From the October 1997 issue of Startups

When Kris and Tammy Kloxin started Designs By Tammy, an Edmond, Oklahoma, flower shop, last January, the last thing they thought they'd get is a good deal on health insurance. But earlier this year, the Kloxins purchased a new, high-deductible health-insurance policy and began contributing about $1,000 per year to a medical savings account (MSA) administered by their insurance company. With family coverage and a $3,000 annual deductible, their total health-insurance costs--including the policy premiums and MSA contributions--have stayed the same.

The difference is the Kloxins' MSA contributions are fully deductible from their federal income taxes. And if they don't spend all the money in their MSA in a given year, they can leave it in the account for use in subsequent years while it accrues tax-free interest.

"I feel like I have more control over my insurance," Kris says. "Before, the insurance company got our money whether or not we went to the doctor. Now if we don't go to the doctor, part of our premium money is still ours, because it goes into the MSA."

The Kloxins are benefiting from a demonstration project authorized by the Health Insurance Portability and Accountability Act of 1996 (HIPAA). The Act will allow 750,000 small-business owners and their employees to open MSAs and fund them with tax-deductible contributions between January 1, 1997, and December 31, 2000, if they also purchase a health-insurance policy with an annual deductible of between $1,500 and $4,500.

Whats an MSA?

MSAs are being offered primarily through insurance companies, which charge an annual fee of $50 to $100 to set up and maintain an the account, says Tenna Merchent, spokesperson for Golden Rule Insurance Co. in Indianapolis. MSA contributions are tax-deductible and earn tax-deferred interest. In fact, MSA money will never be taxed as long as it's used to pay for qualified medical expenses such as doctor visits, dental care and prescriptions. Several states have also made MSA contributions free from state tax; consult your tax advisor for more details.

To maintain these tax benefits, however, you have to follow some rules when making contributions and withdrawals. First, MSA contributions can't exceed a certain percentage of your deductible--65 percent of the deductible for single coverage and 75 percent of the deductible for family coverage. (See "MSA Guidelines," below, for more details on these requirements.)

The money you deposit in your MSA can then be withdrawn, usually via a check or a debit card, to pay your medical expenses. But you must use your MSA funds only to pay for qualified medical expenses, which are outlined in IRS Publication 502, "Medical and Dental Expenses." (See "The ABCs of MSAs" on page 18 for ordering information.) MSA funds used to pay for anything but qualified medical expenses will be subject to regular income taxes plus a 15-percent penalty paid to the IRS. Nonmedical withdrawals made after age 65 or after becoming disabled, however, are only subject to regular income taxes. Any funds left in the MSA at the end of the year must remain there for use in subsequent years.

Using Your MSA

Kent Horn, owner of Chickasha Physical Therapy Clinic in Chickasha, Oklahoma, read about MSAs in a business magazine and did some research before funding an MSA of his own. "I've always had a high-deductible health-insurance policy," Horn says. "But now I can put some of the money that I used to pay for premiums toward the MSA." Horn has family health coverage with a $3,000 deductible, and plans to make MSA contributions totaling about $1,200 this year. "My insurance costs have gone down about 15 percent to 20 percent--and that's including my MSA contribution. The best part about it is the MSA money is my money, not the insurance company's."

When it comes time to take money out of your MSA, the process is relatively hassle-free. Most insurance companies open a checking account in your name or issue you a debit card to make MSA withdrawals to pay for medical care. "We just write a check whenever we go to the doctor," Kris says.

It is important to note, however, that your MSA withdrawals will be limited to the balance in your account. If you make quarterly MSA deposits of $250, for example, and incur $750 in MSA-eligible medical expenses in February, you may only have $250 available in your account. "In these cases, it's important to discuss the situation with your doctor and arrange to make payments as you make additional MSA deposits," Merchent says. This problem, though, should disappear over time, as you roll over each year's excess deposits to put toward the following year's expenses.

Any money left in the MSA at the end of the year belongs to you and will not be taxed as long as you leave it in the MSA for use in subsequent years. Meanwhile, the money earns tax-deferred interest; most insurance companies pay a fixed interest rate of about 4.5 percent to 5.5 percent. "As the amounts in MSA accounts grow in the next few years, insurers are likely to offer more investment options for MSA funds, like stock or bond mutual funds," Merchent says.

