Medical Savings Accounts (MSAs)

To qualify for an MSA, you must be an employee of a small employer or be self-employed. You must also have a high deductible health plan (HDHP) that meets all of the requirements outlined later, and have no other health insurance coverage except permitted coverage. You must be an eligible individual on the first day of a given month to get an MSA deduction for that month.

If another taxpayer is entitled to claim an exemption for you, you cannot claim a deduction for an MSA contribution. This is true even if the other person does not actually claim your exemption.

Understanding MSAs

To understand MSAs, you will want to know what an MSA is and what the benefits are of having one. You will also need to know whether you meet the rules for starting an MSA. If you meet the rules, then you will want to read the section titled Setting Up an MSA.

What is an MSA? An MSA is a tax-exempt trust or custodial account with a financial institution (like a bank or an insurance company) in which you can save money for future medical expenses. This account must be used in conjunction with an HDHP. See What is a high deductible health plan (HDHP), later.

What are the benefits of an MSA? You may enjoy several benefits from having an MSA.

• The interest or other earnings on the assets in your MSA are tax-free.
• You can claim a tax deduction for contributions you make even if you do not itemize your deductions on Form 1040.
• The contributions remain in your MSA from year to year until you use them.

Rules for Starting an MSA

You need to meet the following rules before you can start an MSA.

1. You must work for a small employer or be self-employed.
2. You must have an HDHP.

Who is a small employer? A small employer is an employer who had an average of 50 or fewer employees during either of the last 2 calendar years. The definition of small employer is modified for new employers and growing employers.

New employer. A new employer is also considered a small employer for MSAs if he or she reasonably expects to employ 50 or fewer people this year.

Growing employer. A small employer may begin HDHPs and MSAs for his or her employees and then grow beyond 50 employees. The employer will continue to meet the requirement for small employers if he or she:

• Had 50 or fewer employees when the MSAs began,
• Made a contribution for the last year the employer had 50 or fewer employees, and
• Had an average of 200 or fewer employees each year after 1996.

What is a high deductible health plan (HDHP)? To be eligible for an MSA, you must have an HDHP. If you are an employee, the plan must be through your small employer. You generally cannot have another health insurance plan.

Definition. An HDHP has:

1. A higher annual deductible than typical health plans, and
2. A maximum limit on the annual out-of-pocket medical expenses that you must pay for covered expenses.

Limits. The following tables show the limits for annual deductibles and the maximum out-of-pocket expenses for high deductible health plans for 1999 and 2000. These limits may be changed in future years because of inflation adjustments.

Family plans that do not currently meet the high deductible rules. There are some family plans that have deductibles for individual family members. These deductibles are less than the annual deductible for the family plan. Under these plans, if you meet the individual deductible for one family member, you do not have to meet the annual deductible amount for the family plan. These plans do not qualify as HDHPs.

Example. Mr. Wilber has health insurance with company A in 1999. The annual deductible for the family plan is $3,500. This plan also has an individual deductible of $1,550 for each family member. Mr. Wilber's wife had $1,750 of covered medical expenses. They had no other medical expenses for 1999. The plan paid $200 to Mr. Wilber because Mrs. Wilber met the individual deductible of $1,550, even though the Wilbers did not meet the $3,500 annual deductible for the family plan. The plan does not qualify as an HDHP.

Insurance companies that have family plans with individual deductibles may change these health plans to meet the high deductible rules. Check with your insurance company if you have such a plan to see if they are going to change the plan to meet the rules.

Other health insurance. You (or your spouse if you file jointly) generally cannot have any other health plan that is not an HDHP. However, this rule does not apply if the other health plan(s) only covers the following items.

1. Accidents.
2. Disability.
3. Dental care.
4. Vision care.
5. Long-term care.
6. Benefits related to workers' compensation laws, tort liabilities, or ownership or use of property.
7. A specific disease or illness.
8. A fixed amount per day (or other period) of hospitalization.

Setting Up an MSA

When you set up an MSA, you will need to work with a trustee and know the rules for contributing and withdrawing money from the account.

MSA trustee. The person or business with whom you set up your MSA is called a trustee. A trustee can be a bank, insurance company, or anyone already approved by the IRS to be a trustee of individual retirement arrangements. Your employer may already have some information on MSA trustees in your area.

Who can contribute to my MSA? Your employer may decide to make contributions to an MSA for you. You do not pay taxes on these contributions. If your employer does not make contributions to your MSA, you can make your own contributions to your MSA and deduct these amounts on your tax return without itemizing deductions. Both you and your employer cannot make contributions to your MSA in the same year. There are limits to the amounts that can be contributed to your MSA. See Making Contributions, later. You do not have to make contributions to your MSA every year.

If your spouse is covered by your HDHP and your spouse's employer makes a contribution to your spouse's MSA, you cannot make contributions to your own MSA that year.

When can I make withdrawals from my MSA? You can make tax-free withdrawals from your MSA to pay for qualified medical expenses (discussed later). If you make withdrawals for other reasons, the amount you withdraw will be subject to income tax and may be subject to an excise tax as well. See Receiving Distributions, later. You do not have to make withdrawals from your MSA each year.

Changing employers. If you change employers and still meet the rules for having an MSA, you can continue to use that MSA. However, you may not make additional contributions unless you are otherwise eligible.

Making Contributions

There are two limits to the amount you can contribute to your MSA. One is based on the annual deductible of your HDHP. The other is based on your wages or compensation if you are an employee, or your net self-employment income if you are self-employed.

Annual deductible. You can contribute up to 75% of the amount of your annual health plan deductible (65% if you have a self-only plan) to your MSA. You must have the insurance all year to deduct the full amount.

For each full month you did not have an HDHP, you must reduce the amount you can contribute by one-twelfth. See the MSA Contribution Limits Worksheet, later.

Example 1. You have an HDHP for your family all year. The annual deductible is $4,000. You can contribute $3,000 ($4,000 x 75%) to your MSA for the year.

Example 2. You have an HDHP for your family for the entire months of July through December (6 months). The annual deductible is $4,000. You can contribute $1,500 ($4,000 x 75% x 12 months x 6 months) to your MSA for the year.

If both you and your spouse have a family plan, you are treated as having family coverage with the lower annual deductible of the two health plans. The contribution limit is split equally between you unless you agree on a different division.

Wages or compensation. You cannot contribute more than you earned for the year from the employer through whom you have your HDHP. If you are self-employed, you cannot contribute more than your net self-employment income. This is your income from self-employment minus expenses (including the one-half of self-employment tax deduction).

Example 1. Bob Smith earned $25,000 from ABC Company for the year. He had an HDHP for his family at ABC. He had the plan all year. His annual deductible is $4,000. He can contribute $3,000 to his MSA (75% x $4,000). He can contribute the full amount because he earned more than $3,000 at ABC.

Example 2. Joe Craft is self-employed. He had an HDHP for his family for the entire year and the annual deductible is $3,500. His maximum contribution to his MSA would have been $2,625 (75% x $3,500). However, after deducting his expenses, Joe's net self-employment income is $1,950 for the year. Therefore, he is limited to a contribution of $1,950 to his MSA.

Worksheet to figure your MSA contribution. You can use the following worksheet to figure how much you can contribute to your MSA for the year.

You must figure your limit separately for each employer with whom you have had a different HDHP.

Reporting contributions on your return. Report all contributions to your MSA on Form 8853. Follow the instructions for the form and attach the form to your Form 1040.

You should receive Form 5498-MSA, Medical Savings Account Information (MSA or Medicare + Choice MSA Information for 2000), from the trustee showing the amount you (or your employer) contributed during the year. You can make contributions to your MSA until April 15 (or the next business day if April 15 is a Saturday, Sunday, or holiday) and deduct them on your Form 1040 for the preceding year to the extent your total contributions do not exceed your limitation.

Excess contributions. You must generally pay a 6% excise tax on contributions that you or your employer make to your MSA that are greater than the limits discussed earlier.

However, you will not have to pay the excise tax if you withdraw these excess contributions (and associated earnings) before the date that your tax return is due (generally April 15). You will have to pay tax on any earnings associated with the excess contributions you withdraw.

Report and pay income tax on any excess contributions an employer makes and you withdraw before the due date of your tax return. You will also have to pay tax on any earnings associated with the excess contributions the employer makes that you withdraw. If the employer did not add the excess contributions and associated earnings to the box 1 amount on your Form W-2, include them in your gross income on your Form 1040.

Receiving Distributions

You will generally pay medical expenses during the year without being reimbursed by your HDHP until you reach the annual deductible. When you pay medical expenses during the year that are not reimbursed by your HDHP, you can ask the trustee of your MSA to send you a distribution from your MSA.

