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Health Spending Accounts and Long Term Care

Sat, 01/03/2004 - 1:00am — Karen Stevenson
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There is an interesting, and generally unheralded, development in the new Medicare bill which may be very useful in helping Boomers prepare for long term care costs.

The bill created Health Savings Accounts (HSA?s), which will be available starting this year (2004). These accounts combine a high deductible health insurance policy ($1,000 a year or more) and a medical savings account funded with tax-deductible contributions equal to the cost of the deductible. The HSA is like an IRA, a trust account that belongs to the participant. The IRS expects they will be made available by the same organizations that manage IRA accounts, like banks, brokerages, and insurance companies.

Several things about HSAs are notable. First, anything contributed to the account is deductible ABOVE THE LINE. A deduction above the line is the most valuable kind of tax deduction available. It will benefit all taxpayers, while the current medical expense deduction only benefits those who itemize expenses and have medical expenses that exceed 7.5% of their adjustable income.

Second, you can withdraw money tax-free for ?qualified medical expenses?, which include the same expenses that qualify for the current medical expense deduction, with some notable additions. Non-prescription drugs can be paid for from the account, even though they wouldn?t be deductible as itemized medical deductions. HSA money can also be used to pay long term care insurance premiums, as well as nursing home costs and some other long term care expenses.

Third, earnings on money held in the account are not taxed as they are incurred, and are NEVER taxed so long as the money is withdrawn to pay medical expenses. Therefore you get the best of all possible worlds ? a tax-deductible contribution AND non-taxable withdrawals!!

If you don?t use up the money in one year, it continues to earn interest and is available for medical expenses in later years. If you die without spending all the money in the account, it goes to your named beneficiary. If that is your spouse, it becomes a health savings account available for your spouse?s medical expenses. If it is passed to anyone else, they will have to pay income taxes on it, but the balance can first be reduced by paying qualified medical expenses for the original owner. Since most medical expenses are incurred in the year of death, there is probably a good chance any remaining balance could be used up in that year, and no one would end up paying taxes on it.

The plans will not be available to everyone. They will be available to anyone who is too young to qualify for Medicare, and only if they are not coverable under a low-deductible insurance plan. This is restrictive, but those who are eligible could include the self-employed, Boomers taking voluntary or involuntary early retirement who have no retiree group health plan available, and anyone working for a small business that has switched to a high-deductible group health plan as a cost-cutting measure.

How does all this figure into planning for long term care expenses? First, you could use money in the account to pay long term care insurance premiums. The transformation from an itemized to an above the line deduction will effectively reduce the cost of the premiums. This will make the most sense for people who are healthy enough that they do not need all the money in the account for other medical expenses. This group is most restricted on ways to deduct those costs as itemized deductions since you only benefit from an itemized deduction if you have fairly high medical expenses.

Second, and probably most importantly, you could fund the account every year, but try to pay medical expenses using other sources, with the goal of creating a sizable balance in the account that would be available in later years for tax-free withdrawals to pay long term care expenses.

I ran a ?what-if? scenario for myself to see what could happen. I assumed I would start adding to my account this year, fund it up to the regulatory limit each year, and not withdraw anything from it. Even at a very conservative interest rate I could easily have a balance in triple figures available to me in 20 years. By that time I will be in my early 70?s, a time when I am likely to start to need funds for long term care.

There are a number of restrictions that will keep this from being a viable solution for everyone.

First, the program will not be available to anyone who is coverable by a standard insurance plan.

Second, you must quit funding the program when you turn 65 and become eligible for Medicare (although the balance could remain in the account and continue to earn tax-free interest until you need it.)

Third, there are limits on the amount that can be contributed. For 2004 a single person can contribute no more than $2,600. Anyone age 55 or older can contribute a higher, ?catch-up? amount until they have to quit contributing at age 65.

Fourth, if you want to save the money in the account you have to keep withdrawals to a minimum either by having very low medical expenses or by paying those expenses from other funds.

Fifth, if you now have a lower-deductible insurance plan and switch to a high-deductible plan, your out-of-pocket expenses could increase by the difference in the deductibles, although your premiums will drop to offset part of that increase.

There are lots of questions still to be answered, and many things will only be clarified as we move forward. However, this may be one of the most interesting developments in the area of planning for long term care expenses that we have seen in several years!

