Medicare+choice MSAs.

Per Sec. 138, a Medicare+Choice MSA is a type of medical savings account (MSA) that can be used by taxpayers who are eligible for the traditional Medicare program but prefer to accrue the benefits associated with MSAs. The Medicare+Choice MSA is a nontaxable savings account from which the taxpayer is reimbursed for qualified medical expenses. Contributions to the account are made only by the Secretary of Health and Human Services (Sec. 138(b)(2)). Since the fund is unlikely to have enough funds to cover a lengthy hospital stay, the taxpayer is required to purchase a high-deductible insurance policy. Each year, the deductible amount is increased to take into account rising medical costs; for 1999, the maximum deductible amount is $6,000.

Funds from the account are used by the taxpayer to pay the premiums on the high-deductible insurance policy, satisfy the deductible (if the taxpayer has a medical expense covered by the policy) and pay for any qualified medical expenses not covered by the insurance policy.

Once a taxpayer elects the Medicare+Choice MSA, he must enroll for a minimum of 12 months, although there is a one-time option of withdrawing by December 15 of the first year the beneficiary is enrolled in the Medicare+Choice MSA. The taxpayer who elects to use a Medicare+Choice MSA is not eligible for any other Medicare benefits.

Taxpayers using the Medicare+Choice MSA option should have more flexibility as to which medical providers they use, as some physicians will not accept patients that choose the traditional Medicare option. In addition, there is little chance that a given medical procedure will not be a qualifying medical expense that can be reimbursed from their high-deductible insurance policy or from the MSA. However, there is an investment risk to the individual; the account may not be large enough to satisfy the deductible, the insurance premiums and any qualified medical expenses not covered by the policy.

Banks and insurance companies typically act as trustees for Medicare+Choice MSAs. These trustees must furnish the account holder with a report that includes the fair market value (FMV) of the investments held in the account as of the end of the calendar year. The report must be presented to the account holder no later than January 31 of the calendar year following the one for which the report is prepared. Failure to provide a report for the account holder without reasonable cause could trigger a $50 trustee penalty for each instance in which a report was not filed.

Tax-Free Distributions

If a taxpayer uses a Medicare+Choice MSA to pay qualified medical expenses, the distribution is excluded from income, even if the individual is not enrolled in the Medicare+Choice MSA at the time of the distribution. Qualified medical expenses include withdrawals for any medical expense qualifying under Sec. 213(d) (not reimbursed by an insurance company), withdrawals to pay continuation insurance (COBRA premiums), and withdrawals to pay long-term care insurance premiums. Expenses reimbursed from a Medicare+Choice MSA cannot be reported as an itemized deduction.

Any medical expenses paid out of the Medicare+Choice MSA for the account holder's spouse (if the spouse does not have a Medicare+Choice MSA) or the account holder's dependents are not treated as qualified medical expenses and are subject to inclusion in gross income and a possible 50% excise tax, depending on the amount in the MSA. Also, the assets in the Medicare+Choice MSA cannot be pledged, invested in life insurance contracts or commingled with other property without being subject to inclusion in gross income and the possible 50% excise tax.

Penalties for Nonqualified Distributions

When a taxpayer uses funds in the Medicare+Choice MSA for reasons other than to pay qualified medical expenses, the distribution must be included in gross income. Further, a 50% excise tax is incurred if distributions not related to qualified medical expenses are greater than the excess of the FMV of the Medicare+Choice MSA at the end of the year over 60% of the deductible of the plan under which the individual is covered on January 1 of the current year (Sec. 138(c)(2)). The example below shows how to compute the amount that can be withdrawn from the MSA account without penalty.

Example: T has a deductible of $3,000 per year, contributions to the account are $1,300 per year, the account earns a 10% return, and T had a withdrawal of $600 for qualified medical expenses in Year I and $100 of qualified medical expenses in Year 2.

                                   Year 1   Year 2

Deductible on January 1            $3,000   $3,000
60%                                 1,800    1,800
FMV of the Medicare+Choice
 account on January 1                  $0     $830
Contributions                       1,300    1,300
Earnings on the investment (10%)      130      213
Withdrawals for qualified
 medical expenses                   (600)    (100)
FMV of the Medicare+Choice
 account oil December 31             $830   $2,243
Excess of FMV of the Medicare
 +Choice account over 60% of
 the deductible                    $(970)     $443
Amount available for
 nonmedical withdrawals                $0     $443

Note that in Year 1, any withdrawal will be subject to the 50% excise tax, as the FMV of the Medicare+Choice account on December 31 is less than 60% of the deductible of the catastrophic insurance policy on January 1 of Year 1. In Year 2, T can withdraw $443 for nonmedical reasons, as the FMV of the Medicare+Choice account is greater than 60% of the deductible on January 1 of Year 2 by $443. However, this amount must be included in T's gross income.

Death of the Account Holder

When the Medicare+Choice MSA account holder dies, ownership of the Medicare+Choice MSA transfers to the account holder's beneficiary. If the account holder's beneficiary is the surviving spouse, ownership of the account transfers to the surviving spouse. The spouse is precluded from making any new contributions to the account, but can make tax-free withdrawals, as long as they are for qualified medical expenses. Any distributions the spouse receives that are not used to pay qualified medical expenses must be included in gross income and (similar to regular MSAs) are subject to a 15% excise tax, unless the spouse is at least 65 years old, disabled or dies.

If the account holder's beneficiary is not the surviving spouse, the value of the Medicare+Choice MSA must be included in the beneficiary's gross income. If the account holder does not name a beneficiary, the taxpayer's final income tax return must include the value of the account on the day of his death. The value of the Medicare+Choice MSA is determined on the day the account holder dies.

Advantages/Disadvantages

Medicare+Choice MSAs should provide taxpayers with more physician choices. The Medicare+Choice MSA also provides the taxpayer an investment, allowing for limited withdrawals for purposes other than to pay qualified medical expenses (as illustrated in the example).

Finally, if the taxpayer is married and the spouse is the beneficiary, the Medicare+Choice MSA will revert to the spouse when the taxpayer dies. The spouse can then make tax-free withdrawals from the account, as long as the withdrawals are used for qualified medical expenses. If the spouse is over 65 years old, withdrawals from the account can be made for any purpose without penalty (although they must be included in gross income).

The main disadvantage of the Medicare+Choice MSA is the investment risk the taxpayer assumes. The taxpayer must find an insurance company that would pay for services normally covered (compensated or reimbursed) by Medicare. If the insurance policy does not cover a medical procedure, the taxpayer can use funds from the Medicare+Choice MSA. However, the taxpayer may not have enough money in the Medicare+Choice MSA to pay for the medical procedures and the insurance premiums.

GEORGE SCHMELZLE, PH.D., CPA, ASSISTANT PROFESSOR, AND JAMES LOEBL, ASSISTANT PROFESSOR, INDIANA UNIVERSITY--PURDUE UNIVERSITY, FORT WAYNE, IN (NOT ASSOCIATED WITH DFK INTERNATIONAL)

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA3