The following is the transcript of an informal discussion of employee benefit practitioners held in Washington, D.C. on December 9, 2003. The topic is Health Savings Accounts ("HSAs"), which were recently enacted under the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, P.L. 108-173, signed into law by President Bush on December 8, 2003. In particular, the discussion focused on the importance of the creation of HSAs, the future viability of HSAs and the effect HSAs may have on employer-provided health care.

Discussion Participants:

Stuart M. Lewis, Buchanan Ingersoll, P.C.
Louis T. Mazawey, Groom Law Group, Chartered
Anne Moran, Steptoe & Johnson LLP
Stephen Pavlick, McDermott, Will & Emery
Michael A. Thrasher, Groom Law Group, Chartered

Mr. Lewis: HSAs are a new defined contribution health care arrangement enabling employees and employers to make deductible and excludible contributions, which grow tax-free, in order to pay for qualified medical expenses. I think we would all agree that the predecessor to HSAs, Medical Savings Accounts ("MSAs"), never got off the ground. The new HSAs are a substantial improvement over MSAs. For example, HSAs (1) permit a lower High Deductible Plan ("HDP") to accompany HSAs (e.g., for individuals, HSAs permit an annual $1,000 deductible, whereas MSAs require a deductible of at least $1,700); (2) increase deductible and excludible contributions (e.g., for individuals, the limit is $2,600 under HSAs and only $1,690 under MSAs); and (3) are available to all employers and even individuals, whereas MSAs are only available to small employers. What do you think about HSAs?

Mr. Thrasher: My reaction is that there are four different routes for coverage: (1) traditional Blue Cross/Blue Shield type indemnity coverage; (2) Health Reimbursement Arrangements ("HRAs") coupled with a Flexible Spending Arrangement ("FSA"), where the FSA pays the first dollar expenses until exhausted; (3) MSAs, which are likely to go away as a result of the enactment of HSAs; and (4) HSAs, where an employer offers a HDP that can be funded by the employee and/or the employer. It is way too early to tell how popular HSAs will become.

Mr. Lewis: Was the lack of interest in MSAs due to the limited amount of HDPs available to employers?

Mr. Mazawey: Not necessarily. There are many HDPs and similar insurance products available to employers. If employers look, they can readily find them.

Mr. Pavlick: Many partners in law firms may already be participating in HDPs. Because they are participating in HDPs, they will be eligible for HSAs, and therefore, HSAs may be an ideal health care delivery arrangement for them.

Mr. Thrasher: Many small to mid-sized law firms sponsored MSAs. The fact that MSAs were limited to small employers gave partners the opportunity to take advantage of MSAs.

Mr. Lewis: MSAs were only available to small employers. HSAs are now available to all employers and even individuals who are covered under a HDP so long as the individual is not covered under a non-HDP. Will this increase their popularity?

Mr. Thrasher: It is too early to tell whether HSAs will become popular. Many individuals are unlikely to give up the traditional indemnity coverage.

Mr. Lewis: MSAs can only be offered with an HDP. HRAs can be a stand-alone arrangement, coupled with an HDP, or even offered with an FSA (subject to specific ordering rules). HSAs can even be offered as an option under a Code ��125 cafeteria plan. Why would an employer be inclined to offer an HSA under a cafeteria plan?

Mr. Pavlick: For one, the employer may want to avoid FICA taxes.

Mr. Thrasher: I agree. It is hard to think of other motivating factors. Actually, employers will probably be most inclined to set up a plan that includes an HRA, an FSA, and a traditional indemnity plan. For example, employers may offer a HDP that does not have a very high deductible amount, along with an HRA, and an FSA. The HDP will arguably lower the cost of providing medical coverage to the employee, the HRA can be used by the employee to pay for the cost of the deductible and also allow the employee to rollover any money leftover in their HRA, and the FSA can be used to pay for other costs such as co-pays. Naturally, the FSA would be drawn down first because of the ��125 use-it-or-lose it rule applicable to FSAs, thereby potentially leaving more money in the HRA, which can be rolled over.

Mr. Pavlick: That's right. Employees can use up amounts they contribute to the FSA through salary reduction first, thereby leaving more money available in the HRA, which can be rolled over year to year. Another advantage of an HSA is that if an employee is over 65, they may treat the HSA as an individual retirement account without incurring a tax penalty.

Mr. Lewis: Unlike HRAs, both MSAs and HSAs permit non-health distributions. However, a penalty tax is imposed (10% excise tax under HSA and 15% under MSA) on non-health distributions made before death, disability or becoming Medicare-eligible, i.e., age 65. Thus, individuals 65 and over can make non-health withdrawals from his or her HSA without incurring a tax penalty. Such amounts would still be includible in income in the year of distribution.

Mr. Thrasher: HSAs are attractive because the employee may have access to the money. Under HRAs, however, the employee cannot get the money because, by definition, an HRA must be funded solely with employer money. This may be a design issue in that if employers want to give employees access to the money, HSAs are attractive. But if the employer does not want the employee to gain access to the money, or the employer wants the potential benefit of forfeitures, an HRA is better suited.

Mr. Lewis: Therefore, HSAs may be good for employees but not good for employers because HSAs must be funded, whereas HRAs may be unfunded and simply be maintained on the employer's books. Most HRAs are currently unfunded book accounts.

Mr. Thrasher: Then a complicated question arises under ERISA--Are the HSA's assets "plan assets" under ERISA?

Ms. Moran: I think employers are looking for new options for providing health coverage to employees, and HSAs may just be the answer. For example, most big employers are disinclined to hold on to the old indemnity health plan due to rising health costs. These employers may be looking for new options in an effort to minimize, or at least control, its health care spending.

Mr. Lewis: If the employer thinks HSAs will reduce costs, then maybe HSAs are viable options for the future.

Mr. Thrasher: No one knows how the new Medicare reforms will affect the current state of the employer-provided health care delivery system, let alone how the new changes will affect HSAs and the provision of health coverage through an HSA.

This commentary also will appear in the February 6, 2004, issue of the Tax Management Compensation Planning Journal. For more information, in the Tax Management Portfolios, see 389 T.M., Medical Plans: COBRA, MSAs and Disability, and in Tax Practice Series, see ��5920, Health and Disability Plans, and ��5940, Cafeteria Plans.

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