Several options exist for employers to provide accounts that employees can use to pay for health care expenses not otherwise covered by a health plan; the options vary as to tax treatment, who can contribute, and what expenses can be covered.

There are three types of health spending accounts that can be used to help fund employee health care expenses: flexible spending accounts, health savings accounts (aka, health spending accounts), and health reimbursement arrangements. A description of each type of health spending accounts follow.

Flexible spending accounts (FSA)

One of the more popular health spending accounts is the flexible spending account or FSA which are employer-established benefit plans that reimburse employees for specified medical expenses as they are incurred. These accounts are allowed under section 125 of the Internal Revenue Code and are also referred to as “cafeteria plans” or “125 plans.” The employee contributes funds to the account through a salary reduction agreement and is able to withdraw the funds set aside to pay for medical bills. The salary reduction agreement means that any funds set aside in a flexible spending account escape both income tax and Social Security tax. Employers may contribute to these accounts as well.

There is no statutory limit on the amount of money that can be contributed to health care flexible spending accounts. However, some companies place a limit of $2,000 to $3,000 on flexible spending accounts. Once the amount of contribution has been designated during the open enrollment period that occurs once each year, the employee is not allowed to change the amount or drop out of the plan during the year unless he or she experiences a change of family status. By law, the employee forfeits any unspent funds in the account at the end of the year. There have been proposals introduced in Congress to ease this “use it or lose it” rule by allowing up to $500 to be carried over to the next year; such proposals have not been enacted.

Health savings accounts (HSA)

The second type of health spending account is a health savings account or HSA is a savings accounts used to pay for unreimbursed health care expenses. These type of health spending accounts can accumulate tax-deferred interest similar to individual retirement accounts (IRAs). Authorized by Title III of the Health Insurance Portability and Accountability Act of 1996, medical savings accounts became available starting on January 1, 1997.

Funds are controlled and owned by the account holder. The employee or the employer–never both–makes contributions. In order to qualify, the employee must be covered by a high-deductible health insurance plan and must be self-employed or employed by a firm with 50 or fewer employees. For 2001, the annual deductible for qualifying high-deductible insurance was between $1,600 and $2,400 for self-only coverage; the ceiling on annual out-of-pocket expenses for covered benefits could not exceed $3,200. For family coverage, the deductible could not be less than $3,200 or more than $4,800, and the ceiling on out-of-pocket expenses could not exceed $5,850.

A health savings account is rolled over every year and are portable, regardless of employment status. Funds can be used on a pretax basis to pay for long-term care insurance premiums, health insurance premiums paid while unemployed, and COBRA premiums (for continuation of health insurance coverage available to formerly covered individuals under provisions of the Consolidated Omnibus Budget Reconciliation Act).

HSA insurance funds can accumulate earnings, which are not taxed unless funds are withdrawn for nonmedical expenses. If withdrawn for nonmedical purposes, savings from these health spending accounts are considered taxable income and are subject to income taxes in addition to a 15-percent penalty tax. If the employee becomes disabled or reaches Medicare eligibility age, however, distributions for nonmedical expenses from the health savings account are subject only to ordinary income tax, not the penalty tax.

The maximum contribution to a health savings account or HSA for single coverage is 65 percent of the deductible on the employee?s health plan and 75 percent of the deductible for family coverage. For example, if an employee has a health plan with a deductible of $2,225, then he is allowed to contribute a maximum of $1,446.25 to a medical savings account for single coverage. With a family plan deductible of $4,500, a maximum contribution of $3,375 is allowed.

Health reimbursement arrangements (HRA)

A third type of health spending account are health reimbursement arrangements, also known as “health reimbursement accounts” or “personal care accounts,” are a type of health insurance plan that reimburses employees for qualified medical expenses. The U.S. Department of the Treasury issued guidance on these type of health spending accounts in a revenue ruling in June 2002. Because these health spending accounts are just emerging, their designs are still evolving.

Health reimbursement accounts consist of funds set aside by employers to reimburse employees for qualified medical expenses, just as an insurance plan will reimburse covered individuals for the cost of services incurred. The guidance provided by the Department of the Treasury makes it clear that health reimbursement accounts are not a new type of account designated within the Internal Revenue Code. Rather, employers qualify for preferential tax treatment of funds placed in a health reimbursement account in the same way that they qualify for tax advantages by funding an insurance plan. (Employers can deduct the cost of an insurance plan — and now a health reimbursement account — as a business expense under Internal Revenue Code section 162.)

Health reimbursement arrangements are open to employees of companies of all sizes, unlike medical savings accounts that are only available for small business employees. A health reimbursement account provides “first-dollar” medical coverage until funds are exhausted. For example, if an employee has a $500 qualifying medical expense, then the full amount will be covered by the health reimbursement arrangement if the funds are available in the account. Under a health reimbursement account, the employer provides funds, not the employee. All unused funds are rolled over at the end of the year. Former employees, including retirees, can have continued access to unused reimbursement amounts. Health reimbursement accounts remain with the originating employer and do not follow an employee to new employment.