HEALTH SAVINGS ACCOUNTS

A health savings account (HSA) is an investment vehicle from which individuals can withdraw funds to pay qualified medical expenses as defined by the Internal Revenue Code. Accumulated funds can be used to pay current medical expenses or can be saved for medical expenses incurred in the future. The account can be set up by an employee in conjunction with his or her employer, but may also be set up by individuals through participating insurance companies and banks. To participate, an individual must have a high-deductible health insurance plan as their only form of health insurance and must not be eligible for Medicare. Generally, a high-deductible health care plan is one with at least a $1,000 deductible for an individual or $5,000 for a family. Participants contribute to the HSA and pay a premium for the high-deductible medical insurance, which is usually lower than the premium for conventional medical insurance. Also, an eligible individual cannot be a dependent of another taxpayer.

The individual's contributions to the account are tax deductible and, if an employer contributes to the account on behalf of an employee, the contribution is not taxable to the employee and the employer's tax-able income is reduced by the amount of the contribution. Money placed in the account may be invested in a variety of investment vehicles, including stocks, bonds, and mutual funds. Investment gains are non-taxable, as long as money withdrawn from the fund is used for qualified medical expenses. There are maximum annual contributions, which are adjusted for inflation annually. In 2004, the maximum contribution is $2,000 for an individual plan and $5,150 for a family plan. However, those over age 55 are allowed to make so-called "catch-up" contributions.

PURPOSE

Most individuals in the United States who are not self-employed and who are not eligible for Medicare or Medicaid obtain their health insurance through their employers. There are two major problems with the current system of employer-sponsored health care coverage. First, since the employer usually pays some or all of the insurance premiums and bears the brunt of health care cost increases; the true cost of coverage is hidden from individuals, who therefore have little incentive to manage their health care efficiently. Second, employer-sponsored insurance creates a link between employment and health care that may be broken when an employee loses his or her job. These facts, combined with the tremendous increase in health-care costs in the U.S. experienced since the 1980s, has led the government and employers to look for ways to deliver health care insurance more efficiently and effectively.

Health maintenance organizations (HMOs), adopted by many employers in the 1980s, addressed the cost problem by allowing employers to make arrangements with health care providers to deliver health care services to their employees on a fixed-fee basis. In return for price concessions, employers essentially restricted the choices of participating employees to participating providers. HMOs were successful in reducing health care cost inflation, but their lack of flexibility and perceived over-emphasis on cost containment led to widespread dissatisfaction. Less restrictive preferred provider organizations, which allowed employees more freedom of choice if they were willing to pay a higher portion of costs, became the dominant form of employer-sponsored plan in the 1990s. But PPOs appear to be less successful in restraining health care costs. Thus, the government and employers continue to search for alternatives.

Attention focused on attempting to de-couple health insurance from employment and increasing consumer involvement in health care decisions. Such consumer-driven approaches place greater responsibility on individuals to choose and manage their health care. The goal of such approaches is to encourage individuals to be more careful consumers of health care. Flexible spending accounts and medical savings accounts are both consumer-driven approaches.

Health savings accounts overcome many of the difficulties with the earlier approaches to consumer-driven health care. For example, flexible spending accounts require the individual to use all contributed funds annually or lose the funds. Accumulated funds in HSAs carry over from year to year and can be held for life. Medical savings accounts are available only to the self-employed or those employed by small businesses. HSAs are available to anyone, regardless of employment status.