U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

A. In General 

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003775 established another form of tax-favored savings vehicle to defray the cost of health care expenses, the health savings account (HSA).
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775 P.L. 108-173, § 1201, adding Code § 223 and redesignating former Code § 223 as § 224, effective for tax years beginning in 2004.

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In general, an HSA is a trust or custodial account exclusively created  for the benefit of the account holder776 and his or her spouse and dependents, and is subject to rules similar to those applicable to individual retirement arrangements (IRAs) under § 408.777
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776 Account holder (or account beneficiary) is defined as the individual on whose behalf the HSA was established. § 223(d)(3).

777 Notice 2004-2, 2004-2 I.R.B. 269 (corrected by Notice 2004-50, 2004-32 I.R.B. 196).

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Contributions to an HSA are deductible, within limits, if made by an “eligible individual.”778 An eligible individual generally means any individual covered by a high deductible health plan (HDHP).779 An HDHP may include family coverage and may be sponsored by an employer.  HSA contributions are excludible from income if made by an eligible individual's employer.780 Earnings on the assets of an HSA are not taxable,781 nor are distributions from an HSA that are used to pay qualified medical expenses.782
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778 § 223(a).

779 § 223(c)(1)(A)(i); see XI, B, below.

780 § 106(d).

781 § 223(e)(1).

782 § 223(f)(1).

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Comment: HSAs were intended to replace Archer medical savings accounts (MSAs). Though contributions still can be made to Archer MSAs, no employers may adopt Archer MSA programs after 2003. See XII, below. HSAs are superior to Archer MSAs in all respects, including availability to large employers, and individuals in general, higher contribution limits, a wider range of permissible deductible amounts, eligibility for use in a cafeteria plan and greater overall flexibility.

U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

B. Eligible Individuals Under HSA Rules 

HSAs, and the deduction for contributions, are available to “eligible individuals.” An eligible individual is any individual (1) covered by a high deductible health plan (HDHP)as of the first day of the month; (2) while covered by an HDHP, is not covered by any health plan other than an HDHP (with some exceptions, see below); (3) is not enrolled in Medicare; and (4) may not be claimed as a dependent on another person's tax return.783 Thus, an individual is eligible to make HSA contributions (or have employer contributions made on his or her behalf), only if he or she, as of the first day of the month, is covered under an HDHP and is not covered under any other health plan, other than one providing certain permitted coverage.784 See XI, E, below, for definition of HDHP.
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783 § 223(c)(1)(A); Notice 2004-2, Q& A-2(corrected by Notice 2004-50, 2004-32 I.R.B. 196). See also Notice 2008-59, 2008-30 I.R.B. __, Q& A-1 through -11.

784 § 223(c)(1)(A); see XI, B, 1, below. Coverage under an employee assistance program, disease management program, or wellness program does not make an employee ineligible to contribute to an HSA as long as the program does not provide significant benefits in the nature of medical care of treatment. Notice 2004-50, Q& A-10.

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HSAs are available to self-employed individuals as well as any individual covered under an HDHP not provided by an employer as long as the requirements of  § 223 are met.784.1  Contributions can be made to an HSA either by the eligible individual or by his or her employer.785 In addition, any family member can make contributions for another family member who is an eligible individual.786
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784.1 § 223(c)(1)(A)(i); Notice 2004-50, 2004-33 I.R.B. 196, Q& A-1; Notice 2004-2, Q& A-2(corrected by Notice 2004-50.

785 Employer contributions must be reported on an employee's W-2. § 6051(a)(12); Notice 2004-2, Q& A-34. See Announcement 2004-2, 2004-3 I.R.B. 322 (Code W in box 12 on Form W-2 is used for employer HSA contributions). A qualified HSA distribution rolled over to an HSA is not reported on Form W-2. Notice 2007-22, 2007-10 I.R.B. 670. An employer cannot recoup any portion of its contribution from an employee's HSA. Notice 2004-50, Q& A-82. Employers that contribute to an employee's HSA are responsible for determining if the employee is covered by an HDHP sponsored by the employer and the employee's age for catch-up contributions. Id. at Q& A-81.

786 § 223(a); see Notice 2004-2, Q& A-11. Any person can make HSA contributions on behalf of an eligible individual. Notice 2004-50, Q& A-28.

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An HSA can be maintained by a married individual even if the individual's spouse is covered under a health care plan that is not an HDHP. In that event, the HSA can cover all family members except the spouse who is covered by the other plan.786.1
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786.1 See  Notice 2004-50, Q& A-31, and Rev. Rul. 2005-25, 2005-18 I.R.B. 971 (if one spouse has HDHP coverage and the other spouse has non-HDHP coverage, the spouse with the HDHP coverage is an eligible individual who can contribute to an HSA so long as the individual is not covered under the spouse's non-HDHP).

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1. Permitted Coverage 

a. Permitted Insurance 

Certain types of insurance do not disqualify an individual from contributing to an HSA. An individual is eligible for an HSA despite having coverage(through insurance or otherwise) for accidents, disability, dental care, vision care or long-term care.787 In addition, an individual may have certain “permitted insurance.”787.1 Permitted insurance is acceptable if substantially all of the coverage relates to: (1) liabilities incurred under workers'compensation laws; (2) tort liabilities; (3) liabilities relating to ownership or use of property (such as automobile insurance); or(4) any other similar liabilities specified in IRS regulations.788 Permitted insurance also includes insurance for a specified disease or illness788.1 or hospitalization insurance paying a fixed amount per day (or other period).789
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787 § 223(c)(1)(B)(ii); see Notice 2004-2, Q& A-6.

787.1 § 223(c)(1)(B)(i) and (c)(3). Benefits provided under permitted insurance must be from insurance contracts, rather than self-insured, unless benefits are statutorily provided (e.g., workers' compensation) and resulting medical care benefits are secondary or incidental to other benefits. Notice 2004-50, Q& A-8. See PLR 200704010 (ruling on whether various employer-offered insurance policies, optional benefits, and riders qualify as permitted insurance, permitted coverage or preventive care under § 223(c)(1)(B), (c)(3)(B) or (c)(2)(C), respectively).

788 § 223(c)(3)(A); see Notice 2004-2, Q& A-6.

788.1 § 223(c)(3)(B). Principal health care coverage must be provided by HDHP when eligible individual also is covered by insurance for specific disease or illness. Notice 2004-50, Q& A-7.

789 § 223(c)(3)(C).

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Prescription drug benefits are not permitted insurance or permitted coverage under § 223(c)(1)(B). Because a plan that provides benefits for prescription drugs is considered to be a health plan, an individual who is covered by both an HDHP and by a prescription drug plan is not an eligible individual for HSA purposes unless the prescription drug coverage also is an HDHP (e.g., the prescription drug plan does not provide benefits unless the required minimum annual deductible under § 223(c)(2)(A) for an HDHP has been satisfied).790
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790 Rev. Rul. 2004-38, 2004-15 I.R.B. 717; the result is the same if the prescription drug benefit is provided as a benefit under a health plan (and not separately)or as a benefit for the individual under a spouse's plan. Rev. Proc. 2004-22, 2004-15 I.R.B. 727, suspended Rev. Rul. 2004-38 until 2006. Thus, for months before Jan. 1, 2006, an individual who would otherwise have been eligible under § 223(c)(1)(A), but was covered by both an HDHP that did not provide benefits for prescription drugs and by a separate health plan or rider that provided prescription drug benefits before the minimum annual deductible of the HDHP was met (e.g, the separate prescription drug plan was not an HDHP), could continue to be an eligible individual for HSA purposes. See  Notice 2004-50 (transition relief).

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However, some prescription drugs fall under the  § 223(c)(2)(C) safe harbor for the preventive care deductible791 (discussed at XI, E, below).
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791 Notice 2004-50, Q& A-27.

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b. Health FSA Grace Period Coverage 

For taxable years beginning in 2007 and thereafter, certain coverage under a general purpose health flexible spending account (FSA) also is disregarded in determining whether an individual is eligible to contribute to an HSA.791.1 Specifically, coverage under a general purpose health FSA is disregarded during the period immediately following the end of a plan year during which unused remaining benefits or contributions may be paid or reimbursed to plan participants for qualified benefit expenses (the “grace period”)791.2  if: (1) the balance791.3 in the FSA at the end of the plan year is zero; or (2)the entire remaining balance in the FSA at the end of the plan year is rolled over to an HSA in a “qualified HSA distribution.”791.4
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791.1 § 223(c)(1)(B)(iii), added by the Tax Relief and Health Care Act of 2006, P.L. 109-432, § 302(b). A general purpose health FSA is one that reimburses all qualified medical expenses without restrictions. See Rev. Rul. 2004-45, 2005-23 I.R.B. 1204, Situation 1, discussed below.

