Funding mechanisms for medical expenses.

A previously published item (see Goldsberry, et al., Tax Clinic, "Deductibility of Tuition and Related Fees as Medical Expenses," TTA, November 2002, p. 701) emphasized that tax-deductible medical expenses may include items (e.g., special-school tuition and fees) not commonly thought of as medical expenses. Taxpayers needing to fund large and ongoing expenses of this sort will also be interested in exploring tax-advantaged ways to pay these expenses beyond deducting them under the 7.5% of adjusted-gross-income threshold. Examples of potential alternatives include funding via Sec. 125 "cafeteria plans," health reimbursement arrangements (HRAs), IRA and/or Sec. 401(k) withdrawals and medical savings accounts (Archer MSAs).

Cafeteria Plans

Sec. 125 cafeteria plans are by far the most common tax-advantaged medical expense reimbursement arrangements (after actual medical insurance). Flexible spending accounts (FSAs) are funded by employee contributions on a pre-tax salary-reduction basis to provide coverage for specified expenses (e.g., qualified medical expenses or dependent care assistance costs) incurred during the coverage period. Reimbursement is subject to reasonable conditions, including a maximum salary-reduction amount that may be set by the plan's terms. Participants must use the FSA amounts for the specified expenses or forfeit any amounts remaining as of the plan year-end; see, generally, Prop Regs. Sec. 1.125-1.

Actually obtaining reimbursement may be problematic; as a practical matter, participants regularly report problems in convincing plan administrators that expenses (such as special school tuition and fees) are legitimate medical expenses properly reimbursable by the plan. Also, reimbursements actually available are frequently less than the total actual medical expense, due to employ ee-mandated limits on FSA funding.

HRAs

Another alternative may be an HRA, which is an employee benefit plan intended to reimburse employees for medical expenses not covered by other insurance. In general, HRAs are funded by the employer, without employee salary reductions, to reimburse an employee for substantiated medical care expenses incurred by the employee and his or her spouse and dependents. HRAs typically provide reimbursement up to a maximum dollar amount for a coverage period, and may provide for carry forward of any unused amount.

The reimbursed medical expenses are excludable from the employee's gross income and deductible by the employer. For this purpose, an employer may be a self-employed (SE) individual; under limited circumstances, covered employees may include the SE individual's spouse, even if the spouse is the sole employee. Even though an SE individual may not be covered directly, coverage may be available indirectly, through the employee spouse; see Rev. Rul. 71-588, Letter Ruling 9409001 and Industry Specialization Program, "Health Insurance Deductibility for Self-Employed Individuals" (UIL No. 162.35-02, 3/29/99).

IRA Withdrawals and See. 401(k) Rollovers

Individuals may take withdrawals when and as they direct from their IRA and/or certain Sec. 401(k) or other qualified plan account balances (i.e., rollover account balances).This is certainly not preferable from a retirement planning view, as the distribution will necessarily reduce the funds available at retirement, and typically will be both currently taxable and subject to premature withdrawal penalties. However, all or a portion of these withdrawals can be exempted from the 10% premature withdrawal penalty under a variety of circumstances. One exception is that the penalty will not apply to the extent that file taxpayer has medical expenses deductible after the 7.5% of adjusted-gross-income limit.

Hardship Withdrawals

Sec. 401 (k) plans may also be used to cover medical expenses. To take a hardship withdrawal, a participant must establish immediate and heavy financial need, and show that the requested distribution does not exceed the amount needed to meet that need. Under Regs. Sec. 1.401 (k)-1(d)(2), a distribution is made on account of immediate and heavy financial need if it is to pay expenses for medical care, either previously incurred by or necessary for the medical care of, the employee or his or her spouse or dependents. The regulation also provides that the distribution will not fail to qualify just because it was reasonably foreseeable or voluntarily incurred. The amount distributed cannot exceed the amount needed to meet the financial need, plus the estimated cost of anticipated income taxes and/or penalties. Employers can treat the requested distribution as necessary if they can reasonably rely on the employee's written representation that the need cannot be met by other means (including insurance, reasonable liquidation of assets, or other eligible distributions, plan loans or reasonable borrowing). Employees are also required to agree to cease plan contributions for 12 months following the distribution.

Undesirable consequences include the obvious; the distribution and the consequent premature income tax an penalties ate contrary to sound retirement planning. In this case, unlike with premature IRA distributions, the amount subject to penalty cannot be reduced by Schedule A deductible medical expenses.

Archer MSAs

MSAs were first effective in 1997. Sec. 220 Archer MSAs are set to expire at the end of 2003, but may still be established until then. Contributions in 2004 and thereafter are permitted for those participating in MSAs established before the end of 2003. Whether Congress will again extend the expiration date remains to be seen, but some action is likely in the near term in light of concerns over medical care costs.

Contribution amounts are limited, but are fully deductible as an adjustment to income for SE individuals (or excludible from income under employer-funded plans). Income earned by the MSA is tax exempt; reimbursements from an MSA are excluded from income to the extent used to pay for medical expenses. MSA use is questionable, however, in the case of families with special-needs children (in which the family is likely to have large and continuing uninsured medical expenses over a number of years). In such cases, the annual reimbursable expenses are likely to exceed the allowable contributions to the plat thus, the tax-advantaged savings feature is lost. The plan's tax advantage will be limited to cases in which the amount deductible as a plan contribution exceeds the amount that would have been deductible as a medical expense deduction.

Conclusion

Families and individuals with long-term special medical needs and expenses often have unusual tax planning needs. Limited avenues are available for taxpayers to use medical deductions to help defray their costs. Tax advisers should be able to identify such situations and recommend from among the potentially viable solutions.

FROM EDWARD GOLDSBERRY, CPA, DAVID LUKE, CPA, DAVID PISTORIUS AND ASHLEY TENNEY, PKF TEXAS, HOUSTON, TX