Medical savings accounts were created as a demonstration project under the Health Insurance Portability & Accountability Act of 1996. Starting this year, self-employed individuals can contribute tax-deductible money to a medical savings account to pay for medical expenses combined with a major medical insurance policy. Employers with less than 50 employees can also fund medical savings accounts for their employees. Details about each appear below.
Our government has limited the number of MSA participants to the first 750,000. Proponents herald medical savings accounts as a way of greatly increasing individual control over medical care and cost decisions while opponents believe medical savings accounts will only benefit well-to-do healthy individuals with no benefit to others, leading opponents to favor a more centralized system.
creative ways to increase employee compensation as a way of competing for the best talent. One of these ways was providing healthcare insurance as an employee benefit. Over time, benefits became extremely generous (especially in lowering out-of-pocket employee costs) and the tax code was structured to treat health insurance costs very favorably. Then along came Medicare and Medicaid. Within several decades patients and medical care providers became disconnected from the financial aspects of medical care, as it came to be considered an entitlement with no real limits on the amount of care available. Concurrent with this invisible financing and the illusion of limitless healthcare was an explosion of very expensive medical technology.
As aggregate private and government medical costs soared out of control, the current healthcare crisis was born.
At the core of the healthcare crisis is the fact that healthcare costs paid by employers and the government (taxpayers) have evolved into a financing plan rather than adhering to the principles of traditional insurance.
Healthcare financing refers to a system that pays even first-dollar healthcare costs (in other words, very low deductibles) on a collective basis via employer or government funding. Such a system creates its own set of incentives for patients and providers. The only way to substantially reduce the cost of such a system is to lower payments to providers, which will have an adverse effect on the quality of services provided, and to ration the amount of healthcare available to patients.
On the other hand, traditional insurance is intended to provide protection against large unforeseen medical care costs by collecting a relatively small sum from each insured, each of whom has about the same chance of incurring large medical costs. Therefore, medical insurance would not cover routine medical care costs (up to specified dollar amount), but only large ones that might otherwise cause significant financial hardship on families. By way of analogy, homeowners insurance doesn’t cover yard work, house cleaning, painting, remodeling, etc., but instead covers the home’s replacement cost in the event of a catastrophic occurrence such as damage caused by fires and tornadoes. The amount of time and resources devoted to home maintenance is therefore an individual decision.
Employer-provided healthcare premiums are fully tax-deductible. Out-of-pocket costs that employees have to pay before insurance coverage begins are an aftertax expense to the employee. Therefore, the economic incentives have favored the evolution of this health financing system. But it is first-dollar coverage that has significantly caused healthcare costs to skyrocket because employees have no medical cost-containment incentives.
In response to this situation, some companies, notably Forbes magazine and Golden Rule Insurance Company, instituted their own versions of medical savings accounts, but without any special tax advantages. Essentially, these companies set up a fund employees would use to directly pay healthcare costs up to a certain limit, such as $1,000. To the extent the specified amount wasn’t used in a given year, the employee received a cash bonus of up to twice the amount not used for medical bills annually. Amounts used to fund deductible and co-pay costs, and cash bonuses, were included in the employees’ income and taxable to them, while deductible by the employer as compensation. Companies using these non-tax-deductible medical savings accounts have reported experiencing significant savings in their combined healthcare costs because employees were provided with an incentive to be cost-conscious, which has driven down their premiums.
Let’s look at an example: Bob is self-employed. He purchases an MSA plan and makes his first $3,375 tax-deductible MSA contribution, plus the annual premium for major medical insurance for which he is entitled to take 40% as a deduction from his income. Bob and his family have medical bills of $5,000 the first year: $3,375 is paid from the MSA, the next $1,125 is paid by Bob personally without a tax deduction (totaling $4,500, which is his deductible amount), and the remaining $500 is paid by the insurance company. The next year Bob again makes a tax-deductible contribution of $3,375 to his medical savings account plus his insurance premium. During the second year his family has only $1,000 of medical bills. All $1,000 is paid from the medical savings account, leaving a balance of $2,375 (this ignores the interest the medical savings account earns). The third year Bob again contributes his tax-deductible $3,375 and pays the premium, bringing the MSA total to $5,750. During the third year Bob’s family has medical bills of $6,500. Since Bob’s deductible is $4,500, this is the amount paid out of his medical savings account with the remaining $2,000 covered by his major medical insurance plan, leaving an MSA balance of $2,000 going into the fourth year. If included in the medical bills of $6,500 were services not covered by the major medical insurance plan, but allowed as MSA expenses (such as dental), these bills could be paid from the medical savings account also.
The MSA plan is not a financing plan, it truly is insurance because the first $4,500 of medical costs each year are paid from Bob’s medical savings account or are paid out-of-pocket. Bob’s ability to deduct from income his MSA contributions levels the playing field with healthcare premiums paid by employers.
Amounts remaining in Bob’s medical savings account at the end of each year are rolled over to subsequent years, but continue to be subject to the $4,500 medical payments annual limit. Withdrawals for anything but the payment of approved medical bills are subject to ordinary income taxes and penalties before age 65 except for the payment of long-term care insurance premiums. After age 65, withdrawals are subject to ordinary income taxes without any penalties.
Interestingly, retired investors under age 65 who have enough self-employed
income to cover the MSA funding and 40% of the premium cost (the amount
that can be deducted from income) can obtain the tax advantages of using
an MSA plan and, as I understand it, it may be coordinated with Medicare.
Employer-Provided MSAs
Employers with 50 or fewer employees may also institute an MSA insurance
plan. These work like self-employed MSA insurance plans. That is, employers
will make the tax-deductible contributions to each individual employee’s
medical savings account, with a major medical plan paying costs above the
medical savings account and any additional deductible or co-pay requirements.
Whether employer-provided medical savings accounts will be perceived by
employees as an improvement or whether employers will benefit from better
cost containment depends on what kind of healthcare coverage was previously
provided and how the MSA insurance plan is communicated to employees. In
fact, non-tax-deductible medical savings accounts discussed earlier in
this column offered by such companies as Forbes magazine and Golden Rule
Insurance Company may be perceived as superior to the new tax-deductible
employer-provided medical savings accounts because receiving a cash bonus
of unused medical funds each year is an immediate employee incentive, whereas
the new MSA plan incentives are less obvious and longer-term. Perhaps creative
employers will be able to devise a hybrid that can incorporate immediate
cost-containment incentives of the non-deductible medical savings account
within the new tax-deductible medical savings accounts. (Remember that
the new medical savings accounts are only available for employers with
50 or fewer employees.)
Conclusion
Medical savings accounts are a radical improvement for the self-employed. Tax-deductible medical savings accounts for employers may be disappointing without some improvements or creative employer improvisation; non-tax-deductible medical savings accounts for employers should continue to achieve cost containment because they have significant incentives.
It will be interesting to see how the MSA experiment fares. If it survives, the medical savings account could be improved to such an extent that it could be used by millions of Americans instead of Medicare, thereby greatly increasing the solvency prospects for Medicare: MSA users would still pay Medicare payroll taxes, but voluntarily not use it. This could come about if MSA funding were allowed to increase, say, to $10,000 a year; insurance companies sold an integrated MSA plan lasting a lifetime; and MSA cash values not used could be left to heirs. And that would be a significant benefit to all.
Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance adviser located in Kalamazoo, Michigan (616/372-3497). His book, "The Life Insurance Fiasco: How to Avoid It," is available through the author.
© AAII Journal February 1997, Volume XIX, No. 2