Choose the right health care account: stay well - and well-financed - with an array of savings options.

EXECUTIVE SUMMARY

* Health spending accounts offer opportunities for employees to save and pay for health care with pretax contributions. Three basic types are flexible spending arrangements (FSAs), health reimbursement arrangements (HRAs) and health savings accounts (HSAs).

* FSAs are typically funded by pretax payroll deduction and are subject to cafeteria plan regulations, including a "use-it-or-lose-it" rule that prevents carryover of unused amounts to future years, unless an employer has adopted a 2 1/2-month grace period provision. COBRA provisions, however, allow benefits to continue if an employee has a qualifying event such as termination of employment.

* HRAs may accompany high-deductible health plan (HDHP) coverage, and the employer and employee may share the deductible's cost. An HRA must be funded solely by the employer and cannot be paid for by salary reduction.

* HSAs allow tax-free investment growth, and distributions for medical expenses aren't included in income. HSAs must be paired with an HDHP covering the account owner. Owners can designate a spouse as beneficiary, and the account continues to be treated as an HSA after the death of the account holder and its transfer to the surviving spouse.

Bart H. Siegel, CPA/PFS, CFP, CFE, is principal of Siege/Forensic Accounting and Consulting of Tampa, Fla. His e-mail address is [e-mail].

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Even people in robust health, faced with the variety of tax-favored health spending accounts now available, can find the whirl of regulations and tax considerations dizzying. Three types of employer-sponsored plans offer tax advantages for out-of-pocket or other medical costs: flexible spending arrangements (FSAs), health reimbursement arrangements (HRAs) and health savings accounts (HSAs). Many employees, self-employed people and small business owners will turn to CPAs to sort out each plan's intricacies and help them tailor one to their needs and resources.

The good news: While income tax deductions for health care expenses may be limited by itemization thresholds or the AMT, contributions to health spending accounts generally are excluded from taxable income. Employees may use pretax dollars to make medical-care-related contributions, and self-employed individuals are permitted to take a deduction for health insurance premiums or arrangements having the same effect.

FLEXIBLE SPENDING ARRANGEMENTS

FSAs are savings accounts funded from pretax earnings that people can use to pay qualified medical expenses. Contributions to FSAs (also commonly known as flexible spending accounts and alternately available to cover dependent care costs) typically are made through salary reduction. Distributions to reimburse employees for qualified medical expenses are excluded from their income. Unlike an HSA (discussed below) an FSA need not be accompanied by a high-deductible health plan (HDHP) or other insurance.

FSAs are subject to cafeteria plan regulations, which include a use-it-or-lose-it rule, so an account balance must be spent by the end of each plan year. Starting in 2005, however, the IRS authorized employers to amend their cafeteria plans to allow an optional 2 1/2-month grace period for expenses incurred after the end of the plan year. Therefore, advise your clients to base the amount they elect to have deducted from their pay on an annual budget of likely out-of-pocket expenses. These can include insurance deductibles and copays and even some over-the-counter medications and health supplies.

Because an FSA is considered a group health plan under COBRA and the Health Insurance Portability and Accountability Act of 1996 (HIPAA), though, it is not subject to use-it-or-lose-it in some circumstances. For example, under COBRA continuation-of-benefit rules, recently terminated employees may keep paying into their accounts. Although they must do so with after-tax dollars, the extension allows extra time to spend an accumulated balance that would otherwise be lost. An FSA is also subject to nondiscrimination rules governing self-insured medical reimbursement plans and is a welfare benefit plan subject to ERISA.

HEALTH REIMBURSEMENT ARRANGEMENTS

An HRA, as the name implies, reimburses employees for eligible expenses. As with an FSA, those reimbursements are made from an untaxed account into which the employer pays. Unlike an FSA, the payment is not deducted from the employee's salary but is an additional benefit. It can be accompanied by an HDHP or other insurance plan, but doesn't have to be (see sidebar, "High-Deductible Health Plans"). If it is, the employer can pay the premiums of the HDHP and share the deductible's cost with the employee.

An HRA reimburses only qualified medical expenses and allows the carryover of unused amounts to later years. If the plan is used for nonqualified expenses, all amounts paid become taxable, including prior medical reimbursements.

HEALTH SAVINGS ACCOUNTS

An HSA allows your employees and clients to build tax-free assets to pay for medical care. Similar to an IRA, it allows eligible individuals under 65, their family members or employers to make annual tax-deductible contributions. An HSA is paired with an HDHP. The Tax Relief and Health Care Act of 2006 increased contribution limits this year to $2,850 for an individual or $5,650 for families, regardless of the HDHP's deductible amount. The act also authorized rollovers from FSAs and HRAs, as well as a one-time rollover from an IRA. The latter must be a direct trustee-to-trustee transfer, however. Holders may tap the account to pay qualified medical expenses, with the payments not taxed as distributions. Money withdrawn for other purposes by account holders under 65 is subject to a 10% penalty. The account's investments grow tax-free.

