision allows every individual to give away a specified amount of money to an unlimited number of individuals without any gift or estate tax consequences. In 2011, the amount of the annual exclusion is $13,000 and is subject to indexing in future years. By making annual gifts to their children or grandchildren, or to a trust in their name, taxpayers can reduce future exposure to estate taxes by:
- Eliminating assets from the estate
- Removing the potential that these assets will appreciate as part of the taxable estate.
The gift recipient is not required to claim the gift as income for federal income tax purposes. Thus, a parent could make a gift of part or all of an adult child's HSA contribution to the child under the annual gift tax exclusion without adversely affecting the parent's or the child's tax status. In this case, however, the child, not the parent, would receive the tax deduction for the HSA contribution. Doing so permits the parent to reduce his estate tax liability and fund part or all of the child's tax-deductible HSA contribution. In this small way, the parent can both reduce his taxable estate and can optimize his gift from a personal income tax perspective.
These are challenging times, and the need for young adults to save for retirement and future healthcare costs has never been more critical. HSAs represent one of the most valuable tax-protected accumulation devices available, today. Meanwhile, one of the biggest advantages a child has is time to allow HSA contributions to grow, tax-free. Families who avail themselves of this opportunity will be taking an important step toward securing their young adults' financial future.
The information contained in this article does not constitute legal, accounting, tax, consulting or other professional advice. Before making any decision or taking any action relating to the issues addressed in this article, please engage a qualified professional advisor.
1 Towers Watson 2010 Health Care Cost Survey