791.2 Notice 2005-42, 2005-23 I.R.B. 1204, modified the “use-it-or-lose-it” rule by allowing cafeteria plans to be amended, at the employer's option, to provide a two-and-a-half month grace period immediately following the end of each plan year, during which an individual who incurs expenses for a qualified benefit during the grace period may be paid or reimbursed for those expenses from unused benefits or contributions. See Prop. Regs. § 1.125-1(e), REG-142695-05, 72 Fed. Reg. 43938 (8/6/07), proposed to apply to plan years beginning on or after Jan. 1, 2009, but may be relied upon for guidance pending issuance of final regulations. Cafeteria plans are discussed in T.M. 397, Cafeteria Plans.

791.3 Balances are determined on a cash basis without taking into account expenses incurred that have not been reimbursed as of that date. Notice 2007-22, 2007-10 I.R.B. 670.

791.4 § 223(c)(1)(B)(iii). A qualified HSA distribution is a direct rollover distribution made from a health FSA or health reimbursement arrangement (HRA) to an HSA before Jan. 1, 2012. § 106(e), added by P.L. 109-432, § 302(a), effective for distributions made on or after Dec. 20, 2006. Qualified HSA distributions are discussed below in XI, F.

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As discussed below, in Rev. Rul. 2004-45,791.5 an individual covered by a general purpose health FSA or HRA is not eligible to contribute to an HSA. Further, prior to 2007, an otherwise eligible individual in a general purpose health FSA who was covered by a grace period was not eligible to contribute to an HSA until the first day of the first month following the end of the grace period (even if the individual's FSA balance was zero)unless the employer, when it amended its cafeteria plan to provide for the grace period, converted the general purpose health FSA into an HSA-compatible FSA for the grace period so that these individuals could contribute to an HSA during the grace period.791.6
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791.5 See Situation 1.

791.6 Notice 2005-86, 2005-49 I.R.B. 1075, amplifying  Notice 2005-42. Examples of an HSA-compatible health FSA (or HRA) are: a limited-purpose health FSA that only pays or reimburses expenses for preventive care and permitted coverage; a post-deductible health FSA (or HRA) that pays or reimburses preventive care and other qualified medical expenses only if incurred after the minimum annual deductible for the HDHP is met; a retirement HRA; or a suspended HRA; or a combination of these. Coverage by an HSA-compatible health FSA or HRA does not affect an individual's eligibility to contribute to an HSA, including coverage during a grace period. See Rev. Rul. 2004-45, Situations 2 through 5, discussed below, and Prop. Regs. § 1.125-5(m) (general purpose health FSA is not HDHP), REG-142695-05, 72 Fed. Reg. 43938 (8/6/07), proposed to apply to plan years beginning on or after Jan. 1, 2009, but may be relied upon for guidance pending issuance of final regulations.

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Either one of the following rules must be satisfied to disregard general purpose health FSA coverage during a grace period:791.7
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791.7 Notice 2007-22, 2007-10 I.R.B. 670, modifying Notice 2005-86.

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Zero balance at end of plan year. If an individual has a zero balance in a general purpose FSA on the last day of the FSA's plan year, the individual does not fail to be an eligible individual as of the last day of the immediately following health FSA plan year because of coverage during a health FSA grace period. Likewise, an individual with a zero balance in a general purpose HRA on the last day of the plan year does not fail to be an eligible individual on the first day of the immediately following HRA plan year as long as: (i) effective on the first day of the immediately following HRA plan year, the individual waives participation in the HRA; or (ii) effective on or before the first day of the following HRA plan year, the employer terminates the HRA; or (iii) effective on or before the first day of the following HRA plan year, the employer converts the general purpose HRA to an HSA-compatible HRA.

Qualified HSA distribution. An individual with a balance in a general purpose health FSA with a grace period or general purpose HRA at the end of the plan year is treated as an eligible individual as of the first day of the first month in the immediately following plan year that the individual has HDHP coverage on the first day of the month if:
• the employer amends the health FSA or HRA effective by the last day of the plan year to allow a qualified HSA distribution;

• a qualified HSA distribution from the health FSA or HRA was not made previously on behalf of the individual for that particular health FSA or HRA;

• the individual has HDHP coverage as of the first day of the month during which the distribution occurs, and is otherwise an eligible individual;

• the individual elects by the last day of the plan year to make a qualified HSA distribution from the health FSA or HRA to an HSA;

• the health FSA or HRA makes no reimbursements to the individual after the last day of the plan year;

• the employer makes the qualified HSA distribution directly to the HSA within the grace period (i.e., by the 15th day of the third calendar month following the end of the immediately preceding plan year), but after the individual becomes HSA-eligible;

• the qualified HSA distribution from the health FSA or HRA does not exceed the lesser of the balance of the health FSA or HRA on September 21, 2006, or on the date of the distribution; and

• either(i) after the distribution there is a zero balance in the health FSA or HRA, and the individual is no longer a participant in any non-HSA compatible health plan, or (ii) effective on or before the date of the first qualified HSA distribution the general purpose health FSA or general purpose HRA is converted to an HSA-compatible health FSA or HRA.791.8

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791.8 These rules applied under special transition relief for amounts remaining at the end of 2006, except that: (i)there was no requirement to freeze the year-end balance in the health FSA or HRA; and  (ii) the deadline for completion of the amendment, election, and transfer was Mar. 15, 2007. Notice 2007-22. See Prop. Regs. § 1.125-5(n), REG-142695-05, 72 Fed. Reg. 43938 (8/6/07), proposed to apply to plan years beginning on or after Jan. 1, 2009, but may be relied upon for guidance pending issuance of final regulations.

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Rev. Rul. 2004-45792 describes different situations(or a combination of these situations) in which an individual can be an eligible individual and contribute to an HSA while also being covered by a health FSA or HRA.
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792 2004-22 I.R.B. 971, amplified by  Notice 2005-86, 2005-49 I.R.B. 1075, as modified by  Notice 2007-22. See Notice 2008-59, Q& A-1,-4 and -8 (guidance on eligibility for HSA while covered by HRA or FSA).

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Situation 1. A general purpose health FSA and HRA pay or reimburse all  of the individual's § 213(d) medical expenses that are not covered by the HDHP. This individual is not an eligible individual under § 223(c)(1)(A) and cannot contribute to an HSA because he is covered by an HDHP, an FSA and HRA that pay or reimburse medical expenses incurred before the minimum annual deductible under § 223(c)(2)(A)(i) has been satisfied. Furthermore, the FSA and HRA pay or reimburse medical expenses that are not limited to the exception for permitted insurance, permitted coverage or preventive care.792.1
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792.1 See the discussion above of § 223(c)(1)(B)(iii) and Notice 2007-22, which allow an otherwise eligible individual covered under a general purpose FSA or HRA to contribute to an HSA during a grace period provided certain conditions are met.

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Situation 2. The FSA and HRA are limited-purpose arrangements that pay or reimburse only vision and dental expenses (whether or not the minimum annual deductible of the HDHP has been met). The FSA and HRA also pay or reimburse preventive care benefits as described in Notice 2004-23.793 This individual is eligible because the medical expenses paid or reimbursed by the FSA and HRA only include vision and dental benefits (which are permitted coverage under § 223(c)(1)(B)), and preventive care. All of these benefits may provided as a separate health plan, a separate or optional rider, or as part of the HDHP, regardless of whether the minimum annual deductible under § 223(c)(2)(A)(i) has been satisfied.
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793 2005-15 I.R.B. 725.

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Situation 3. The individual covered under an HRA elects, before the beginning of the HRA coverage period, to forgo payment or reimbursement of medical expenses incurred during that coverage period. This election does not apply to permitted insurance, permitted coverage and preventive care. Medical expenses incurred during the suspended HRA coverage period cannot be paid or reimbursed by the HRA currently or after the HRA suspension ends. This individual is eligible to make HSA contributions until the HRA suspension period ends.

Situation 4. The FSA and HRA are post-deductible arrangements that only pay or reimburse medical expenses (including the individual's 20% coinsurance responsibility for expenses above the deductible)after the minimum annual deductible of the HDHP has been satisfied. The individual is eligible because the FSA and HRA pay or reimburse medical expenses (including the 20% coinsurance not otherwise covered by the HDHP) only after the HDHP's minimum annual deductible has been met.794
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794 See Notice 2004-50, Q& A-33, regarding HSA contribution limit in this situation.

