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Benefits to Early Participation in a Medical Savings Plan

In 1996, Congress created Medical Savings Accounts (MSAs) as a four-year program to help self-employed individuals and employees of certain small employers pay for medical costs. An MSA is a tax exempt trust or custodial account set up with a financial institution in which individuals set aside money on a tax-deferred basis to defray future medical costs. Due to its status as a pilot program, Congress restricted the number of qualified participants to 750,000 and the limitation has yet to be reached. In addition, several bills have been introduced that would provide MSAs with some degree of permanence and include a provision such as removing the 2000 sunset and dropping the participation limitation. Furthermore, for those individuals who enter the program before it is closed to new participants, the rules appear to offer permanent tax benefits. Essentially, the MSA program establishes an investment account controlled by the insured to pay medical costs.

The benefits include tax-free accumulation of earnings on the account, deductibility of plan contributions even if you do not itemize and continued growth of funds to cover eligible medical expenses. Using the MSAs in combination with low premium, high deductible insurance can save an estimated 40 to 50 percent while large balances accumulate for future qualified medical expenses.

To be eligible for an MSA, self-employed individuals must purchase a "high deductible” medical insurance plan and employees must be covered by a high deductible health plan provided by their small employer. A “high deductible” medical insurance plan is a plan with a permitted deductible of $1,500 to $2,250 for individual coverage, $3,000 to $4, 500 for family coverage, and an out-of-pocket expense limit (including the deductible but not including the insurance premiums) of $3,000 for individuals and $5,500 for family coverage. Please note that you generally cannot have any other health plan that is not a high deductible plan unless its coverage is limited to accidents, disability, dental care, vision care, long-term care, workers compensation, specific disease or illness, or fixed amount per day for hospitalization.

To ease administration, IRS approval is not needed to start an MSA. Form 8853 is simply attached to the individual's Form 1040 for each year a deduction is claimed. Only self-employed individuals and employees of small employers are eligible for MSAs. A small employer is an employer who had an average of 50 or fewer employees during the last two calendar years. If an employer originally was classified as a small employer and has grown past the 50 employee limit, the employer continues to meet the requirement for small employers if the employer made a contribution for the last year s/he had 50 or fewer employees and had an average of 200 or fewer employees each year after 1996.

The maximum amount that can be contributed annually to an MSA is equal to the applicable percentage (65 percent of single coverage and 75 percent for family coverage) times the deductible amount for the high-deductible health insurance policy. For example, a sole proprietor with a $3,000 deductible for family insurance coverage could annually contribute (and deduct) a maximum of $2,250 (75 percent of $3,000). Contributions below the maximum also are permitted and are deductible (or excluded from income, if made by an employer).

When MSA owners incur un-reimbursed medical expenses, they can take tax-free withdrawals from their MSA to pay for the expenses. Qualified expenses are those that would otherwise be allowed as a medical deduction on Schedule A (without regard to the 7 1/2 percent of adjusted gross income floor). However, such expenses do not include health insurance premiums. Any withdrawals not used for qualified medical expenses are taxable and subject to a 15 percent penalty tax, unless the withdrawal occurs after the account holder reaches age 65, dies or becomes disabled. Withdrawals at age 65 and later are simply subject to income tax, without penalty.

In summary, MSAs offer self employed individuals and employees of small businesses an additional means to offset medical costs by establishing a tax-free savings account. This account must be opened this year to take advantage of the permanent tax benefits offered. You may annually contribute 65% (individual) to 75% (family coverage) of the deductible.