In 2010 President Barack Obama officially signed the Affordable Care Act (ACA) into effect, thereby requiring employers with at least 50 employees (or full-time equivalents) to provide health benefits and pay for a significant portion of the cost. Following IRS guidance, employers were essentially prevented from offering stand-alone health reimbursement arrangements (HRAs) which allowed employees to purchase coverage on the individual market.
However, on June 13, 2019, the U.S. Departments of Health and Human Services and Labor and Treasury issued a final rule, affecting the original ACA guidelines. Under the final rule, starting January 1, 2020 employers of all sizes that do not offer a group coverage plan may fund an individual coverage HRA (ICHRA).
With the topic of HRAs trending up due to the recent regulation changes, it is best to understand the differences between an HRA and a health savings account (HSA). Prepare yourself for changes in individual healthcare by understanding the alternative options now available.
What is an HRA?
A health reimbursement arrangement is an employer-funded plan that reimburses employees for qualified medical expenses and, in some cases, insurance premiums. Through the arrangement, the employer decides how much money it will put into the plan. As of 2020, all employees in the same class are required to receive equal HRA contributions. Employees that are older or have more dependents may receive more.
Notably, an HRA is not an account from which you can withdraw funds. Rather, the employee requests reimbursement as they incur actual medical expenses. In the event that the allocated HRA amount is used up prior to the end of the year, employees are expected to pay additional healthcare costs out-of-pocket. However, rather than out-of-pocket expenditures, it is also possible to utilize a flexible spending account (FSA), when available, or an HSA for employees who have a high-deductible health plan (HDHP).
On the other hand, if an employee does not utilize the maximum HRA reimbursement amount by the year-end, the unspent money may roll over to the following year. However, the employer indicates the maximum rollover limit. Furthermore, if an employee’s employment ends during the year, the HRA does not travel with them to their next stop. It is immobile.
What is an HSA?
A health savings account is an account owned by an employee to help pay for qualified health expenses that are not covered by their health coverage plan. To be eligible for an HSA, an employee must have a qualified HDHP but no other health coverage, cannot be enrolled in Medicare and cannot be a dependent on someone else’s tax return. An HDHP is a health plan with lower premiums and higher deductibles than a traditional health plan.
The HSA is comprised of cash contributions of pre-tax dollars from the taxpayer themselves, as well as any other individual such as a family member or even an employer. While the employee invests in the HSA over time, there is a designated limitation on the amount each year. In 2019, the HSA maximum amount is $4,500 for self-only accounts and $7,000 for a family account. Both limits increased from the previous year and will increase again in 2020.
The qualified expenses covered by an HSA include most medical care such as dental, vision and over-the-counter drugs. Also, an HSA is portable from job to job.
What are the advantages and drawbacks of an HRA?
As of 2019, an HRA can be utilized to cover qualified medical expenses. These include, but are not limited to:
- Prescription medications
- Annual physical exams
- Birth control pills
- Meals paid for while receiving treatment at a medical facility
- Care from a psychologist or psychiatrist
- Substance abuse treatment
- Transportation costs incurred in order to receive medical care
Also, under HRA rules the money can cover allowed medical, dental and vision costs of their spouses and dependents.
Two HRA Categories
- Individual Coverage HRA
The new regulations starting in 2020 will substantially alter HRAs. Prior to the changes, only small employers had the ability to offer individual coverage HRAs instead of group health insurance. The idea is that employees can use the HRAs to purchase their own individual health insurance with pretax dollars either on or off the ACA’s health insurance marketplace. The ICHRAs can also reimburse employees for qualified health expenses such as copayments and deductibles. Currently, the maximum amount possibly funneled into an ICHRA is $5,150 for single coverage and $10,450 for family coverage. However, under the new regulations, there are no limitations and both large and small employers can offer them.
- Expected Benefit HRA
Additionally, employers offering traditional group health insurance may also offer expected benefit HRAs. These HRAs only subsidize employees spending on benefits not required by the ACA employer mandate, such as dental and vision services.
