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Association of American Physicians and Surgeons, Inc.
A Voice for Private Physicians Since 1943
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Tax-Advantaged Medical Coverage

by Madeleine Pelner Cosman, J.D., Ph.D.

This is a review of the four types of currently available tax- advantaged accounts, which may or may not require high-deductible insurance policies: the FSA, HRA, MSA, and HSA.

Of these medical spending accounts, the most free- market, patient-centered, and consumer-driven are Health Savings Accounts and their precursors, Medical Savings Accounts. The other two types invite consumer participation but corrupt the possibilities to truly influence spending choice because the account users are not the account owners. Flexible Spending Accounts (FSAs) and Health-Reimbursement Arrangements (HRAs) are beneficial but forfeit the rights of ownership.

FSAs, HRAs, MSAs, and HSAs, however, all are creatures of federal law that marry health insurance plans to tax-favored cash accounts to pay for medical expenses. They all have potential to control medical inflation. They all give patients as consumers some control over their own medical decisions. They require patients as consumers to take some financial responsibility for consequences of their decisions. But only the MSAs and HSAs achieve the rationality and savings of private ownership and free-market medical decisions.

Flexible Spending Accounts (FSAs)

Flexible Spending Accounts, the so-called Cafeteria Plans, permit employees to divert a portion of their paycheck, tax-free, to pay medical expenses not covered by insurance. IRS Section 125 controls contributions of pretax dollars for spending on medical care. FSAs are sponsored only by employers. The self-employed or those who work for an employer who does not provide FSAs cannot create FSAs.

In theory, FSAs should encourage thoughtful, circumspect use of medical money because the employee as consumer is using his own money, rather than the insurance company's, to pay for routine care. In practice, however, FSAs promote wasteful spending because the IRS code makes FSAs "Use It or Lose It" money. Unused funds at year-end revert to the employer. Employees usually go on an annual end-of-year lavish medical spending spree. President Bush has proposed eliminating this perverse incentive by allowing unused funds to roll over to the following years.

Health Reimbursement Arrangements

Health Reimbursement Arrangements (HRAs), created in June 2002, resemble FSAs. HRAs are not available to the self-employed. Companies set up HRA plans for their employees and, using employer funds only, permit employees to pay with tax-free dollars medical expenses not covered by insurance. HRAs became valuable when the IRS issued revised regulations allowing unused dollars in HRAs to roll over from year to year, mitigating "Use It or Lose It" binges.

One of the hidden wonders of the HRA is that an employer could provide, for instance, $8,000 for medical uses, not by raising salaries $8,000 (and paying payroll and income taxes on the new money) but by contributing the $8,000 to an HRA that the employee can withdraw tax free to pay for individual (or union- sponsored) coverage. For the first time since ERISA was passed, employers can pay for workers' individual health premiums on a tax-preferred basis. An HRA does not require a high-deductible plan. An HRA can work with any insurance plan, or no insurance plan at all. It can be for any amount of money. Although it is employer-only money, the employee can spend it on any 213(d) qualified expense, which includes insurance premiums.

Nonetheless, HRA monies are not employee-owned and are not "portable." If an employee changes jobs his HRA cannot be moved to a new employer. In some instances the employee with a new job may have rights to use the HRA in the former employer's company. Some employers allow the employee who changes jobs to use the HRA for the same number of months into the future as he had been employed by the company with the HRA. But since the sponsoring employer owns and controls the accounts, there is little incentive for employees to control spending. As with FSAs, the best way for an employee to gain value from an HRA is to spend every penny. There is, however, some fiscal responsibility and freedom of choice.

Health Savings Accounts (HSAs) and Medical Savings Accounts (MSAs)

The most exciting new medical instruments for all Americans are Health Savings Accounts (HSAs), the brand-new free-market medical mechanisms legislated into law in the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. HSAs closely resemble Medical Savings Accounts (MSAs) that were created in 1996 by HIPAA, the Health Insurance Portability and Accountability Act. But HSAs are superior. HSAs and MSAs credit each American's intelligence, individuality, discretion, and responsibility. Every HSA or MSA has two distinct but interconnected parts:

  • a personal medical savings account
  • a catastrophic health insurance policy with a high deductible.

Visualize an HSA as a benevolent handshake. One hand is the actual savings account. The other hand is catastrophic medical insurance, whose deductible equals the amount of money annually placed in the HSA savings account. If you prefer, think of an HSA as a pair of pliers. The two arms of this tool move in synchrony and together expand the reach and power of the HSA owner's hand.

HSAs are not discounted prepayments for medical care. HSAs utilize true medical insurance that protects assets against expenses for physical catastrophes we hope will not happen. Since HSAs will be far more popular and available than MSAs, I shall refer only to HSAs, but any description here of an HSA pertains also to an MSA. The older MSAs intentionally were restricted by Congress to 750,000 people and dedicated to those who are self- employed or who work in companies of fewer than 50 employees. MSAs in theory are open to people who qualify for Medicare but in actuality, no Medicare MSAs exist because no insurance companies have had the corporate courage to leap the huge number of federal and state legal hurdles to create catastrophic polices that will conform to Medicare law. The new HSAs emulate the best of MSAs with few restrictions on who can buy them. One irony is that these magnificent consumer-directed, patient-centered HSAs created by the Medicare bill exclude people covered by Medicare. But in due time we shall fix that folly.