Employee Accounts

If you have employees, switching to an MSA/high-deductible health-insurance plan can be a cost saver, even if you don't contribute to your employees' MSAs. After all, insurance premiums are lower when deductibles are higher. This gives you the option of depositing the money you save through lower premiums into individual employees' MSAs.

You still may want to think twice before making MSA contributions, according to Fred Farkouh, a partner with New York City accounting firm Farkouh, Furman, & Faccio. Under MSA rules, if a business owner chooses to make MSA contributions on behalf of his or her employees, those contributions must be comparable for all employees, either as the same dollar amount or as the same percentage of the deductible. Companies may offer different health-insurance plans to different employee groups--part-time and full-time employees, for example--but this approach can make administration more complex. Another important restriction is that contributions can be made only by the employer or by the employee, but not by both, in a given year.

"MSA contributions are tied to the level of the plan's deductible--not to the level of an employee's compensation--so an employee making $20,000 per year gets the same benefit through an MSA as an employee making $200,000 per year," Farkouh says. "Small businesses may find that something like a 401(k) contribution will be more appreciated among higher-paid employees. From a business perspective, the time and money required to implement and administer one of these programs may be disproportionate to the benefits realized by the company."

The best way to avoid this potential administrative hassle is by simply offering the MSA/high-deductible policy combination to employees, but requiring employees to fund the accounts themselves. The contributions are tax-deductible for workers at companies with fewer than 50 employees.

Using MSA Money

Withdrawals are tax- and penalty-free if used to pay for:

  • Medical expenses as defined by Internal Revenue Code section 213(d), including things such as doctors' fees, prescriptions and dental fees;
  • COBRA premiums (health premiums paid to continue employer-sponsored health-insurance coverage after you leave a company);
  • Health premiums paid while the policyholder is receiving unemployment compensation; and
  • Long-term care insurance premiums. You will have to pay taxes and penalties on the following types of MSA withdrawals:
  • If you are younger than 65 and make an MSA withdrawal to pay for a nonmedical expense, that money will be taxed as income and charged a 15-percent penalty;
  • If you are over age 65 and make an MSA withdrawal to pay for a nonmedical expense, that money will only be taxed as regular income, and not charged a penalty; and
  • MSA withdrawals made after death or disability are penalty-free.

The Future of MSAs

If you open an MSA under this demonstration project, you can continue to fund it in the future--even if Congress decides not to extend the demonstration project beyond the year 2000. For their part, both Kloxin and Horn plan to continue funding their MSAs. "It'll be really nice when we have more money in the account and it becomes more of a savings-type deal," Kris says. After all, if MSAs live up to their promise, smart and healthy consumers who don't use a lot of health-care services will be able to roll their MSA balances over from year to year, accruing tax-deferred interest and accumulating MSA balances that can be used to pay for health care in their old age.

MSA Guidelines

Required deductible

To use an MSA, your deductible must fall within the following range:

Individual coverage: $1,500 to $2,250

Family coverage: $3,000 to $4,500

Maximum annual contribution to MSA

Your tax-free contributions may not exceed the maximum amounts designated by the IRS:

Individual coverage: 65 percent of deductible

For example, an individual with a $1,500 deductible could deposit $975 per year in an MSA ($1,500 x .65).

Family coverage: 75 percent of deductible

For example, a family with a $3,000 deductible could deposit $2,250 per year in its MSA ($3,000 x .75).

The ABCs Of MSAs

IRS Publication 502, "Medical and Dental Expenses," lists medical expenses that can be paid for with MSA funds. Call (800) TAX-FORM for a free copy.

These two Web sites provide lists of MSA providers:

Joanne Sammer provided tips to make the most of your travel budget in the September issue of Business Start-Ups.

Contact Sources

Designs By Tammy, P.O. Box 7661, Edmond, OK 73083, (405) 340-3008

Farkouh, Furman & Faccio, 1370 Ave. of the Americas, New York, NY 10019, (212) 245-5900

Golden Rule Insurance Co., 7440 Woodland Dr., Indianapolis, IN 46278-1719, (800) 672-0829