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Situation 5. The individual is covered by a retirement HRA that only reimburses those medical expenses incurred after retirement. The individual is eligible to make HSA contributions before retirement because the HRA will pay or reimburse only medical expenses incurred after retirement.

The revenue ruling pointed out that if the individual has available an HSA, a health FSA and an HRA that pay or reimburse the same medical expense, the health FSA or HRA may pay or reimburse the medical expense subject to the ordering rules in Notice 2002-45.795 The individual must certify that the expense has not been reimbursed and that the individual will not seek reimbursement under any other plan or arrangement covering that expense (including the HSA).
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795 2002-2 C.B. 93, Part V; see III, B, 2, d, above.

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2. Noneligible Individuals—Medicare 

Individuals entitled to benefits under Medicare are not eligible individuals.796 Also, an individual who may be claimed as a dependent on another person's tax return is not an eligible individual.797
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796 § 223(b)(7). Medicare-eligible individual must be enrolled in Medicare. Notice 2004-2, Q& A-2 (corrected by Notice 2004-50); individual must be eligible for Medicare and enrolled in Medicare in Part A or Part B, otherwise, Medicare-eligible individual who is not enrolled in Medicare can contribute to HSA. Notice 2004-50, Q& A-2. See also Notice 2008-59, Q& A-5 and -6.

797 § 223(b)(6); Notice 2004-2, Q& A-2 (corrected by Notice 2004-50).

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

C. Deductibility of HSA Contributions 

Individual contributions made by or on behalf of an eligible individual to an HSA are deductible, within limits, above the line by that eligible individual.798 Alternatively, employer contributions are excludible from employee gross income within the same limits.799
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798 § 62(a)(19). The contributions are deductible whether or not the eligible individual itemizes deductions. However, the individual cannot also deduct the contributions as medical expense deductions under § 213. Notice 2004-2, Q& As-17 and 18. Further, the deduction for a self-employed individual's HSA contribution is not taken into account in determining net earnings under § 1402(a). Notice 2004-50, Q& A-84.

799 § 106(d)(1); Notice 2004-2, Q& A-19. Contributions by an employer to an HSA are not subject to the rules under  § 419. Id.  at Q& A-36. HSA contributions by partnerships and S corporations to partners and shareholders are not treated as excludible employer contributions under § 106(d) but are treated as payments to partners and shareholders deductible under § 62(a)(19). Notice 2005-8, 2005-4 I.R.B. 368.

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Contributions to an HSA must be made in cash, and, thus, may not be made in the form of stock or other property800 except for rollover contributions. HSA contributions may be made available as an option under a cafeteria plan.801 Contributions for a year can be made until the due date for the individual's federal income tax return for the year, excluding extensions.802
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800 § 223(d)(1)(A)(i); Notice 2004-2, Q& A-16. Contributions of cash credits by provider of HDHPs and HSAs that acts as HSA trustee or custodian to an account holder's HSA are not prohibited transactions under ERISA or the Code. DOL Adv. Op. 2004-09A. See DOL Field Assistance Bulletin (FAB) 2006-02 (frequently asked questions on ERISA's application to HSAs).

801 § 125(d)(2)(D); Prop. Regs. § 1.125-1(o)(3)(iv), REG-142695-05, 72 Fed. Reg. 43938 (8/6/07), proposed to apply to plan years beginning on or after Jan. 1, 2009, but taxpayers may rely on the proposed regulations for guidance pending issuance of final regulations. See Notice 2004-2, Q& A-33, and Notice 2004-50, Q& As-57 through -61. For a detailed discussion of cafeteria plans, see 397 T.M., Cafeteria Plans.

802 § 223(d)(4)(B) cross-referencing § 219(f)(3); Notice 2004-2, Q& A-21.

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1. Rollover Contributions 

Generally, rollover contributions may be made to an HSA from an Archer MSA or another HSA.803 For taxable years beginning in 2007, a one-time rollover may made from an IRA to an HSA,803.1 and beginning on or after December 20, 2006, certain amounts in a health FSA or HRA may be rolled over to an HSA until 2012.803.2
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803 § 223(d)(1)(A)(i) and (f)(5).

803.1 § 408(d)(9), added by the Tax Relief and Health Care Act of 2006, P.L. 109-432, § 307(a).

803.2 § 106(e), added by P.L. 109-432, § 302(a). Prior to Dec. 20, 2006, and 2007, rollovers from a health FSA or HRA or IRA were not permitted. Notice 2004-2, Q& A-23.

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a. IRA Rollovers 

Beginning in 2007, a one-time “qualified HSA funding distribution”may be rolled over from an IRA to an HSA in a direct trustee-to-trustee transfer.803.3 The amount that can be rolled over generally is the maximum deductible HSA contribution amount.803.4 The rollover amount reduces the maximum HSA contribution amount that would otherwise be allowed, and no deduction is allowed for the rollover contribution.803.5
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803.3 § 408(d)(9)(B). Rollovers from a § 408(k) SEP or § 408(p) SIMPLE retirement account are not allowed. Id.

803.4 § 408(d)(9)(C)(i); see XI, C, 2, below.

803.5 § 223(b)(4)(C), added by P.L. 109-432, § 307(b), effective for taxable years beginning after Dec. 31, 2006.

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In general, only one qualified HSA funding distribution from an IRA may be rolled over to an HSA during an individual's lifetime, except if the rollover is made during a month in which an individual has self-only coverage under an HDHP as of the first day of the month, the individual may elect to make an additional qualified HSA funding distribution rollover during a subsequent month within the taxable year in which the individual converts from self-only coverage to family coverage under the HDHP.803.6 An employee's election to make a qualified HSA funding distribution is irrevocable.803.7
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803.6 § 408(d)(9)(C)(ii).

803.7 § 408(d)(9)(C)(ii)(I).

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If an individual who makes a qualified HSA funding distribution does not remain an eligible individual under the HSA rules for 12 months (the “testing period”) after the distribution, the rollover contribution amount is includible in the individual's gross income and is subject to a 10% additional tax unless the individual dies or becomes disabled.803.8 Otherwise, the distribution is not includible in income to the extent that it otherwise would be.803.9
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803.8 § 408(d)(9)(D). The additional 10% tax is not included as a tax liability under § 26(b)(2). § 26(b)(2)(S), as amended by the 2007 Tax Technical Corrections Act, P.L. 110-172, § 11(a)(3), effective Dec. 29, 2007.

803.9  § 408(d)(9)(A) and (E). In determining the extent to which amounts distributed from the IRA otherwise would be includible in income, the aggregate amount distributed from the IRA is treated as includible in income to the extent of the aggregate amount that would have been includible if all amounts were distributed from all IRAs of the same type (i.e., in the case of a traditional IRA, there is no pro-rata distribution of basis). This rule separately applies to Roth IRAs and other IRAs. Technical Explanation of H.R. 6408, the “Tax Relief and Health Care Act of 2006” (JCX-5-06) (12/7/06) (Technical Explanation of H.R. 6408) at 79.

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Qualified HSA funding distributions are not subject to the 10% additional tax on early distributions for taxpayers under age 59 1/2 .803.10
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803.10 Technical Explanation of H.R. 6408 at 79.

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b. Health FSA and HRA Rollovers 

Beginning on or after December 20, 2006, “qualified HSA distributions”may be made from a health FSA or HRA to an HSA in a direct rollover before January 1, 2012.803.11 To be a qualified HSA distribution, the distribution amount cannot exceed the lesser of the balance803.12 in the FSA or HRA: (1) as of September 21, 2006; or (2) as of the date of the distribution.803.13 Only one rollover distribution may be made from each FSA or HRA of an employee.803.14.
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803.11 § 106(e)(2), added by P.L. 109-432, § 302(a). A qualified HRA distribution is treated as a rollover contribution under § 223(f)(5). § 106(e)(4)(C). The direct rollover contribution must be made by the employer to the employee's HSA. § 106(e)(2)(B). See generally Notice 2007-22, 2007-10 I.R.B. 670, and Prop. Regs. § 1.125-5(n), REG-142695-05, 72 Fed. Reg. 43938 (8/6/07), proposed to apply to plan years beginning on or after Jan. 1, 2009, but may be relied upon for guidance pending issuance of final regulations. Note that although the title of § 106(e) is “FSA and HRA Terminations to Fund HSAs,” there is no termination requirement to make a qualified HSA distribution. Notice 2007-22. Health FSAs and HRAs that allow for qualified HSA distributions do not violate § 105 and still must satisfy the requirements of § 105. § 106(e)(1).

