The basics of medical savings accounts.

What you need to know before offering a new federal tax-favored benefit that could reduce health care costs for your association, your employees, and your members.

Does your association staff consist of 50 or fewer employees? Are your members primarily small-business owners or self-employed professionals? If you answered yes to one or both of these questions, your association is a prime candidate for offering a relatively new health care benefit known as a medical savings account, or MSA. (Even if you answered no, read on for details about how associations of any size or membership makeup can reap the rewards of MSA-style plans.)

A new federal law--the Health Insurance Portability and Accountability Act (HIPAA) of 1996--which became effective January 1,1997, enables employers to offer their employees and/or their members an alternative to traditional health insurance that can help the insured build reserves for future medical expenses and potentially provide supplemental retirement savings. (See sidebar, "The Federal MSA Project.")

While other MSA-type programs have been around in some form or another since the beginning of this decade, the passage of HIPAA heralds the first federal program allowing tax breaks on the funding of savings accounts established for medical expenditures. In addition to the federal law, 20 states have passed laws allowing for state income tax deductions on MSA contributions.

While employers with more than 50 employees are currently restricted from offering this federal tax-favored health benefit to their employees, they can still offer MSA-style programs--albeit with limited tax benefit (see sidebar, "The MSA Concept Holds True for All"). Many have been and are choosing to do so, since the incentive toward savings is still present for employees. Companies such as Forbes and Dominion Resources are corporate leaders on this front. (In certain states where high-deductible health plans are not allowed to be sold or where certain health benefits are mandated that do not fit within the high deductible-MSA arrangement, the federal MSA is also not allowed.)

One significant difference between the federal MSA and state MSA programs is that most states don't put the cap at 50 employees. Several bills currently exist in Congress to try to abolish or raise the cap on the federal program as well to allow wider participation in MSAs.

The Employee Benefits Research Institute, Washington, D.C., estimates that more than 40 million people in the United States are currently uninsured. As continued efforts toward health care reform seek to reduce the number of uninsured in the United States, MSA use--and the push for legislation in favor of MSAs--will likely grow. One implication for associations is that as MSA use and demand grow, associations will likely become more active in offering this health benefit option to their own employees and members.

The American Dental Association, Chicago, recently added MSAs to its benefits package for members. "Because most ADA members are self-employed or work in practices with 50 or fewer employees, MSAs represent a health care coverage alternative that is particularly well-suited to their needs," explains James H. Sweeney, ADA associate executive director and president and chief executive officer of ADA's Financial Services Company.

Members of the Association for Family Finances in America, Washington, D.C., also fit the typical MSA audience. "Our members are mostly self-employed or small employers, and they like the MSA idea because it provides them with a means for families to create capital," says Bob de Marcellus, AFFA president.

How an MSA works

An MSA is a savings account used to pay health care expenses that works in combination with a high-deductible health insurance policy. The self-employed individual or small employer purchases a high-deductible policy, which usually costs significantly less than a low-deductible policy. For example, a $3,000 annual deductible policy typically costs less than half what a $500 deductible policy costs. The high-deductible policy still protects the insured from catastrophic illness, prolonged hospitalization, or a particularly unhealthy year.

In addition to the high-deductible policy, the self-employed individual or employer, on behalf of the insured, establishes an MSA with a designated trustee--usually a bank or an insurance company. This account establishes funds for paying the medical expenses of the insured and his or her family.

Current tax law permits the self-employed to only partially deduct health care premiums from their income (45 percent for 1998). This is true for both traditional and MSA high-deductible plan premiums. With a traditional health plan, out-of-pocket medical costs for self-employed individuals are deductible only if they exceed 7.5 percent of the individual's adjusted gross income. However, the new law permits those enrolled in an MSA to deduct 100 percent of their contributions to their MSAs.

Because high-deductible policies cost less than traditional insurance and self-employed individuals may deduct their MSA contributions, individuals can recoup more of their expenditures with an MSA than with traditional insurance. (See "Traditional Plan Versus MSA" table.) Often the MSA itself can be funded by the cost savings from switching to the high-deductible plan from other health plans.

