How health care reform changes FSAs, HSAs

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If you pay for medical care out of a tax-advantaged account such as a health savings account or flexible spending account, passage of the new health care reform law might make these so-called cafeteria plan benefits such as FSAs and HSAs a little less tasty when it comes tax time.

The new law reduces the amount of money you can contribute to these accounts and shelter from Uncle Sam’s reach. It also creates stricter rules about how the dollars you put away can be used. These new rules and penalties are designed to generate revenue to offset the cost of the health care reform law’s health insurance tax credits and other spending.

Cafeteria plans are so named because they allow employees to choose from a list of benefit options much like a cafeteria menu. Among those options are health care spending accounts.

Flexible spending accounts, or FSAs, allow employees to sock away tax-free dollars that can be used to pay for medical expenses such as drug co-pays, deductibles and treatments not covered by insurance plans. Up until now, there hasn’t been an official limit to how much you could contribute to an FSA, although IRS rules dictated that employers create some kind of maximum contribution. Many employers cap the amount in the $2,000 to $5,000 range according to a 2009 report by the Center on Budget and Policy Priorities in Washington, D.C.

Starting Jan. 1, 2013, FSAs will have annual limits of $2,500 per year. Going forward, the limit will rise annually based on the rate of inflation. Still, it likely will remain above the average employee contribution, which was $1,424 in 2009, according to Mercer’s National Survey of Employer-Sponsored Health Plans, an annual report on health care benefits.

In addition, FSAs will remain “use-it-or-lose-it” accounts. That is, any unused balance for one year can’t be used to fund health care spending in the next year.

New restrictions on how you can spend FSA funds will change more quickly. Starting Jan. 1, 2011, you won’t be able to spend FSA dollars on over-the-counter medical supplies that aren’t specifically prescribed by a doctor, putting a damper on the annual ritual of FSA holders trying to spend unused funds by stocking up on their favorite over-the-counter medicines.

Despite the new limits, the law isn’t intended to discourage the use of FSAs, says Sara Collins, vice president for the Affordable Health Insurance Program at The Commonwealth Fund, a health care research foundation in New York.

“It’s designed to bring some balance back into the tax code and make sure those dollars are used for medical purposes,” says Collins. “You can still put money aside in these accounts, there just won’t be quite as big of a tax break.”

Health savings accounts, or HSAs, also are getting new limits and restrictions. HSAs allow employees who have a high income or who are in good health to save part of their earnings tax-free and use the savings to pay most of their medical care out of pocket. Unlike FSAs, which are meant to supplement a typical health insurance plan, HSAs are paired with a “catastrophic” insurance policy that kicks in once the high annual deductible has been paid.

Also unlike FSAs, HSA balances roll over from year to year, allowing participants to save for health care costs and even for long-term care later. Because of the new health care reform law, HSA funds can no longer be used to buy over-the-counter drugs without a doctor’s prescription. Those who withdraw HSA funds for nonmedical purposes will see their tax penalty double, from 10 percent to 20 percent of the total withdrawal, starting Jan. 1, 2011.

The Archer Medical Savings Account, the small-business version of an HSA known as an Archer MSA, will see similar restrictions, with the only difference being the Archer MSA’s penalty for nonmedical withdrawals now stands at 15 percent and will go up to 20 percent. Archer MSAs also will have restrictions on buying over-the-counter drugs without a prescription starting Jan. 1, 2011.

The HSA’s cafeteria plan cousin, the health reimbursement account, known as an HRA, is also affected by the new law. HRAs work similarly to HSAs, but instead of being funded by employee contributions, HRAs are funded by the employer. HRAs will get the same restrictions on over-the-counter medicine.

On the bright side, tax-free contributions to HSAs and Archer MSAs won’t be affected. And with far-reaching reform set to transform health care by 2020, it might be comforting for HSA holders to know that the HSA/high deductible model isn’t going anywhere.

In fact, legislators looked to the high-deductible insurance plans typically packaged with HSAs today as a template for the minimum coverage that will be available on state insurance exchanges once they’re up and running in 2014.

“The floor for health insurance plans under the new law will be similar to the insurance plans that are now HSA compliant,” says Collins.