803.12 Balances are determined on a cash basis without taking into account expenses incurred that have not been reimbursed as of that date. Notice 2007-22; Prop. Regs. § 1.125-5(n)(1)(iv).

803.13 § 106(e)(2)(A); Prop. Regs. § 1.125-5(n)(1)(iii). An individual who was not covered by a health FSA or HRA on Sept. 21, 2006, cannot elect to make a qualified HSA distribution. Further, if an individual participated in one employer's FSA on Sept. 21, 2006, and participates in another employer's FSA after Sept. 21, 2006, that individual cannot elect to make a qualified HSA distribution from the second FSA. Notice 2007-22.

803.14 § 106(e)(2) (flush language).

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The rollover amounts are excludible from gross income and from wages for employment tax purposes, are not counted in applying the maximum annual deduction limit for HSA contributions, and are not deductible.803.15  If the individual making a qualified HSA distribution does not remain an eligible individual for HSA purposes803.16 for a 12 months (the “testing period”)after the contribution, the distribution amount is includible in gross income and is subject to a 10% additional tax unless the individual dies or becomes disabled.803.17
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803.15 § 106(e)(4)(C) and (5)(A), referencing § 106(d).

803.16 See § 223(c)(1).

803.17 § 106(e)(3) and (e)(4)(A) and (B); Prop. Regs. § 1.125-5(n)(2). An individual does not have to be an eligible individual with HDHP coverage to make a qualified HSA distribution, but must be an eligible individual immediately after the distribution. Notice 2007-22. An employee who begins HDHP coverage after the first day of the month is not an eligible individual until the first day of the next month. If a qualified HSA distribution is made on behalf of such an employee before the next day of the next month, the employee is not an eligible individual as of the date of the distribution. Thus, if an employee begins HDHP coverage after the first day of the month, any qualified HSA distribution on behalf of the individual made on or after the first day of the next month avoids income inclusion. Id. The failure to remain an eligible individual for the 12 months after the distribution does not require withdrawal of the distribution and the distribution amount is not an excess contribution. However, any HSA withdrawal not used for qualified medical expenses is included in income subject to the 10% additional tax (with certain exceptions), regardless of whether the HSA received a qualified HSA distribution that was previously included in the individual's income and subject to the additional tax. Id.

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Although qualified HSA distributions can be made from general purpose health FSAs or HRAs and HSA-compatible arrangements, the eligibility of an individual for HSA purposes in a general purpose arrangement can be a problem.803.18 Under a general purpose arrangement, an individual can become an eligible individual only after making a qualified HSA distribution at the end of the arrangement's plan year that results in disregarded grace period coverage under § 223(c)(1)(B)(iii), or if the arrangement's coverage at the end of the plan year is terminated. Thus, distributions from a general purpose health FSA or HRA that occur at any time other than the end of plan year are included in income and incur an additional 10% tax. In addition, any unused amounts in an FSA at the end of a plan year (or grace period) are forfeited and cannot be transferred as part of a qualified HSA distribution after the end of the plan year. Although these amounts can be distributed prior to the end of an FSA's plan year, because the FSA coverage continues until the end of the plan year, an individual covered by the FSA is not an eligible individual immediately after the distribution and the distribution, therefore, is included in income and subject to the 10% penalty tax. Also, an individual with a balance in the general purpose FSA with a grace period or HRA at the end of the plan year is not an eligible individual if the distribution does not result in a zero balance in the FSA or HRA. Because the individual is covered under a health plan that is not an HDHP during the testing period, the distribution is included in income and subject to the additional tax.803.19
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803.18 See the discussion above in XI, B, 1, b, of § 223(c)(1)(B)(iii) and Notice 2007-22, for disregarding grace period coverage for an individual under a general purpose FSA or HRA following the end of a plan year.

803.19 Notice 2007-22; Prop. Regs. § 1.125-5(n)(3).

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An employer that chooses to provide qualified HSA distributions must amend its FSA or HRA.803.20 Further, if an employer provides qualified HSA distributions, to comply with the comparability rules (discussed below at XI, D), it must allow all employees who are covered under the employer's HDHP to make the same distributions. An excise tax of 35% applies to the amount contributed if this requirement is not met.803.21
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803.20  Notice 2007-22; Prop. Regs. § § 1.125-1(c)(1)(x), -5(n)(1).

803.21 § 106(e)(5)(B)(ii), referencing § 4980G.

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2. Maximum Deductible Amount 

The amount that can be deducted by an eligible individual cannot exceed the allowed annual contribution amount.804 The statutory maximum annual contribution to an HSA is $2,250 for an individual with single coverage or $4,500 for an individual with family coverage,805 as indexed for cost-of-living adjustments(COLAs).806 These limits are applied on a prorated monthly basis.807 The contribution limit is reduced by any contribution to an Archer MSA.808 In addition, an individual who is at least age 55 but younger than 65 can make catch-up contributions.809 The limits on contributions do not apply to rollover contributions,810 except for rollover contributions from an IRA.810.1
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804 § 223(b)(1).

805 § 223(b)(2), as amended by P.L. 109-432, § 303(a), effective for taxable years beginning after Dec. 31, 2006. For taxable years beginning before 2007, the maximum annual contribution to an HSA was the lesser of the annual deductible under the HDHP or the statutory dollar amount. See Notice 2004-2, Q& A-12. For 2009, the annual maximum HSA contribution amounts will increase to $3,000 and $5,950, respectively. Rev. Proc. 2008-29, 2008-22 I.R.B. 1039. The maximum annual HSA contribution for 2008 is $2,900 for individuals with single coverage and $5,800 for individuals with family coverage. Rev. Proc. 2007-36, 2007-22 I.R.B. 1335, § 4. For 2007, the maximum annual HSA contribution is $2,850 for individuals with single coverage and $5,650 for individuals with family coverage. Rev. Proc. 2007-36, § 3, modifying and superseding Rev. Proc. 2006-53, 2006-48 I.R.B. 996, § 3.24(1). For prior years, the contributions for individuals with single coverage and for individuals with family coverage were: for 2006, $2,700 and $5,450, respectively (Rev. Proc. 2005-70, 2004-47 I.R.B. 979, § 3.22(1)); for 2005, $2,650 and $5,250, respectively(Rev. Proc. 2004-71, 2004-50 I.R.B. 970, § 3.22(1)). For taxable years beginning before 2007, if family HDHP coverage includes embedded individual deductibles and an umbrella deductible, then the maximum annual contribution is the lesser of the statutory contribution limit for family coverage, the umbrella deductible, or the embedded individual deductible multiplied by the number of family members covered by the HDHP. Notice 2004-50, Q& A-30. The account holder is responsible for determining if the annual contribution limit has been exceeded and also for reporting any excess contributions to the HSA trustee or custodian. Id. at Q& A-74.

806 § 223(g)(1). COLAs may be applied to the minimum annual deducible amounts or maximum annual out-of-pocket expenses under HDHP. Notice 2004-50, Q& A-86.

807 § 223(b)(2). The annual contribution limit is the sum of the limits determined separately for each month, based on the individual's status and health plan coverage as of the first day of the month. Notice 2008-52, 2008-25 I.R.B. 1166, modifying Notice 2004-2 and Notice 2004-50, provides examples of how to calculate the annual contribution limit.

808 § 223(b)(4); Notice 2004-2, Q& A-12.

809 § 223(b)(3)(A). The 2004 catch-up amount is $500, increasing annually in $100 increments thereafter until it reaches $1,000 in 2009. § 223(b)(3)(B); Notice 2004-2, Q& A-14. Medicare-eligible individual (e.g., age 65) who is not enrolled in Medicare can make catch-up contributions to HSA. Notice 2004-50, Q& A-3. An eligible individual cannot make a catch-up contribution to a spouse's HSA. Notice 2008-59, Q& A-22.

810 § § 223(f)(3)(B), 4973(g)(1).

810.1 § 223(b)(4)(C), added by the Tax Relief and Health Care Act of 2006, P.L. 109-432, § 302(a), effective for taxable years beginning in 2007.

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For 2009, the annual maximum HSA contribution amounts will increase to $3,000 and $5,950, respectively. Rev. Proc. 2008-29, 2008-22 I.R.B. __.