When qualified health care expenses for any year exceed the deductible and total out-of-pocket maximum, the insurance company pays the remaining medical expenses during that year. If any balance remains in the MSA at the end of the year (because the insured did not reach the deductible), the funds roll over and are available for the next year, thereby prefunding future medical expenses.

Rather than reduce employee health coverage because of the rising costs of comprehensive indemnity plans, many small employers--including smaller associations--are implementing MSA programs to rein in rising costs and retain good employees. In instances in which the employer cannot afford to offer both a high-deductible policy and make deposits to the MSA, the new law allows the employer to buy the high-deductible insurance and the employee to contribute to the MSA. Both receive a tax deduction for their role in purchasing health benefits.

MSA advantages

Medical savings accounts have advantages not always available with other health plan options:

* Freedom of choice. Consumers and their families have complete freedom of choice of doctors and available treatments. Unlike with a managed care plan, individuals with an MSA make their own decisions about their health care and establish a working relationship with their doctors without regard to a particular plan's provider selections.

* Portability. MSAs belong to the individual. If the insured loses a job or retires, the MSA follows the individual owner. This feature allows a person to have funds available for medical care when it is needed most. (If an insured changes employment and moves to a company that has more than 50 employees, the insured still owns current MSA funds but loses the ability to further contribute to the account.)

* Tax-favored savings. MSAs are similar to individual retirement accounts in that the money deposited is tax deductible. However, MSAs differ from IRAs because the interest earned in the MSA is never taxed as long as it is used for medical care. In a typical year, the average person or family will not spend their allotted maximum on medical expenses. Whatever money is left in the MSA at year-end remains in the account and continues to earn interest. Each year, the maximum contribution can be made to the account regardless of built-up funds. After several years, a sizable nest egg could be available for future medical care.

* No monies lost. An MSA is different from a flexible spending account (also known as a Section 125 cafeteria-style plan). Under the FSA arrangement, the employee must declare how much money he or she is going to spend on medical care for the upcoming year. If all of the money pledged is not spent, the money reverts back to the employer and the employee loses the money. With an MSA, money not used rolls over and is not lost to the employee, creating savings for future medical expenses. In addition, MSAs are available to self-employed individuals; FSAs are not.

MSA disadvantages

While many advantages can be named for those eligible to participate in an MSA, disadvantages do exist:

* High deductibles. Medical savings account users must be prudent about spending each MSA dollar so that they don't leave themselves too exposed with an uncovered deductible, since MSA funds can be used for medical benefits that are not covered under a typical high-deductible health plan. For instance, if an individual has a $2,250 deductible and spends $250 on eyeglasses--which are not covered by his or her health insurance plan--$2,250 is still left on the deductible to be satisfied before the insurance company will pay for covered medical expenses.

* Penalties and taxes. MSA withdrawals made for non-qualified or nonmedical care are subject to a 15 percent penalty and are taxed as income. The MSA withdrawal penalty is 5 percent greater than the IRA withdrawal penalty. Likewise, an individual cannot make MSA withdrawals for other types of FSA-allowable withdrawals, such as child care, without incurring the 15 percent penalty and income taxes. After age 65, there is no penalty for any MSA withdrawal, although the money withdrawn for non-medical purposes is taxed as regular income.

Finding an MSA provider

Associations will want to make wise choices when offering MSAs to their employees or members. As with any insurance product, it's important to select a company that you can trust to provide you with the required high-deductible health insurance. Further, associations need to compare the cost of the high-deductible insurance and the benefits provided. Considerations include how claims are paid, how quickly claims are processed, and how much the insured will be responsible for once the deductible has been satisfied.

This is an important point, says Bill Paradise, director of national accounts for Golden Rule Insurance Company, Indianapolis, speaking from an employee's perspective. "At some point in time, you are going to have enough medical bills during a single year to satisfy your deductible. That's when you will want the insurance coverage to be good. Study the company's brochure to see if the coverage is going to fit your family's needs. Look particularly at how much, if anything, you will be responsible for out-of-pocket after you have satisfied the deductible," says Paradise. "Some plans will pay 100 percent of covered expenses after the deductible."