There is an interesting, and generally unheralded, development in the new Medicare bill which may be very useful in helping Boomers prepare for long term care costs.

The bill created Health Savings Accounts (HSA?s), which will be available starting this year (2004). These accounts combine a high deductible health insurance policy ($1,000 a year or more) and a medical savings account funded with tax-deductible contributions equal to the cost of the deductible. The HSA is like an IRA, a trust account that belongs to the participant. The IRS expects they will be made available by the same organizations that manage IRA accounts, like banks, brokerages, and insurance companies.

Several things about HSAs are notable. First, anything contributed to the account is deductible ABOVE THE LINE. A deduction above the line is the most valuable kind of tax deduction available. It will benefit all taxpayers, while the current medical expense deduction only benefits those who itemize expenses and have medical expenses that exceed 7.5% of their adjustable income.

Second, you can withdraw money tax-free for ?qualified medical expenses?, which include the same expenses that qualify for the current medical expense deduction, with some notable additions. Non-prescription drugs can be paid for from the account, even though they wouldn?t be deductible as itemized medical deductions. HSA money can also be used to pay long term care insurance premiums, as well as nursing home costs and some other long term care expenses.

Third, earnings on money held in the account are not taxed as they are incurred, and are NEVER taxed so long as the money is withdrawn to pay medical expenses. Therefore you get the best of all possible worlds ? a tax-deductible contribution AND non-taxable withdrawals!!

If you don?t use up the money in one year, it continues to earn interest and is available for medical expenses in later years. If you die without spending all the money in the account, it goes to your named beneficiary. If that is your spouse, it becomes a health savings account available for your spouse?s medical expenses. If it is passed to anyone else, they will have to pay income taxes on it, but the balance can first be reduced by paying qualified medical expenses for the original owner. Since most medical expenses are incurred in the year of death, there is probably a good chance any remaining balance could be used up in that year, and no one would end up paying taxes on it.

The plans will not be available to everyone. They will be available to anyone who is too young to qualify for Medicare, and only if they are not coverable under a low-deductible insurance plan. This is restrictive, but those who are eligible could include the self-employed, Boomers taking voluntary or involuntary early retirement who have no retiree group health plan available, and anyone working for a small business that has switched to a high-deductible group health plan as a cost-cutting measure.

How does all this figure into planning for long term care expenses? First, you could use money in the account to pay long term care insurance premiums. The transformation from an itemized to an above the line deduction will effectively reduce the cost of the premiums. This will make the most sense for people who are healthy enough that they do not need all the money in the account for other medical expenses. This group is most restricted on ways to deduct those costs as itemized deductions since you only benefit from an itemized deduction if you have fairly high medical expenses.

Second, and probably most importantly, you could fund the account every year, but try to pay medical expenses using other sources, with the goal of creating a sizable balance in the account that would be available in later years for tax-free withdrawals to pay long term care expenses.

I ran a ?what-if? scenario for myself to see what could happen. I assumed I would start adding to my account this year, fund it up to the regulatory limit each year, and not withdraw anything from it. Even at a very conservative interest rate I could easily have a balance in triple figures available to me in 20 years. By that time I will be in my early 70?s, a time when I am likely to start to need funds for long term care.

There are a number of restrictions that will keep this from being a viable solution for everyone.

First, the program will not be available to anyone who is coverable by a standard insurance plan.

Second, you must quit funding the program when you turn 65 and become eligible for Medicare (although the balance could remain in the account and continue to earn tax-free interest until you need it.)

Third, there are limits on the amount that can be contributed. For 2004 a single person can contribute no more than $2,600. Anyone age 55 or older can contribute a higher, ?catch-up? amount until they have to quit contributing at age 65.

Fourth, if you want to save the money in the account you have to keep withdrawals to a minimum either by having very low medical expenses or by paying those expenses from other funds.

Fifth, if you now have a lower-deductible insurance plan and switch to a high-deductible plan, your out-of-pocket expenses could increase by the difference in the deductibles, although your premiums will drop to offset part of that increase.

There are lots of questions still to be answered, and many things will only be clarified as we move forward. However, this may be one of the most interesting developments in the area of planning for long term care expenses that we have seen in several years!