For taxable years beginning in 2007 and thereafter, for purposes of computing the annual HSA contribution amount, an individual who is eligible during the last month of a taxable year is treated as having been eligible for all months during the taxable year and as having been enrolled in the same HDHP in which he or she was enrolled during the last month of the taxable year.810.2  Thus, the individual is allowed to make a full contribution despite part-year coverage and is allowed to make contributions for months before he or she was enrolled in an HDHP. If the individual does not remain eligible for a full year, a portion of HSA contributions is includible in gross income and is subject to a 10% additional tax.810.3 However, income inclusion and the additional tax do not apply if the individual's loss of status is due to death or disability.810.4
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810.2 § 223(b)(8)(A), added by P.L. 109-432. § 305(a). See Notice 2008-59, Q& A-19;Notice 2008-52, Example 1.

810.3 § 223(b)(8)(B)(i) and (iii). See  Notice 2008-52, Example 2.

810.4 § 223(b)(8)(B)(ii).

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With respect to a married couple, if either spouse has family coverage, both spouses are treated as having only such family coverage (and as having the family coverage with the lowest annual deductible if coverage is under different plans). The allowable deduction as so calculated is divided equally between them unless they agree on a different division.811
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811 § 223(b)(5); Notice 2004-2, Q& A-15; Notice 2004-50, Q& A-32. However, if only one spouse under the family HDHP coverage is an eligible individual, only that spouse may contribute to the HSA. Notice 2004-50, Q& A-31. See Rev. Rul. 2005-25, 2005-18 I.R.B. 971 (notwithstanding the rule for married couples in § 223(b)(5), if one spouse has HDHP coverage and the other spouse has non-HDHP coverage, the spouse with the HDHP coverage is an eligible individual who can contribute to an HSA up to the amount of the annual contribution limit so long as the individual is not covered under the spouse's non-HDHP; the maximum amount that the eligible individual can contribute depends on whether the individual has self-only or family HDHP coverage). Although eligible individuals can have more than one HSA, spouses cannot have joint HSAs. Notice 2004-50 at Q& As-64 and 63, respectively. See also  Notice 2008-59, Q& A-16 through -18.

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3. Excise Tax 

An excise tax of 6% for each tax year is imposed on the account holder for excess individual and employer contributions.812 If, however, the excess contributions for a tax year and the net income attributable to these excess contributions are paid to the account holder before the last day prescribed by law, including extensions, for filing the account holder's federal income tax return for the tax year, then: (1) the excise tax does not apply; (2) the distribution of the excess contributions is not taxed; and (3) the net income attributable to the excess contributions is included in the account holder's gross income for the tax year in which the distribution is made.813
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812 § 4973(a)(5).

813 § § 223(f)(3)(A) and 4973(g). Note that employer contributions are included in an employee's gross income to the extent that they exceed the deductible amount limits or if they are made on behalf of an employee who is not an eligible individual. Notice 2004-2, Q& A-22. See Notice 2004-50, Q& A-34.

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

D. HSA Comparability Requirement 

If an employer contributes to an HSA for any employee, the employer must make available a comparable contribution on behalf of all employees with comparable coverage during the same period.814 Contributions are comparable if they are either of the same amount or the same percentage of the deductible under the high deductible plan.815 For taxable years beginning in 2007 and thereafter, HCEs815.1 are not treated as comparable participating employees under § 4980E(d)(3) in making comparable contributions on behalf of NHCEs.815.2 Thus, employers may make larger HSA contributions for NHCEs than for HCEs.
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814 § 4980G(a). See generally Regs. § § 54.4980G-1 through -5, which clarify and expand the guidance provided in Notices 2004-2 and 2004-50. T.D. 9277, 71 Fed. Reg. 43056 (7/31/06), corrected at 71 Fed. Reg. 53966(9/13/06), applicable to employer HSA contributions made on or after Jan. 1, 2007. See also Notice 2004-2, Q& A-32;Notice 2004-50, Q& As-46, -48 and -50 through -54; Regs. § 54.4980G-1, Q& A-1. Comparable participating employees are eligible individuals (as defined under § 223(c)(1)) who are in the same category of employees and who have the same category of HDHP. Regs. § 54.4980G-1, Q& A-1. The comparability rules do not apply to contributions made through a cafeteria plan. Notice 2004-50, Q& As-47 and -49; Regs. § 54.4980G-5, Q& As-1 through -3. Nor do the comparability rules apply to rollovers from an employee's HSA or Archer MSA. Regs. § 54.4980G-2. However, the rules do apply to qualified HSA distributions rolled over to an HSA from a health FSA or HRA. § 106(e)(5)(B). See  Prop. Regs. § 54.4980G-7, REG-120476-07, 73 Fed. Reg. 40793 (7/16/08) (comparability rules for qualified HSA distributions contributed to HSAs on or after Dec. 20, 2006 and before Jan. 1, 2012). The comparability rules also apply to accelerated HSA contributions made by an employer on behalf of employees who have incurred qualified medical expenses during the calendar year exceeding the employer's cumulative HSA contributions at that time; however, an employer is not required to contribute reasonable interest on either accelerated or nonaccelerated HSA contributions. Regs. § 54.4980G-4, Q& A-15. Although this regulation applies to employer contributions made for calendar years beginning on or after Jan. 1, 2009, employers may rely on this guidance beginning on or after Apr. 17, 2008. Regs. § 54.4980G-4, Q& A-16;T.D. 9393, 73 Fed. Reg. 20794, 20795 (4/17/08). See REG-143797-06, 72 Fed. Reg. 30501, 30503 (6/1/07), corrected at 72 Fed. Reg. 35672 (6/29/07), as to reliance on earlier proposed regulations.

815 § § 4980G(b) and 4980E(d)(2)(A); Regs. § 54.4980G-4, Q& A-1(a). An employer is not required to contribute the same amount or percentage of the deductible for employees who are eligible individuals with one category of HDHP coverage that it contributes for employees who are eligible individuals with a different category of HDHP coverage. Regs. § 54.4980G-4, Q& A-1(a). Contributions to HSAs of independent contractors, sole proprietors and partners in a partnership are not taken into account. Regs. § 54.4980G-3, Q& As-1 through -3. All comparable participating employees do not receive comparable HSA contributions if an employer makes age 55 catch-up HSA contributions under § 223(b)(3) to comparable participating employees who are eligible for the catch-up contribution but not to comparable participating employees who are not eligible for the catch-up contribution. Regs. § 54.4980G-4, Q& A-11. Employers are permitted to contribute up to the maximum annual contribution to the HSAs of employees who become eligible individuals mid-year, but employers who opt to provide more than a pro-rata contribution based on the number of months that such an employee was eligible during the year must contribute the same amount on an equal and uniform basis to all comparable participating employees who become eligible mid-year. Prop. Regs. § 54.4980G-4, Q& A-2(h) and (i), REG-120476-07, 73 Fed. Reg. 40793 (7/16/08)(proposed to be effective in the first calendar year after final regulations are published, but employers may rely on guidance with respect to contributions made on or after Jan. 1, 2007).

815.1 As defined in § 414(q).

815.2 § 4980G(d), added by the Tax Relief and Health Care Act of 2006, P.L. 109-432, § 306. The IRS proposed a special rule for larger comparable contributions to NHCEs. See  Prop. Regs. § 54.4980G-6, REG-120476-07, 73 Fed. Reg. 40793 (7/16/2008) (proposed to be effective in the first calendar year after final regulations are published, but employers may rely on guidance with respect to contributions made on or after Jan. 1, 2007).

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In cases in which an employee has not established an HSA at the time the employer funds its employees' HSAs, the employer may satisfy the comparability requirement by contributing comparable amounts, plus reasonable interest, to the employee's HSA when the employee establishes the HSA, taking into account each month that the employee was a comparable participating employee.815.3
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815.3 Regs. § 54.4980G-4, Q& A-6(a). For employees who have not established an HSA by Dec. 31, or who have established an HSA but have not notified their employer of the HSA, an employer is in compliance with the comparability rules if it provides written notice (which may be delivered electronically) to all such employees by Jan. 15 of the following calendar year, that each eligible employee who, by the last day of Feb., establishes an HSA and notifies the employer that an HSA has been established will receive a comparable contribution to the HSA. For each eligible employee who does so, the employer must contribute by Apr. 15 comparable amounts plus reasonable interest. Regs. § 54.4980G-4, Q& A-14, which also provides a sample model notice employers may use. Although this regulation applies to employer contributions made for calendar years beginning on or after Jan. 1, 2009, employers may rely on this guidance beginning on or after Apr. 17, 2008. Regs. § 54.4980G-4, Q& A-16;T.D. 9393, 73 Fed. Reg. 20794, 20795 (4/17/08).  See REG-143797-06, 72 Fed. Reg. 30501, 30503 (6/1/07), corrected at 72 Fed. Reg. 35672 (6/29/07), as to reliance on earlier proposed regulations.

