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Tax-Free Bill of Health

Health-care accounts with tax benefits

Tax-advantaged health-care spending accounts are proliferating--and that means more opportunities to save on taxes as well as more ways to help pay for health costs. Here's a look at how each one stacks up.

  • Health Savings Accounts (HSAs): With an HSA, an employer or employee--or both--can make tax-free contributions to the account if the employee is covered by a qualified high-deductible health plan. Employer contributions are tax deductible, excludable from gross income, and are not subject to employment taxes. Employees can use tax-free withdrawals to pay for most medical expenses not covered by the high-deductible plan. It's possible for employees to make after-tax contributions and take a deduction on their tax returns, or pretax contributions if the employer has a Section 125 plan. In the latter case, employees reduce their salary by the amount of the contribution, and the employer makes the contribution on their behalf. HSA amounts are fully vested and can be retained when an employee leaves employment.
  • Health Reimbursement Arrangements (HRAs): HRAs are more beneficial for employers than are HSAs. They can be used to pay any qualified medical expenses, including health-care premiums. HRAs are typically not funded--they are bookkeeping accounts that are credited with amounts by the employer. No employer assets are actually set aside. Reimbursements to employees come from employer assets--it's at that point that the employer pays for the expense and is entitled to a deduction.

Only employers can contribute to the accounts, and these contributions are not taxable to the employee. Employers can design an HRA so that when employees leave the company, they forfeit whatever remains in the account. "This means employers have more control and flexibility with an HRA compared to an HSA,' says Joe Walshe, principal at accounting firm PricewaterhouseCoopers' HR Services in Washington, DC.

  • Flexible Spending Accounts (FSAs): Employees contribute pretax funds to an FSA to help pay for expenses not covered by insurance. If funds aren't spent within a year, employees forfeit whatever remains. Employers pay no employment taxes on the contributions, nor are employees required to pay federal, Social Security or state taxes on contributions.
  • Medical Savings Accounts (MSAs): An MSA is a tax-exempt account with a financial institution in which accountholders can save money exclusively for future qualified medical expenses. Set up as a demonstration project under a 1996 law, MSAs were extended by Congress through 2005. MSA amounts can be rolled over to HSAs. Keep in mind that MSAs are a pilot program, so it's likely that they will disappear after 2005.

You'll want to consider the tax benefits of each of these plans and take advantage of the ones that best fit your business' needs.

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This article was originally published in the January 2005 print edition of Entrepreneur with the headline: Tax-Free Bill of Health.

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