In some instances, the insurance company will only offer the high-deductible health insurance, and you will need to shop around for a financial institution to administer the MSA. In other cases, the insurance company will offer both. It's important to obtain a fair comparison of the costs associated with the MSA. Questions to consider include whether the account is federally insured and how often (monthly, quarterly, or annually) statements are issued.

Also worth asking is whether any other charges are associated with the MSA, such as initial set-up fees, monthly maintenance or administrative fees, or other surcharges, and whether a minimum balance is required to earn the tax-deferred interest.

As for withdrawals, you need to know how these are conducted. For instance, does the insured use a bank credit card, a checking account, or a debit card to make payments?

Finally, you will want to find out how the company pays interest. Ask questions about rates earned on the MSA and how interest is accrued.

Education is key

Education is critical for an association offering an MSA plan to its employees or members. Dennis F. Kelly is president of Plan3, a Bethesda, Maryland-based benefit service firm that offers both federally qualified and other types of MSA plans. As Kelly sees it, "workplace education is a key factor in the success of any MSA or incentive program. Consumers need to be aware that their insurance claims for routine health care drive up the cost of premiums and divert funds that could be spent on direct employee benefits. For every dollar spent on typical insurance premiums, approximately 40 percent goes toward yearly routine claims, while 35 percent is reserved for insuring major incidents, and 25 percent for life-altering incidents."

AFFA's de Marcellus agrees that consumers require time for the MSA concept to sink in. "There is a huge learning curve associated with the MSA. It takes people a while to learn about them and then make the decision to switch to them. Sometimes they have to wait for their current insurance to come up for renewal," says de Marcellus. AFFA uses its monthly association newsletter to educate members on how to take advantage of the new program.

According to Kelly, MSA use will likely grow from repeat business and word-of-mouth referrals. "In Plan3's experience, 40 percent of the workforce will initially subscribe to an MSA-style plan when it is first offered as part of a menu of options. The positive feedback of the initial users yields a 60 percent rate by year two and typically will grow to 90 percent as employees reap the benefits. All employees need not participate in an incentive-style plan, and employers will recognize significant economies with a participation rate as low as 30 percent," says Kelly.

Even for larger associations ineligible to offer the tax-favored medical savings account to its employees, health care savings can still be had by both the employer offering the MSA option and the insured enrolled in an MSA plan. Especially for smaller associations and associations whose memberships are composed of self-employed individuals and small-business owners, the control over health care expenditures is greatly entranced by the arrival of this federal demonstration project. Perhaps the greatest intangible benefit provided by the federal MSA and other MSA-style options is that individuals are being empowered to become more involved in their own health care choices and more cognizant of the cost of that care.

Traditional Plan Versus MSA

                                  Traditional plan(*)

Annual premium                       $5,028.48
MSA deposit (100 percent tax
  deductible)                        not available
Pre-tax deduction on premium
  (40 percent)                       $2,011.39
Taxable income (60 percent of
  premium)                           $3,017.09
Taxes paid (assuming 28 percent
  tax bracket)                       $1,173.31

Total annual cost                    $6,201.79

                                  MSA plan(**)

Annual premium                    $2,327.64
MSA deposit (100 percent tax
  deductible)                     $2,250.00
Pre-tax deduction on premium
  (40 percent)                      $931.10
Taxable income (60 percent of
  premium)                        $1,396.54
Taxes paid (assuming 28 percent
  tax bracket)                      $543.10

Total annual cost                 $5,120.74(***)

Note: This comparison is for a self-employed, nonsmoking family of four living in Dallas.

(*) The traditional plan has a $500 deductible, and 80/20 coinsurance to $5,000.

(**) The MSA plan has a $3,000 deductible.

(***) Overall savings realized by choosing the MSA is $1,081.05. (The total annual cost is equal to the annual premium, plus the MSA deposit, plus taxes paid.)

Source: Golden Rule Insurance Company, Indianapolis

RELATED ARTICLE: The Federal MSA Project

Outlined here are the basic requirements and parameters of the four-year federal MSA pilot project launched early last year with passage of the Health Insurance Portability and Accountability Act of 1996.