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The comparability rules apply separately to full-time employees, part-time employees (those who customarily work fewer than 30 hours per week) and former employees.815.4. An employer's ability to offer other types of plans to different groups of employees is not restricted.816 In applying the comparability rules, employers under common control are aggregated.817
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815.4 § § 4980G(b) and 4980E(d)(4)(A) and (B); Regs. § 54.4980G-3, Q& As-5(a),(b) and -10. The comparability rules do not apply to employees or former employees who are covered by a collectively bargained agreement whose health benefits were subject to good faith bargaining. Regs. § 54.4980G-3, Q& A-6. If an employer limits HSA contributions to employees who are eligible individuals with coverage under the employer's HDHP, the employer is not required to make comparable contributions to HSAs of employees who are eligible individuals with coverage under a nonemployer-provided HDHP. However, if the employer makes contributions to HSAs of employees who are eligible individuals with coverage under a nonemployer-provided HDHP, the employer must make comparable contributions to HSAs of all comparable participating employees whether or not covered under the employer's HDHP. An employer satisfies this rule if it makes a reasonable good faith effort to identify all comparable participating employees with nonemployer-provided HDHP coverage and makes comparable contributions to the HSAs of those employees. Regs. § 54.4980G-3, Q& A-7.

816 § § 4980G(b) and 4980E(d)(3).

817 § § 4980G(b) and 4980E(e);Regs. § 54.4980G-3, Q& A-4.

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The penalty for failure to comply with the comparability requirement is the imposition of an excise tax for the calendar year of the violation equal to 35% of the aggregate amount contributed by the employer to HSAs of the employees for taxable years of such employees ending with or within such calendar year.818 The Secretary can waive part or all of the penalty tax if the failure was due to reasonable cause and not willful neglect to the extent that the payment of such tax would be excessive relative to the failure involved.819
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818 § § 4980G(b) and 4980E(b); Regs. § 54.4980G-1, Q& A-4. An employer cannot recoup excess HSA noncomparable contributions from an employee's HSA at the end of the calendar year. Regs. § 54.4980G-4, Q& A-12. The IRS proposed a filing requirement for persons liable for the excise tax under § 4980E or § 4980G. See  Prop. Regs. § § 54.4980E-1, Q& A-1, and 54.4980G-1, Q& A-5, REG-120476-07, 73 Fed. Reg. 40793 (7/16/08) (proposed to be effective for tax years after the date the final regulations are published in the Federal Register). The proposed regulations would require employers who are liable for the excise tax under § 4980E or § 4980G to file Form 8928, “Return of Certain Excise Taxes Under Chapter 43 of the Internal Revenue Code,”and pay the excise tax on or before the 15th day of the fourth month following the end of the calendar year in which the noncomparable contributions were made.

819 § § 4980G(b) and 4980E(c);Regs. § 54.4980G-5, Q& A-4.

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

E. High Deductible Health Plan 

A “high deductible” health plan (HDHP) is a health plan with an annual deductible of at least $1,100 for individual coverage, and at least $2,200 for family coverage.820 Also, the maximum out-of-pocket expenses with respect to allowed costs, including the deductible, must not exceed $5,600 for individual coverage and $11,200 for family coverage.821 These dollar amounts are indexed annually for inflation.822
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820 § 223(c)(2)(A)(i). These amounts are the same for 2008 and 2007. Rev. Procs. 2007-36, § 4, and 2006-53, § 3.24(2), respectively. The 2006 amounts were $1,050 and $2,100, respectively. Rev. Proc. 2005-70, 2004-47 I.R.B. 979, § 3.22(2). In the case of family coverage, a plan is an HDHP only if, under the terms of the plan and without regard to which family member or members incur expenses, no amounts are payable from the HDHP until the family has incurred annual covered medical expenses in excess of the minimum annual deductible. Notice 2004-2, Q& A-3, Ex. 1. An employer-sponsored self-insured medical reimbursement plan can be an HDHP. Id.  at Q& A-7. Family HDHP coverage is a health plan covering one eligible individual and at least one other individual, whether or not that individual is an eligible individual. Notice 2004-50, Q& A-12. A state high-risk health insurance plan can qualify as an HDHP if the plan does not pay benefits below the minimum HSA annual deductible. Id.  at Q& A-13. See  Notice 2008-59, Q& A-12(Guidance on changing from family to self-only HDHP) and Q& A-14 and -15 (guidance on benefit restrictions and meeting deductibles).

821 § 223(c)(2)(A)(ii);Rev. Proc. 2007-36, § 4(for 2008). The 2007 amounts are $5,500 and $11,000, respectively. Rev. Proc. 2006-53, 2006-48 I.R.B. 996, § 3.24(2). The 2006 amounts were $5,250 and$10,500, respectively. Rev. Proc. 2005-70, 2004-47 I.R.B. 979, § 3.22(2). The 2005 amounts were $5,100 for individual coverage and $10,200 for family coverage. Rev. Proc. 2004-71, 2004-50 I.R.B. 970, § 3.22(2). Out-of-pocket expenses do not include premiums. Notice 2004-2, Q& A-3; Notice 2004-50, Q& A-21. A plan with no express limit on out-of-pocket expenses is not an HDHP unless such limit is not necessary to prevent exceeding the out-of-pocket maximum. Notice 2004-50, Q& A-17; see  Q& A-20. Also, an HDHP can impose reasonable limits on benefits and those amounts paid by the covered individual above the restrictions are not treated as out-of-pocket expenses. Id. at Q& As-14, -15, -16. Notice 2004-43, 2004-27 I.R.B. 10, provides transition relief for individuals who are not eligible to participate in HSAs because they live in states where HDHPs are not available. Thus, for months before Jan. 1, 2006, a health plan that would otherwise qualify as an HDHP under  § 223(c)(2), except that it complies with state law requirements that certain benefits be provided without a deductible or below the minimum annual deductible, will be treated as an HDHP if the disqualifying benefits are required by state law in effect on Jan. 1, 2004. During this transition period, otherwise eligible individuals covered under these plans will be treated as eligible individuals for HSA purposes. For any coverage period of 12 months or less beginning before Jan. 1, 2006, a health plan that otherwise qualifies as an HDHP, except that it complied on its most recent renewal date before Jan. 1, 2006, with state mandated requirements in effect on Jan, 1, 2004, will be treated as an HDHP. Notice 2005-83, 2005-49 I.R.B. 1075,  amplifying Notice 2004-43. See  Notice 2004-50 (transition relief). See also  Notice 2008-59, Q& A-13(separate deductible for specific benefits not treated as out-of-pocket expense).

822 § 223(g)(1).

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For 2009, the annual HDHP deductible limits will increase to $1,150 and $2,300, respectively, and the maximum out-of-pocket expense amounts will increase to $5,800 and $11,600, respectively. Rev. Proc. 2008-29, 2008-22 I.R.B. 1039.

A plan does not fail to qualify as high deductible plan merely because it does not have a deductible for preventive care.823 Further, any increased deductible for use of a provider outside the plan's network is disregarded for purposes of out-of-pocket expense limits.824
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823 § 223(c)(2)(C) (Note: Section 223(c)(2)(C) erroneously defines preventive care by reference to § 1871 of the Social Security Act, a provision providing Medicare regulatory authority to the Department of Health and Human Services).  Notice 2004-23, 2005-15 I.R.B. 725, provides a safe harbor for preventive care benefits allowed under an HDHP. For purposes of § 223(c)(2)(C), preventive care includes, but is not limited to: (1) periodic health evaluations, including tests and diagnostic procedures ordered in connection with routine examinations; (2) routine prenatal and well-child care; (3)immunizations; (4) tobacco cessation and obesity weight-loss programs;and (5) screening services for cancer, heart disease and other conditions. Preventive care generally does not include services or benefits intended to treat an existing illness, injury or condition. The determination of what care is preventive is determined under IRS guidance and not state mandated benefits law. See Notice 2004-50, Q& A-26(any treatment that is incidental or ancillary to preventive care service or screening described in Notice 2004-23 falls within the preventive care safe harbor of § 223(c)(2)(C)), and Q& A-27(the preventive care safe harbor also includes prescription drugs taken for a disease that has not yet manifested itself or not yet become clinically apparent or to prevent reoccurrence of a disease from which a person has recovered; for example, cholesterol-lowering drugs to prevent heart disease and angiotensin-coverting enzyme inhibitors, when used to help recovered heart attack or stroke victims prevent reoccurrence, constitute preventive care, as well as drugs or medications used as part of weight-loss or tobacco cessation programs, however, this does not include medications used to treat an existing illness, injury, or condition). See also  PLR 200704010 (ruling on whether various employer-offered insurance policies, optional benefits, and riders, qualify as preventive care under § 223(c)(2)(C)).