Companies began offering the new accounts on January 1, 2004, to thousands who applied. Both parts of HSAs are established at the same time. Anyone under age 65 is enabled to deposit into an HSA tax-free up to $2,600 for individuals and $5,150 for families. Some of the same banks and companies that establish the HSA savings account will sell or arrange for the consumer's purchase of a catastrophic health insurance policy. You can make your own contribution to your HSA savings account. Your employer can provide the annual amount. Or you and your employer each can contribute funds. Again, the amount in the savings account will be roughly equal to the deductible of the insurance policy.

President Bush clearly made HSAs "a cornerstone of his health reform plan," said Greg Scandlen, director of Galen Institute's Center for Consumer Driven Health Care. The President's plan allows 100% above-the-line tax deductibility of premiums for catastrophic insurance associated with HSAs. People who purchase catastrophic policies on their own are able to deduct 100% of the premiums. This full tax deductibility "will supercharge HSAs and make them an even more attractive option for millions of Americans, including the uninsured." Under current law, the health insurance is tax-favored if individuals are self- employed or their employer purchases the policy for them.

With money from your HSA savings account, you pay directly any physician you choose or any pharmacist for any medicine you choose for whatever minor medical problems you reason it worth paying a practitioner to solve. If you have a medical disaster, then the catastrophic insurance takes over payments after you meet the deductible.

You, who own your body and mind, decide what is medically necessary along with the doctor providing medical care. No one tells you whether you are permitted to go to a specific doctor or when or how or why. No one tells you what treatment is or is not "covered." No one tells your employer why you went to a physician or that you went or where. No one transmits your confidential medical records to an insurance company adjuster. You maintain confidentiality of your medical record for all routine medical problems. Only if and when your catastrophic insurance policy starts to pay for care is there any reason for anyone but you and your physician to know what is in or not in your medical record.

Moreover, you totally own your HSA savings account. You can deduct from it small or large sums to pay directly or you can use a debit card to pay any valid medical expense. The only restriction is the alphabetical list in IRS Code Section 213 (d) that identifies valid medical deductions on taxes. This includes acupuncture and physical therapy as well as drugs or surgery.

Since what you do not spend you keep, some call such an account a SIKI, Spend It or Keep It. That is a powerful incentive to prudent spending. HSAs respect your intelligence, individuality, initiative, and financial judgment. You determine the benefit versus the cost of each medicine or procedure before consent. Do you prefer the generic or the brand-name drug? Conservative or aggressive treatment? You decide.

Because you are paying cash, many practitioners will welcome you with enthusiasm and provide a cash discount on their fees because you honor their talent by directly exchanging your valuable money for their valuable skill, the customary capitalistic method of exchange in America. Furthermore, by paying cash at time and place of service you are saving the doctors' precious time and money. Good cardiologists, internists, dermatologists, and urologists have the same market incentives to behave justly and fairly when selling their medical talents and services as do other American professionals, craftsmen, and purveyors of honest products.

Deposits to HSA are tax-free, as are earnings and medical expenditures. HSA money is taxed only if you withdraw it for nonmedical purposes. Just as with an IRA from which money is removed before the statutory time, nonmedical use, before age 65, generates both ordinary income tax and a 10% penalty. After 65, the penalty does not apply. Since the HSA is your money, not your employer's and not the government's, you can roll over whatever is left over in your account at year's end and let it earn interest. Again, that is comparable to an IRA.

Furthermore, even if you suffered a medical disaster after a healthy year in which you rolled over your unused money, you would spend no more from the HSA account than the stipulated deductible for that particular year. If, for instance, the deductible is $3,000, you will pay only $3,000 cash even if by that time you have $79,000 accumulated in your HSA. A reasonably healthy person cannot fail to make money with an HSA prudently invested. Customary health insurance, the bogus insurance that is discounted prepayment for medical services, produces for the policyholder at year's end nothing but a canceled check.

The HSA is yours no matter where you work, no matter whether you change from job to job, and whether or not you work. It is completely portable. Like other property that you own, you can convey it to your family upon your death.

With HSAs, people have the same legal protections and ethical incentives as elsewhere in the American economy. HSAs are predicated on contract-law protection against false promises and overpayments. HSAs diminish the severest intrusions upon freedoms of physicians and patients imposed by laws governing managed care and Medicare. HSAs avoid: criminalizing physicians; qui tam whistle blower actions for False Claims; capitation; most forms of community rating; violation of confidentiality; third-party definitions of medically necessary treatment; and medical rationing by third parties. HSAs have no need of a Medicare Operation Restore Trust with its harsh penalties, fines, forfeitures, and prison terms for physicians and surgeons. Under HSAs the physician's allegiance is to the patient who pays, not to a third-party payer. Trust not violated needs no restoration.

HSAs are rational, logical, responsible salutes to the intelligence and comparative good health of America. Patients freely select their doctors. Employers pay no more, usually much less. Medical innovation and medical entrepreneurship thrive. Doctors need not fear inadvertently violating arcane rules. Insurance carriers, marketers, and agents benefit. Banks benefit. Everyone wins except the social engineers who want to impose "protections" against personal freedom.