Medicare and the Law

by William G. (Bill) Stuart

Let’s create a scenario: Your family of four has just won a seven-day vacation to a popular theme park. The prize was advertised as paying for your air transportation, housing, and two meals a day, as well as a $1,500 cash for admission tickets, daily lunch, and souvenirs. You figured that you'll end up spending about $2,000 on those items, so you'll have to kick in $500 of personal funds.

Then, a week before you arrive, the prize suddenly changes. You still receive $1,500 cash, but you can't use it for meals, but rather for admission tickets and souvenirs only.

Do you care? You now have to dig into your wallet to pay for your lunch each day, rather than use the cash allowance. But you were going to spend well more than $1,500 on admission tickets, lunch, and souvenirs. The change in rules simply means that you spend the $500 extra on lunches rather than spending it to pay for the last two days of admission tickets, lunches, and souvenirs. Either way, you end up spending $2,000 and putting $500 of your own money into the vacation.

Examining the Downside

This lesson is important in view of a recent CNBC article that discusses the downside of HR 3796, the bill that extends Health Savings Accounts to Medicare enrollees. The article lists two major drawbacks to the bill. Let's look at each:

Tax-free distributions for Medicare premiums would be disallowed. Under current law, Medicare Part A, Part B, and Part C (Medicare Advantage) premiums are qualified expenses that Health Savings Account owners can reimburse tax-free. Part B and Part D premiums together cost about $2,000 annually. A Medicare enrollee with a Health Savings Account can save $400 in taxes under current law if her federal and state income tax rates total 20%. She would lose that benefit under the proposed bill.

But let's look more closely. Fidelity® estimates that a couple retiring today at age 65 and living a normal lifespan will spend $285,000 on health-related expenses in retirement (others’ estimates are even higher). Very few Americans who retire this year have accumulated as much as $50,000 in their Health Savings Accounts, and only those who have participated since the early days (Health Savings Accounts launched in 2004 and their predecessors a decade earlier) and have racked up extraordinary investment gains will retire with a balance approaching $285,000.

Thus, the change in the law won’t have a meaningful effect on Medicare recipients. Sure, they won’t be able to save $400 by paying premiums with Health Savings Account distributions rather than with Social Security benefits or withdrawals from a traditional 401(k) plan. But they retain those balances and have the opportunity to invest the funds to increase their balance. 

They can subsequently make tax-free distributions for all other qualified expenses – Medicare cost-sharing, as well as services not covered by Medicare, like dental and vision services and hearing aids – long after they would have exhausted their balances with reimbursements for qualified premiums.

Thus, at the end of the day, this change in the law merely extends their Health Savings Account balances and requires that they use some taxable funds to pay Medicare premiums early in retirement rather than reimburse Medicare premiums and other qualified expenses with personal funds after exhausting Health Savings Account balances sooner.

Additional Tax on Distributions for Non-qualified Expenses. Under current law, distributions for non-qualified expenses are included in taxable income and subject to a 20% additional tax as a penalty. The additional tax doesn’t apply once the Health Savings Account owner towns age 65 or is disabled. HR 3796 disallows that waiver, so anyone – regardless of age or disability – who uses Health Savings Account funds for non-qualified expenses is subject to the 20% additional tax.

Viewed one way, this provision – like the change in the status of premiums – is a takeaway. Current Health Savings Account owners have been told that if they accumulate more in their Health Savings Account than they have qualified expenses, they can withdraw the funds on the same terms (included in taxable income) as distributions from a traditional 401(k) plan or Individual Retirement Account. Under this legislation, that benefit would be lost.

But again, very few Health Savings Account owners accumulate sufficient balances to pay all of their own and their spouse’s qualified expenses. Waiving the penalty strengthens the Health Savings Account as an account with balances dedicated to certain expenses only – thus extending its life and reducing political criticism that wealthy owners will use the funds for purposes not intended once the penalty (but never the income tax) is waived.

Looking at the Upside

The advantages of this bill far outweigh the provisions that shift tax-free reimbursements to later in life. For many of the 58 million Americans enrolled in Medicare, this legislation would give them their first opportunity to open and contribute to a Health Savings Account. They would enjoy the peace of mind that comes with funding an account dedicated to meeting their out-of-pocket medical expenses and the roughly 20% discount that they’d enjoy whenever they paid for a qualified service. 

These new Health Savings Account owners would experience neither of the downsides listed above because they never would have been subject to the old rules.

For existing Health Savings Account owners, this legislation would represent a positive trade-off. In exchange for foregoing an immediate $400 tax benefit (in our scenario above, paying approximately $2,000 for Medicare premiums with 20% tax savings), they could contribute up to $4,550 to a Health Savings Account in 2020. That contribution would generate tax savings of about $910.

So, the question for Health Savings Account owners is this: Are you willing to forego a $400 in annual tax savings in exchange for (A) up to $910 in annual tax savings, (B) additional earnings on higher Health Savings Account balances, and (C) more funds with which to reimburse qualified medical, dental, and vision expenses, plus hearing aids and many over-the-counter items, tax-free later in life?

The enthusiastic answer from this Health Savings Account balance builder: Every day of the week!

William G. (Bill) Stuart is director of strategy and compliance at Benefits Strategies, a New Hampshire-based administrator of medical reimbursement accounts. His new book, HSAs: The Tax-Perfect Retirement Account (available at Amazon in print form and as an e-book), is a reference guide to Health Savings Account compliance issues and the intersection of Health Savings Accounts, Medicare, and retirement planning.