824 § 223(c)(2)(D); Notice 2004-2, Q& A-4.

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Although amounts contributed by an employer to an HSA are not considered part of a group health plan subject to COBRA continuation, an HDHP that covers an HSA account holder may be a group health plan and may be subject to COBRA continuation coverage requirements. 824.1
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824.1 Notice 2004-2, Q& A-35.

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

F. Taxation of Distributions 

Distributions (including contributions and earnings) from an HSA to pay for qualified medical expenses of the individual and his or her spouse or dependents are excludible from the individual's gross income.825 Distributions that are not for qualified medical expenses are includible in income826 and subject to an additional 10% tax unless the distribution was after the individual became eligible for Medicare (age 65), or on account of the individual's death or disability.827
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825 § 223(f)(1). In general, HSA amounts can be used for qualified medical expenses and are excludible from income even if the individual is not currently eligible to make HSA contributions. Notice 2004-2, Q& A-25. If the account holder no longer is an eligible individual, distributions used exclusively for qualified medical expenses continue to be excludible from the account holder's income. Id. at Q& A-28; Notice 2004-50, Q& A-36. However, if both spouses are covered by HSAs, the HSAs cannot reimburse the same expenses. Notice 2004-50, Q& A-38. For distributions to be excludible, the account holder must keep sufficient records of medical expenses. Id. at Q& A-39. An HSA distribution for reimbursement for qualified medical expenses can be deferred to later tax years as long as the expenses were incurred after the HSA was established. Id. Debit, credit or stored-value cards can be used to receive distributions from HSAs for qualified medical expenses. Notice 2004-2, Q& A-37. See  Notice 2008-59, Q& A-27;Notice 2006-69, 2006-31 I.R.B. 107. An account beneficiary may authorize someone else to withdraw funds from his or her HSA. Notice 2008-58, Q& A-27.

826 § 223(f)(2). An HSA cannot restrict distributions to pay or reimburse only the account holder's medical expenses but can restrict the frequency or minimum amount of distributions. Notice 2004-50, Q& As-79 and -80, respectively. HSA distributions are not subject to the § 105(h) nondiscrimination rules. Id. at Q& A-83.

827 § 223(f)(4). If a distribution was made by reasonable mistake and the account holder repays the mistaken distribution to the HSA by Apr. 15 following the first tax year the account beneficiary knew or should have known the distribution was a mistake, then no penalty is incurred. Notice 2004-50, Q& A-37. However, the HSA trustee or custodian does not have to allow the return of mistaken distributions. Id. at Q& A-76. The additional 10% tax is not included as a tax liability under § 26(b)(2). § 26(b)(2)(U), as redesignated by the  2007 Tax Technical Corrections Act, P.L. 110-172, § 11(a)(3), effective Dec. 29, 2007. Nor are distributions from an HSA considered for purposes of the health coverage tax credit under § 35(a). See Notice 2005-50, 2005-27 I.R.B. 14. For further discussion of the credit under § 35, see VII, C, 3, e, above, and 506 T.M., Tax Credits: Concepts and Calculation.

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Qualified medical expenses generally include any amount paid for medical care as defined under § 213(d).828 Qualified medical expenses do not include the payment of premiums for health insurance coverage, except for COBRA premiums, long-term care insurance premiums,829 health plan premiums paid while an individual is receiving unemployment compensation and premiums paid while an individual is eligible for Medicare (except for Medigap premiums).830 Thus, premiums for Medigap policies are not qualified expenses for HSA purposes.
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828 § 223(d)(2)(A). Qualified medical expenses cannot be reimbursed tax-free unless incurred after the HSA is established. Notice 2004-2, Q& A-26. However, Q& A-26 was suspended until 2005 by Notice 2004-25, 2004-15 I.R.B. 727, which granted transition relief for calendar year 2004 eligible individuals who established HSAs by Apr. 15, 2005. Thus, for 2004, an HSA established by an eligible individual by Apr. 15, 2005, may pay or reimburse on a tax-free basis an otherwise qualified medical expense if the expense was incurred on or after the later of Jan. 1, 2004, or the first day of the first month that the individual became an eligible individual under § 223. For further discussion of qualified medical expenses, see III, B, 3, a, above.

829 Qualified long-term care insurance premiums can be paid by an HSA that is part of a cafeteria plan. Notice 2004-50, Q& A-40. The § 213(d)(10) deduction limit for long-term care premiums applies to the amount of HSA distributions that can be excluded from income; thus, excess long-term care premium reimbursements are includible in gross income and may be subject to the 10% penalty in § 223(f)(4). Id. at Q& A-41. Payments for long-term care services constitute qualified medical expenses. Id. at Q& A-42.

830 § 223(d)(2)(B) and (C); Notice 2004-2, Q& A-27;Notice 2004-50, Q& A-43 and -45; Notice 2008-59, Q& A-29 through -33. Although the Medicare exception permits Medicare-eligible retirees to pay for employer-sponsored retiree health coverage with HSA funds, it does not provide similar relief for pre-Medicare eligible retirees. Thus, a 60-year old retiree could not use HSA funds to pay for retiree health coverage. A pre-Medicare eligible retiree also cannot use HSA funds to pay for Medicare premiums for a Medicare-eligible spouse. See  Notice 2008-59, Q& A-30.

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For purposes of determining the § 213 itemized deduction, any payment or distribution from an HSA for qualified medical expenses is not treated as an expense for medical care.831
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831 Notice 2004-2, Q& A-26.

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One tax-free rollover between HSAs is permitted by an account holder in any 12-month period if the rollover takes place within 60 days of distribution.832 An HSA may also accept rollover contributions from Archer MSAs,833 IRAs and health FSAs and HRAs.833.1 An individual's interest in an HSA may be transferred tax free to a spouse or former spouse under a separation or divorce instrument described in § 71(b)(2)(A), and thereafter is considered the transferee's HSA.834
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832 § 223(f)(5); Notice 2004-50, Q& A-55. This limit does not apply to direct trustee-to-trustee transfers. Id.  at Q& A-56. Under § 7508A, employee plan deadlines may be postponed for up to one year due to Presidentially declared disasters, or terroristic or military actions; see Rev. Proc. 2007-56, 2007-34 I.R.B. 388, for a list of time-sensitive acts that may be postponed under § 7508A.

833 § 220(f)(5); Notice 2004-2, Q& A-23. An HSA cannot restrict the account beneficiary's ability to rollover amounts from his or her HSA. Notice 2004-50, Q& A-77. Although rollover contributions are allowed from HSAs or Archer MSAs, the HSA trustee or custodian does not have to accept them. Id. at Q& A-78.

833.1 See the discussion above of rollover contributions in XI, C, 1.

834 § 223(f)(7).

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If, upon death, the HSA passes to a named beneficiary other than the surviving spouse, it ceases to be an HSA as of the date of the decedent's death, and the beneficiary must include the fair market value of the HSA assets as of the date of death in gross income for the taxable year that includes the date of death.835 The amount includible in income is reduced by the amount in the HSA that is used, within one year of death, to pay qualified medical expenses incurred before death.836 In computing taxable income, the beneficiary may deduct under § 691(c) that portion of the federal estate tax on the decedent's estate tax that was attributable to the amount of the HSA balance.837
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835 § 223(f)(8)(B)(i); Notice 2004-2, Q& A-31. If the surviving spouse is the named beneficiary, the spouse is treated as the account holder. § 223(f)(8)(A). Note that the spouse must be named as the beneficiary of the account; becoming entitled to the account proceeds by virtue of being the beneficiary of the estate is not enough to avoid taxation.

836 § 223(f)(8)(B)(ii)(I);Notice 2004-2, Q& A-31.

837 § 223(f)(8)(B)(ii)(II).

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

G. Establishing and Maintaining HSAs 

1. Institutional Trustee or Custodian 

Eligible individuals can establish HSAs with a qualified HSA trustee or custodian in much the same way individuals establish individual retirement accounts (IRAs).838 However, because HSAs also differ from IRAs in a number of ways, the two types of accounts cannot be combined into a single account.839
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838 Notice 2004-2, Q& A-8. Model IRS forms may be used to establish HSAs. Notice 2004-50, Q& A-10. Any administration and account maintenance fees withdrawn from HSAs are not taxable distributions. Id.  at Q& A-69; Notice 2008-59, Q& A-42. State trust law determines when an HSA is established, but an earlier establishment date may be used where an HSA was funded with rollover contributions or where a previous HSA was established. See  Notice 2008-59, Q& A-38 through -41.