Account holders under age 65 must be covered under an HDHP but no other health policy providing any of the same benefits.

Your clients can use an HSA to save for anticipated big-ticket services, such as orthodontics, which may not be covered fully, or even at all, by other health plans. But it may be to your clients' advantage to instead pay for medical bills out of pocket and let their accounts' investments appreciate. The account continues to be treated as an HSA after the death of the holder and its transfer to a surviving spouse, provided the surviving spouse is the designated beneficiary.

"You're under no obligation to pay your medical bill out of the HSA account," says Martha Priddy Patterson, a director with Deloitte & Touche. "If you can afford not to, it's smart."

Here's an additional side benefit to your clients: Because they are paying for most of their health care out of savings, they're likely to reduce costs by using medical care more judiciously.

Clients can sign up for HSAs with banks, credit unions, insurance companies and other approved companies. As with IRA contributions, post-year-end contributions to HSAs made by the due date for the tax return for the prior year will be deductible. Many states also exempt HSA contributions from state income tax.

Your client owns and controls the money in an HSA, including deciding how it is invested, except that it may not be invested in life insurance. But here are some restrictions to watch out for:

* Contributions over the limits are not deductible, and IRC section 4973 imposes a 6% excise tax on the excess funds.

* Excess contributions by an employer generate taxable income to the employee.

* People may withdraw funds at any time for nonmedical expenditures, but distributions not used for medical expenses must be included in income and are subject to a 10% penalty. When an individual becomes eligible for Medicare, dies or becomes disabled, however, the funds may be used for any purpose without incurring the penalty (although withdrawals for nonmedical purposes are taxed as ordinary income).

An HSA with an HDHP can offer significant savings over traditional insurance, especially if you don't have--or lose--group coverage. For example, my wife left a company that provided our coverage. We received a notice, as a result of COBRA, that we had the right to continue coverage for a limited period as long as we assumed the employer contribution of the cost. Talk about sticker shock: Our monthly premiums rose from about $300 a month to more than $1,200. Most individual policies with comparable benefits were similarly expensive. Then I priced HDHPs with a health savings account.

First, I was pleased to find that as my annual deductible rose to $10,000, my monthly premium fell to $250 a month. After the deductible, the plan provided almost 100% coverage. So compared with paying $14,400 annually in premiums, plus copayments, I found the HSA to be the obvious choice, before I even started analyzing the significant tax benefits.

Next, I found that doctors often lower their fees when they know you are paying out of pocket. Prescription costs, although higher than health insurance copayments, were much lower than we expected. An HDHP may have contracted rates with medical providers like conventional insurance plans, which also reduces out-of-pocket costs.

Especially with recent changes expanding the flexibility of HSAs, the time has never been better for people to take charge of financing their health care and take advantage of the range of options. That's where CPAs, as advisers in this increasingly important aspect of financial planning, can help point clients in the right direction, at the crossroads of health and wealth.

Healthy Outlays

Increased spending for health care in recent years has gobbled up about one-quarter of the growth in the economy. Health-related spending now amounts to more than three times the federal defense budget and twice what the nation devotes to education.

Source: Boston University School of Public Health.

High-Deductible Health Plans

A high-deductible health plan (HDHP),commonly referred to as "catastrophic" health insurance, has a deductible of at least $1,100 for individual or $2,200 for family coverage. The annual out-of-pocket deductibles and copayments cannot exceed $5,500 (individual) or $11,000 (family). An HDHP may have "first-dollar coverage," meaning it has no deductible or only a small one, for preventive care. It also may contain higher out-of-pocket limits, copays and coinsurance for out-of-network services.

Young, healthy individuals, who traditionally incur few medical expenses, will find HDHP coverage available, but those with preexisting medical conditions and those over age 60 or in poor health will probably have difficulty getting underwritten. A physical exam is required as part of the underwriting procedure.

Practical Tips

* Flexible spending arrangements' use-it-or-lose-it feature pertains not just to the end of a calendar year (and possible 2 1/2-month grace period) but to termination of employment with a company. If employees know they're going to leave a job where they have an FSA, they can review their contributions and expenditures since the beginning of the year and make qualifying purchases from any unspent balance. But they'll have to do it before they leave the job.

