Health Savings Accounts

Revised: October 10, 2008

Background

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (nicknamed DIMA) includes an incentive for qualified individuals to accumulate pre-tax dollars in a health savings account (HSA) for later use to pay a wide range of medical expenses. The medical expenses qualified for payment from an HSA include the out-of-pocket cost of long term care and any premiums paid for LTC insurance coverage.

The three main incentives to establish an HSA are:

• The account is funded with pre-tax dollars,
• The investment earnings of the HSA are not currently taxed, and
• Distributions from the HSA are not taxed.

In addition, if contributions to the HSA are made through a salary or bonus reduction arrangement with an employer, both the employer and the employee avoid Medicare taxes on the amounts diverted into the HSA.

HSAs could be described as “401(k) plans on steroids”. Both accumulate pre-taxed assets and pay no taxes on their investment gains, but withdrawals from 401(k) plans are taxed at ordinary income rates. HSA withdrawals may only be used to pay qualified medical expenses and create no tax liability. This advantage, as will be illustrated below, is huge.

HSAs can only be established by individuals who are covered by a high deductible medical plan. (For 2008 a high deductible is defined as a minimum of $1,150 for an individual or $2,300 for a family.) In 2008 contributions to the HSA are subject to two limits: $3,000 for an individual or $5,450 for a family, but in no case more than the amount of the medical plan deductible. Individuals aged 55 and older in 2004 are allowed to make “catch-up” contributions on a schedule that begins with $500 in 2004 and grows by $100 a year to a top of $1,000 beginning in 2009.

Taken as a whole the HSA provisions of DIMA are a great tax benefit for highly paid executives, successful professionals and business owners. Who else can afford to divert $5,950 a year from current consumption? Who else will consider a high deductible in his or her medical plan a prudent risk? These are the same people who are the “natural buyers” of Long Term Care insurance coverage.

Combining an HSA with Long Term Care coverage

With these thoughts in mind we expanded the scope of our LTC economic model to include an HSA projection feature that tests the implications of using the HSA to pay LTC premiums after retirement, when their tax-advantaged status will usually end or be materially reduced. (Notes: HSA contributions must stop at age 65. Employer paid contributions for LTC coverage will typically end at retirement. Tax deductions for LTC coverage of partners and Sub-S business owners usually end at retirement and thereafter are subject to the 7 1/2% income test.)

The example presented below is based on the following assumptions about Mr. Smith, an executive now age 56 who is to purchase Long Term Care insurance policies for himself and his wife with a combined annual premium of $7,657 and an effective date of October 1, 2004. Mr. Smith has a medical plan with a $5,100 family deductible and is therefore eligible to defer the maximum amount qualified for accumulation in an HSA:

Building the Health Savings Account

Over the years before his 65th birthday in March of 2013 Mr. Smith will defer $50,258 of salary and deposit these amounts in his HSA account. As a consequence he will avoid taxes of $23,295 and reduce his spendable income by $26,964. The Net Present Value of the reduction in his spendable income is $22,146. (See Box 1 for the full detail of this projected outcome.)

Using the Health Savings Account

The Smith’s HSA balance will grow to $62,391 by 2014, the year in which he reaches age 65 and retires. At age 66 he will commence a series of withdrawals equal to the maximum LTC premiums qualified for tax deduction. After paying a total of $73,976 in LTC premiums the HSA will be exhausted in 2023. The internal rate of return on Mr. Smith’s HSA investment – spendable income not received prior to age 65 in exchange for LTC premiums not paid from his post-retirement income - will be 10.9%, a very attractive return on investment capital. Using his assumed after-tax return on other invested assets – 4.5% - to discount the cash flows, the Net Present Value of the HSA investment will be $17,235. (See Box 2 for the full detail of the HSA cash flows.)

Impact of the LTC Purchase

The net present value (NPV) of the Smith’s LTC premiums, after adjustment for the tax benefits they will receive, is estimated to be $107,530. The NPV of their HSA transactions, as mentioned above, is estimated to be $17,235. Taken together, the HSA will offset about 16% of the NPV present value of their tax-adjusted LTC premiums, a savings that will be persuasive to many interested, but cautious potential buyers of LTC policies.

The Combined Cash Flow and Financial Impact

The full effect of twinning the purchase of LTC policies with creation of a Health Savings Account is detailed in Box 3.

The combined cash flow from a coordinated HSA-LTC financing program is displayed in the chart below. By concentrating the effective cost of their LTC policies in the high earning years prior to his retirement Mr. Smith will reduce his cash flow for this coverage to a trickle during the first 11 years of his retirement and materially improve the net cost of his LTC purchase.

Conclusion

Mr. Smith is aware that Health Savings Accounts can be used to pay other types of medical expenses he and his wife may face, both before and after retirement. He wants to take full advantage of the very substantial tax advantages of his HSA and understands the importance of delaying distributions for as long as possible. He is also aware that indefinite deferral of the distributions may leave an undistributed – and taxable – account balance upon his death. Coordinating the financing of his Long Term Care premiums and expenses with his Health Savings Account distributions supports both of his objectives: improving the economics of his LTC purchase and optimizing the value of his HSA opportunity. This strategy makes empirical sense to him and his spouse and, furthermore, does not limit his other distribution options.