839 Notice 2004-50, Q& A-66.

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Any insurance company or bank (including a similar financial institution as defined in § 408(n))can be an HSA trustee or custodian.840 Any other persons already approved by the IRS to be trustees or custodians of IRAs or Archer MSAs are automatically approved to be HSA trustees or custodians. An eligible individual who is an employee may establish an HSA without any involvement of the employer.841
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840 Notice 2004-50, Q& A-72(revised and corrected 8/9/04). Persons other than banks, insurance companies, or previously approved IRA trustees or custodians may request approval to be a trustee or custodian in accordance with the procedures set forth in Regs. § 1.408-2(e). See Announcement 2007-47, 2007-20 I.R.B. 1260, for a list of IRS approved nonbank custodians.

841 Notice 2004-2, Q& A-8.

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The institutional trustee or custodian need not have investment direction.842 However, investment restrictions regarding prohibited transactions and pledging an account as security for a loan, similar to those that apply to IRAs under § 408(c)(2) and (4), apply to HSAs.843 Thus, HSAs are subject to the excise tax on prohibited transactions except if the transaction causes the HSA to terminate.844 Any amount treated as distributed under such rules is included in the account holder's gross income.
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842 See  PLR 9821016. HSA funds can be invested in investments approved for IRAs. Notice 2004-50, Q& A-65.

843 § 223(e)(2).

844 § 4975(c)(6), added by P.L. 108-173, § 1201(f)(1), effective for tax years beginning in 2004.

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2. Reporting by Trustees and Custodians 

The information reporting requirements for HSAs are similar to those for Archer MSAs.845 Thus, HSA trustees may be required to report amounts with respect to contributions, distributions and other matters as required by the Secretary of Treasury.846 The failure to file such reports may result in a penalty of $50 per failure.847
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845 See Notice 2004-2, Q& A-34.

846 § 223(h). HSA trustee is responsible for filing required information returns and for tracking account beneficiary's age. Notice 2004-50, Q& As-74 and -75, respectively. An HSA trustee also must report qualified HSA distributions under § 106(e) as rollover contributions on Form 5498-SA. Notice 2007-22, 2007-10 I.R.B. 670. HSA administration and maintenance fees withdrawn by the trustee must be reflected on Form 5498-SA in the fair market value of the HSA at the end of the taxable year; the trustee should not report these fees as distributions. Notice 2008-59, Q& A-42.

847 § 6693(a)(2)(C), added by P.L. 108-173, § 1201(g), effective for tax years beginning in 2004.

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3. Prohibited Tax Shelter Transactions 

If an HSA (or an Archer MSA) is a party to a prohibited tax shelter transaction, excise taxes may be imposed. An entity manager —a person who knowingly approves the participation of the HSA in, or otherwise causes the HSA to be a party to, a prohibited tax shelter transaction (including any listed transaction or other prohibited reportable transaction) at any time during the taxable year —is subject to an excise tax of $20,000 for each approval (or other act causing participation) for the taxable year.847.1 In addition, the HSA must disclose to the IRS that it is a party to the prohibited tax shelter transaction and the identity of any other party to the transaction which is known to the HSA. An HSA that does not comply with the disclosure requirement is subject to a penalty of $100 for each day during which the failure to disclose continues, up to $50,000 for a single disclosure.847.2
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847.1 § 4965, added by the 2005 Tax Increase Prevention and Reconciliation Act (TIPRA), P.L. 109-222, § 516(a), effective for taxable years ending after May 17, 2006, with respect to transactions before, on, or after May 17, 2006, except that no tax under § 4965(a) will apply with respect to income or proceeds that properly are allocable to any period ending on or before Aug. 15, 2006. TIPRA § 516(d)(1). See generally Prop. Regs. § § 53.4965-1 through -9, REG-142039-06 and REG-139268-06, 72 Fed. Reg. 36927 (7/6/07), generally applicable to taxable years ending after July 6, 2007, upon publication of final regulations. An HSA is a party to a prohibited tax shelter transaction if it facilitates the transaction by reason of its tax-exempt, tax indifferent, or tax-favored status or if published guidance identifies it as one by type, class or role. Prop. Regs. § § 53.4965-2(c)(6)(v), -4(a) and (b); Notice 2007-18, 2007-9 I.R.B. 608. An individual beneficiary or owner of the HSA may be liable as an entity manager if the individual beneficiary or owner has broad investment authority under the arrangement. Prop. Regs. § 53.4965-5;Notice 2006-65, 2006-31 I.R.B. 102. See 351 T.M., Plan Qualification —Pension and Profit-Sharing Plans, and 798 T.M., Tax Shelters, for further discussion of § 4965.

847.2 § 6033(a)(2), as amended by TIPRA § 516(b); § 6652(c)(3), as amended by TIPRA § 516(c). The IRS may make a written demand for disclosure on any entity or manager subject to the penalty for nondisclosure. A failure to comply with the demand results in an additional penalty of $100 for each day of noncompliance after the expiration of the time specified in the demand, up to $10,000 for a single disclosure. § 6652(c)(3)(B). See Regs. § § 1.6033-5T and 301.6033.5T, T.D. 9335, 72 Fed. Reg. 36869 (7/6/07), applicable for transactions entered into by a tax-exempt entity after May 17, 2006, and scheduled to expire on July 6, 2010.

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

H. Applicability of ERISA to HSAs 

An HSA is not treated as an employee welfare plan under ERISA if it meets the criteria for the group insurance arrangement safe harbor.847.3 The DOL also provides an alternative basis for exclusion from ERISA coverage, because employer contributions or payments are not necessarily significant in analyzing the status of an HSA under ERISA. The employer may contribute to an HSA as long as the establishment of the HSA is completely voluntary on the part of the employees and the employer: does not require employees to participate in an HSA; cannot stop employees from moving HSA funds to other HSAs or limit use of HSA funds beyond tax Code limits; cannot make or influence investment decisions of HSA holders; cannot represent to employees that the HSA is an employer-sponsored benefit plan; and cannot receive any payment or compensation in connection with the HSA.847.4 If the employer complies with these alternative conditions, it may open an HSA for an employee and deposit employer funds into the HSA; limit the HSA providers that it allows to market its HSA products in the workplace or select a single HSA provider;choose and forward contributions to an HSA provider that offers a limited selection of investment options, provided that there is more than one option, or investment options that replicate the investment options available to employees under their 401(k) plan; not pay FICA and FUTA taxes on amounts contributed to an HSA through a cafeteria plan;or pay fees associated with an HSA that the employee otherwise would be required to pay. However, the employer may not receive a discount on another product from an employer-selected HSA vendor, and would be subject to fiduciary and prohibited transaction violations if it did so.847.5 Account beneficiaries and trustees of HSAs also are subject to prohibited transaction rules.847.6
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847.3 DOL FAB 2004-01. See DOL Regs. § 2510.3-1(j).

847.4 DOL FAB 2004-01.

847.5 DOL FAB 2006-02. See  Notice 2008-59, Q& A-37.

847.6 Notice 2008-59, Q& A-34 through -37.

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U.S. Income Portfolios: Compensation Planning 
  Portfolio 389-4th: Medical Plans — COBRA, HIPAA, HRAs, HSAs and Disability 
  Detailed Analysis 
  XI. Health Savings Accounts

I. Employer Contributions 

Employer contributions to the HSA of an employee who is an eligible individual are excludible from the employee's income.847.7 Employer contributions that are made between January 1 and the date for filing the employee's tax return, without extensions, may be allocated to the prior year if the employer so notifies the HSA trustee or custodian. The employer still must report the contributions on the employee's Form W-2 for the year in which the contributions actually are made.847.8 If an employer contributes to an account of an employee who was never an eligible individual under § 223(c), or contributes more than the maximum annual contribution under § 223(b), then the employer may correct the error and recoup the amount contributed in error. If the amounts are not recovered by the end of the tax year, then the employee must include the erroneous contribution as gross income and the amounts must be reported as wages on the employee's Form W-2. However, an employer may not recover amounts contributed in error to the HSA of an employee who ceases to be an eligible individual during the year.847.9
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847.7 § 106(d). Employer contributions to the HSA of an employee's spouse (who is not employed by the employer) must be included in the gross income and wages of the employee. Notice 2008-59, Q& A-26.

847.8 Notice 2008-59, Q& A-21.

847.9 Notice 2008-59, Q& A-23 through -25.

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