Under the new regulations, employers offering traditional group health insurance can simultaneously contribute up to $1,800 annually per employee to an expected benefit HRA. Expected benefit HRAs are available even if an employee declines group health insurance coverage; however, the funds cannot be used to purchase comprehensive health insurance. Instead, the dedicated amount can be used to pay for short-term health insurance, dental and vision premiums and qualified medical expenses.
HRAs only cover qualified medical expenses. These include costs generated from alleviating or preventing physical or mental ailments. This does not include expenses to maintain general wellbeing.
Thus, some of the medical expenses that do not qualify are:
- Teeth whitening
- Maternity clothes
- Funeral services
- Health club membership fees
- Controlled substances
- Childcare for a healthy baby
- Marriage counseling
- Medication from other countries
- Non-prescription medications
Furthermore, an employer has the option to exclude certain medical expenses even if they qualify by the IRS. The employer should provide a list of reimbursable medical expenses upon hiring.
What are the advantages and drawbacks of an HSA?
An HSA offers a number of advantages, typically tax-related. Some advantages were already mentioned, such as the large number of expenses that qualify (explained here in IRS Publication 502), the number of people eligible to contribute to the account, and the contributions made with pre-tax dollars. Furthermore, unlike an HRA, an HSA is a mobile account.
Other noted advantages include:
- Contributions made with after-tax dollars can be deducted from your gross income on your tax return, reducing your tax bill for the year.
- Withdrawals are not subject to federal (and usually, state) taxes if used for qualified medical expenses.
- Money leftover at the end of the year rolls over to the next year.
- Greater convenience due to issued debit cards to immediately pay for prescription medications and other eligible expenses.
While an HSA offers substantial advantages, it is also important to weigh the drawbacks as well. Most significantly, there is the requirement of an HDHP in order to qualify. Even with lowered premiums each month, the cost of high deductibles can be finically burdensome.
Other possible drawbacks are:
- Pressure to save may discourage seeking healthcare when needed.
- If funds are withdrawn for non-qualified expenses before the taxpayer is 65 years old, they owe taxes and a 20% penalty. After 65, taxes are owed but no penalty is incurred.
- Tracking receipts to prove withdrawals were used for qualified expenses.
- Potential monthly maintenance fees or per-transaction fees.
What are the tax implications?
The change to HRA governance marks a radical liberalization of regulations. This in turn may transform how employers pay for employee health care coverage by letting employers use pretax dollars to subsidize employee premiums in the individual market.
Through the selection of an HRA, employers are permitted to claim a tax deduction for the reimbursements and the reimbursement dollars the employees receive are typically tax free. They are 100% tax deductible.
One significant tax advantage of an HSA is the use of pre-tax income to fund it. By contributing pre-tax income to the account, the taxpayer decreases their total taxable income. As a result, the individual receives a lower tax liability.
Furthermore, contributions made to the HSA are 100% tax-deductible and any interest accumulated is tax free. However, excessive contributions incur a 6% tax and are not tax-deductible.
In terms of using the funds from an HSA, there are tax implications as well. Mainly, the money will not be taxed as long as the withdrawals are directed toward qualified expenses not covered by an HDHP. Qualified expenses include deductibles, dental services, vision care, prescription drugs, co-pays, psychiatric treatments and others. Typically, insurance premiums do not qualify – unless the premiums are for Medicare or other healthcare coverage if 65 years or more, for healthcare insurance while unemployed and receiving unemployment compensation, or for long-term care insurance.
In the event the HSA funds are used for anything other than paying medical expenses, the amount withdrawn is subject to both income tax and an additional 20% tax penalty.
So what does all of this mean for you?
Both options are worth considering amongst standard benefits offerings. Smaller employers, in particular, can offer an HRA instead of traditional health insurance. However, if you are able to offer health insurance and employees can select an HDHP, providing a pre-tax HSA is an excellent option.
Smaller businesses looking to attract and retain top talent, yet are unable to afford ACA-compliant health insurance, should consider HRAs and HSAs. It allows you the ability to offer reimbursement or savings options to offset health expenses for your staff and their families.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.