* If an HSA holder's spouse is the account's designated beneficiary, following the death of the account holder and the transfer of interest, the account continues to be treated as an HSA, with the spouse as the account holder. If the designated beneficiary is not the account holder's spouse--for example, the estate or another individual--the account ceases to be an HSA as of the date of death, and the fair market value of the funds is includible in the beneficiary's gross income.

AICPA RESOURCES

CPE 

* Personal Financial Planning: Group Insurance and Employee Benefits, by Carla Gordon. Covers menu-type employee benefit programs such as cafeteria plans and FSAs, www.cpa2biz.com/ OnlineProducts/CPExpress/ Consulting+Services/IB_GTL.htm.

* Understanding the Mechanics of Health Savings Accounts, by Gary S. Lesser, Susan D. Diehl and Christine L Keller (# 180311JA).

Personal Financial Planning Center

Articles on all the health spending accounts described in this article are available to AICPA PFP Section members at pfp.aicpa.org,

Publication

The Adviser's Guide to Health Spending Accounts, by Gary S. Lesser, Christine L. Keller and Susan D. Diehl (# 091020JA).

For more information or to make a purchase, go to www.cpa2biz.com or call the Institute at 888-777-7077.

OTHER RESOURCES

IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans, www.irs.gov/publications/p969.

Exhibit 1
Choosing a Plan
Comparing key features of health spending accounts

                      Flexible spending         Health reimbursement
                      arrangement               arrangement

Initial legislation   Revenue Act of 1978       U.S. Department of the
or regulation                                   Treasurc revenue ruling
                                                2002-41

Date effective        Jan. 1, 1979              June 26, 2002

Internal Revenue      IRC sections 106 and      IRC section 105
Code reference        125

Eligibility           All employees except      All employees
                      sell-employed.

Qualified             Unreimbursed medical      Unreimbursed medical
medical               care expenses as          care expenses as
expenses              defined by IRC section    defined by IRC section
                      213, but not premiums     213.
                      for health insurance
                      coyeragc and long-term
                      care expenses.

Nonqualified          Expenses not covered      Expenses not covered
medical               under IRC section 213.    under IRC section 213
expenses              Health rnsiuance
                      premiums under a
                      continuation-of-
                      coverage arrangement
                      (such as COBRA). Health
                      insurance premiums when
                      receiving unemployment
                      compensation. Qualified
                      long-tern care
                      insurance premiums.

Must be covered       No                        No
by a health
insurance plan

Contributor           Employee, employer or     Employer
                      both

Contribution          No statutory limit;       No statutory limit;
limits                limits may be set by      limits may be set by
                      employer.                 employer.

Funds carried         No, except plans may      Yes
over to next year     offer a 2 1/2-month
                      grace period.

Portability           Account cannot be         At employer discretion
                      maintained if the
                      employee is no longer
                      working for the
                      employer, except under
                      COBRA continuation-of-
                      benefit provisions.

                      Health savings account

Initial legislation   Medicare Prescription Drug Act of 2003
or regulation         Greatly expands the former Medical Savings
                      Accounts.

Date effective        Jan. 1. 2004

Internal Revenue      IRC section 223
Code reference

Eligibility           Individuals undct age 67 who have a high-
                      deductible health plan.

Qualified             HSA distributions are tax-free if they are used
medical               to pay for qualified medical expenses including
expenses              prescription drugs, qualified long-term care
                      services and long-term care insurance. COBRA
                      coverage, Medicare expenses fbut not Medigap),
                      and retiree health expenses for individuals age
                      65 and older.

Nonqualified          Distributions made for any other purpose.
medical
expenses

Must be covered       Yes
by a health
insurance plan

Contributor           Tax-advantaged contributions can be made in
                      three ways: (1) the individual and family
                      members can make tax-deductible contributions
                      even if the individual does not itemize
                      deductions, (2) the individual's employer can
                      make contributions that are not taxed to either
                      the employer or the employee and (3) employers
                      with cafeteria plans can allow employees to
                      contribute untaxed salary through a salary
                      reduction plan.

Contribution          The maximum annual contribution is $2,850 for
limits                self-only policies and 55,650 for family
                      policies (indexed annually).
                      Individuals age 55 to 65 may make additional
                      "catch-up" contributions of up to $800 in 2007,
                      increasing to $1,000 annually in 2009 and
                      thereafter A married couple can make two
                      catch-up contributions as long as hoth spouses
                      are at least 55.

Funds carried         Yes
over to next year

Portability           Amounts contributed to an HSA helong to
                      individuals and are completely portable. Money
                      not spent stars to the account and gains
                      interest tax-free, just like in IRA. Unused
                      amounts remain available for later years.

Source: Division of Compensation Data Analysis and Planning, Bureau
of Labor Statistics; Department of the Treasury, Office of Public
Affairs.