Employee Benefits Bulletin, July 2002
Defined Contribution Health Plans
IRS Gives the OK for Health Reimbursement Accounts
Defined contribution health plans ("DC Health Plans") are a relatively new phenomenon. Employers have been searching for an alternative to their increasingly expensive PPO and HMO health plans. DC Health Plans developed as a potential solution to the sky-rocketing health care costs.
The phrase "defined contribution health plan" has no concrete definition in ERISA or the Internal Revenue Code and encompasses an entire spectrum of plans-these plans vary in the amount of employee responsibility for acquiring healthcare coverage but all have the common link of a design intended to control employers' cost through a fixed contribution. This fixed employer contribution is the hallmark of a DC Health Plan, as opposed to the employer financing a specific health insurance benefit package (a defined benefit approach).
The defined contribution health plan spectrum starts with the purest form of defined contribution: a subsidy paid by the employer to employees as extra W-2 (taxable) wages. The employees then purchase their own health insurance coverage on the open market. This extreme form of defined contribution plan has not gained much popularity.
DC Health Plans actively managed by the plan sponsor are at the other end of the employee responsibility spectrum. In this scenario, the employer still pre-screens and selects a variety of health plans. However, the employer then establishes a maximum contribution that it will make to help fund employee health benefits. The employee must make up any difference between the cost of the plan of their choice and the employer's contribution.
Somewhere in the middle of the DC Health Plan spectrum are the new "consumer-driven" or "consumer-directed" health plans. In these plans, participants are given accounts funded with employer contributions for current-year medical expense reimbursements. These accounts (called "health reimbursement accounts," "personal care accounts" or "personal spending accounts") are typically offered in conjunction with high-deductible or catastrophic health insurance coverage. The design would work something like this: the health reimbursement account would be funded with a fixed amount (e.g., $1000) of employer money. These funds would be used to reimburse qualified medical expenses until the account was exhausted. Then, the employee must pay out-of-pocket for medical care (e.g., $1,500) until he or she reaches the deductible on the health insurance (which would be $2,500 in this example). At that point the insurance would pay the remainder of qualified health care expenses.
These consumer-driven plans have been generating notable interest from employers. However, until recently, the IRS has refused to rule on the tax treatment of any of the new defined contribution health plans. Supporters of the plans point to this lack of guidance-particularly on the tax treatment of the health reimbursement accounts-as a reason for the slow movement of employers toward the DC plans. (However, the plans have been criticized for reasons other than just uncertain tax treatment, including accusations that they are unfair to older and sicker employees.)
In late June, the IRS granted approval for Health Reimbursement Accounts ("HRAs") in Notice 2002-45 and Revenue Ruling 2002-41. The IRS guidance defines and establishes certain requirements for HRAs and clarifies that amounts from an HRA used to reimburse participants for qualified, substantiated medical expenses will not be taxed (they are covered under the exclusion in Internal Revenue Code §105(b)).
At this point, you are probably thinking that these HRAs sound a lot like Flexible Spending Arrangements ("FSAs"). However, FSAs and HRAs are very different:
HRAs must be funded only by employer contributions; FSAs may be funded by employee salary deferrals through a cafeteria plan.
HRA participants may carry-over amounts remaining in their accounts at year end for medical expense reimbursements in the next plan year; FSAs have the "use it or lose it" rule-unused amounts are forfeited at the end of the year.
HRA participants may be reimbursed for accident or health insurance premiums (including COBRA coverage); FSAs may not reimburse for any type of health insurance premiums.
HRA participants may be restricted to reimbursement in the amount that is actually in the account at the time of request for reimbursement; FSAs are required to have insurance-type risk pooling so that the maximum amount of reimbursement permitted under the FSA must be available at all times, even if the employee has not funded the FSA with enough to cover the reimbursement.
Employers interested in consumer-driven health plans with HRAs should also be aware that these plans can be designed so participants may continue to use their accounts after they retire. If the HRA does not cover retirees (and the retiree did not elect COBRA coverage), any money left in the account is forfeited. Cash-outs are never permitted. If the IRS thinks that any person has the right to receive cash or a taxable or non-taxable benefit other than the reimbursement of medical care expenses from the HRA (directly or indirectly), the HRA will lose its favored tax status and all of the participants will be taxed on the reimbursement distributions.
The consumer-directed HRA plans may also be used when an employer has a cafeteria plan, although the structure must be set up very carefully so that the HRA is not being funded (directly or indirectly) through the salary deferrals. Finally, an HRA may be used in conjunction with an FSA, and the plan may even be set up so that the FSA pays reimbursements before the HRA will.
HRAs appear to be subject to COBRA's continuation requirement, §105 nondiscrimination rules, ERISA and HIPAA, although more guidance is needed to clarify the effect these laws will have on HRA plan operations.
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