A distribution is money you get from your MSA. The trustee will report any distribution to you and the IRS on Form 1099-MSA, Distributions From Medical Savings Accounts.

How to report distributions on your tax return. How you report your distributions depends on whether or not you use the distribution for qualified medical expenses (defined later).

• When you use a distribution from your MSA for qualified medical expenses, you do not pay tax on the distribution. You do have to report the distribution on Form 8853. Follow the instructions for the form and attach it to your Form 1040. You cannot file Form 1040A or Form 1040EZ.
• When you do not use a distribution from your MSA for qualified medical expenses, you must pay tax on the distribution and report the amount on Form 8853. Follow the instructions for the form and attach it to your Form 1040. You must also report and pay an excise tax on your Form 1040 unless you meet one of the exceptions listed later.

If an amount is contributed to your MSA this year (by you or your employer), you also must report and pay tax on a distribution you receive from your MSA this year that is used to pay for medical expenses of someone who is not covered by an HDHP, or is also covered by another health plan that is not an HDHP, at the time the expenses are incurred. See the instructions for Form 8853 for more information.

Reporting and paying an excise tax. There is a 15% excise tax on the part of your distributions not used for qualified medical expenses. You report the excise tax on line 53 of your Form 1040.

Exceptions to excise tax. There is no excise tax if you are disabled, age 65 or older, or die during the year.

Death of the MSA holder. You should choose a beneficiary when you set up your MSA. What happens to that MSA when you die depends on whom you designate as the beneficiary.

Spouse is the designated beneficiary. If your spouse is the designated beneficiary of your MSA, it will be treated as your spouse's MSA after your death.

Spouse is not the designated beneficiary. If someone other than your spouse is the designated beneficiary of your MSA, on the date you die:

1. The account stops being an MSA , and
2. The fair market value of the MSA becomes taxable to the designated beneficiary.

No designated beneficiary. If you have no beneficiary, the fair market value of the MSA will be included on your final income tax return after your death.

Qualified Medical Expenses

Qualified medical expenses are explained in Publication 502, Medical and Dental Expenses. Examples include amounts paid for doctors' fees, prescription medicines, and necessary hospital services.

You cannot deduct qualified medical expenses as an itemized deduction on Schedule A (Form 1040) if you pay for them with a tax-free distribution from your MSA. You also cannot claim a deduction if you use other funds equal to the amount of the distribution.

Special rules for insurance premiums. Generally, you cannot treat insurance premiums as qualified medical expenses for MSAs. You can, however, treat premiums for long-term care or health care coverage while you receive unemployment benefits as qualified medical expenses for MSAs. This includes COBRA-type continuation coverage required under any federal law.

Recordkeeping. For each qualified medical expense you deduct or pay with a distribution from your MSA, you must keep a record of the name and address of each person you paid and the amount and date of the payment. Do not send these records with your tax return. Keep them with your tax records.

Filing Form 8853

You must file Form 8853 and attach it to Form 1040 if you (or your spouse, if married filing a joint return) had any activity on your MSA during the year. You must file the form even if your employer or your spouse's employer made contributions to the MSA.

Employer Participation

This section contains the rules that employers must follow if they decide to make MSAs available to their employees. Unlike the previous discussions, "you" refers to the employer, and not to the employee.

Health plan. If you want your employees to be able to have an MSA, you must make an HDHP available to them. You can provide no additional coverage other than those exceptions listed previously under Other health insurance.

Contributions. You can make contributions to your employees' MSAs. You deduct the contributions on the "Employee benefit programs" line of your business income tax return for the year you make these contributions.

Comparable contributions. If you decide to make contributions, you must make comparable contributions to all comparable participating employees' MSAs. Your contributions are comparable if they are either:

• The same amount, or
• The same percentage of the annual deductible limit under the HDHP covering the employees.

Comparable participating employees. Comparable participating employees:

• Are covered by your HDHP and are eligible to establish an MSA,
• Have the same category of coverage (either self-only or family coverage), and
• Have the same category of employment (either part-time or full-time).

Additional tax. If you made contributions to your employees' MSAs that were not comparable, you must pay an additional tax of 35% of the amount you contributed. See Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, to report and pay this tax.

Employment taxes. Amounts you contribute to your employees' MSAs are generally not subject to employment taxes. You must report the contributions in box 13 of the Form W-2 you file for each employee during the calendar year. Enter Code "R" in box 13.

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