Scope. The federal MSA demonstration project is currently limited to 750,000 taxpayers (individuals or households), plus an unlimited number of qualified uninsured individuals. For the year 2000 and thereafter, only active MSA participants and employees of participating employers are eligible to continue using the MSA benefit, unless the project is expanded by Congress. Growing bipartisan consensus does exist in Congress to expand the benefit to more Americans. In fact, the Balanced Budget Act of 1997 authorized MSAs to be part of a Medicare demonstration project for senior citizens. (States are leading the way with demonstration MSA programs for Medicaid recipients to benefit low-income women and children.)

Availability. Those eligible to participate in the federal MSA program include uninsured individuals whose employers do not provide health benefits, employer groups of 50 or fewer, and self-employed individuals.

Qualifications. Participants must have a qualified high-deductible health plan to participate in an MSA. For individuals, the deductible must be between $1,500 and $2,250 (with a total out-of-pocket maximum of $3,000), and for families, between $3,000 and $4,500 (with a total out-of-pocket maximum of $5,500).

Contributions. Contributions to the MSA can be made by the employer or the employee, but not by both during the same year. Individuals can contribute up to 65 percent and families up to 75 percent of their high-deductible policies. Under current law, this translates into the insured or the employer annually depositing into the MSA up to $1,462.50 for an individual and up to $3,375.00 for a family. Regardless of who makes the contribution, MSA funds always belong to the insured and accrue tax-deferred interest until the insured reaches age 65, when the funds may be withdrawn for any purpose (subject to income tax for non-medical expenditures).

Withdrawals. MSA withdrawals are not only available for routine medical expenses. Withdrawals for any health care procedure or item permitted under Section 213(d) of the Internal Revenue Code are also allowed. For example, withdrawals may be made for eyeglasses, braces, dental procedures, chiropractic expenses, and alternative medicines. Other qualified medical withdrawals include premiums for COBRA continuation coverage when between jobs, long-term care insurance premiums or services, and premiums for coverage while receiving unemployment compensation.

RELATED ARTICLE: The MSA Concept Holds True for All

Associations of any size and scope may reap the rewards of an MSA-style program by building on the program's underlying concepts of purchasing higher-deductible health insurance and then awarding employees with premium savings for medical expenditures or enhanced benefit options.

Regardless of their size, employers are still able to deduct the medical and medical supplemental benefits they offer with an MSA-style plan. And while certain benefits to the employee may be taxable in a plan for a company with more than 50 employees, the money is still the employee's to keep. As with any MSA-style plan, employees have the incentive to shop for value and to make prudent health care decisions for themselves and the care of family members. Regardless of the magnitude of the tax benefit attached, all MSA participants can benefit from provider choice, portability, and accrued savings.

In addition, employers have numerous options for how to award premium savings from the purchase of employee high-deductible plans. For example, employer-sponsored benefits such as flexible spending accounts or wellness benefits funded with savings on health care premiums are good tools for sharing insurance benefits equally among a workforce. Health club payments, prescription cards, vision benefits, disability insurance, and more may all be offered on a tax-favored basis to employees. Reduced premium savings may also be used to provide employees with other tax-favored benefit options such as tax-sheltered and tax-deferred annuities, 403(b), and now even 401(k) accounts. With some advance planning, most of the tax benefits available to small employers through the federally qualified MSA program can be preserved in programs traditionally designed for larger organizations.

--Dennis F. Kelly, president of Plan3, a Bethesda, Maryland-based benefit service firm

RELATED ARTICLE: MSA Program Sponsored by ASAE 

A new ASAE-sponsored program with Mellon Bank allows associations to offer medical savings accounts to their employees and members. Mellon's package includes depository and investment services. In addition, Mellon provides referrals to insurance carriers that offer a high-deductible health care policy compatible with the medical savings account. For more information or to receive a free brochure, call Mellon Bank, [phone]. Or call the ASAE Services Corporation, [phone].

Victoria Craig Bunce is a freelance writer and a research and policy director for the Council for Affordable Health Insurance, Alexandria, Virginia.