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Medical Savings Accounts

by William F. Decker, AARP Public Policy Institute, Public Policy Institute, May 1, 2000

Although federally authorized Medical Savings Account (MSA) health insurance plans have been available to some Americans since 1997, relatively few policies have been purchased. This Fact Sheet explains what MSAs are, identifies who can purchase them, and describes how the savings account component of these health insurance plans is taxed. It then discusses federally authorized Medical Savings Account plans, including a Medicare demonstration program, and concludes with the common arguments made both for and against the use of Medical Savings Accounts.

What are Medical Savings Accounts?

  • A Medical Savings Account (MSA) is a type of health insurance plan that combines both a tax advantaged personal savings account and a high-deductible health insurance policy.
  • Individuals must purchase a health insurance policy before deposits can be made into the savings account, up to a limit set by law.
  • The user of the MSA plan is expected to pay for routine health care costs from the MSA plan's savings account.
  • If the user's medical spending meets the cost of the insurance policy's deductible, the insurance becomes available to meet other covered medical costs. Annual deductibles for individuals and families will vary, depending upon the particular type of MSA plan purchased.
  • Spending on qualified (allowable) medical expenses from an MSA is not subject to federal taxation. ("Qualified medical expenses" are defined as those so designated by the Internal Revenue Service.)
  • Any money remaining in an MSA plan's savings account at the end of a tax year can be rolled over without penalty into the next year's account.

To whom are Medical Savings Account plans currently available?

  • The Balanced Budget Act of 1997 (the BBA) established a limited MSA demonstration program in the Medicare program. This Medicare MSA option is designed to test whether MSAs will give both the Medicare program and its beneficiaries better control over health care spending. Although the BBA permitted insurers to begin offering an MSA option starting on January 1, 1999, no insurers were offering MSA plans to Medicare beneficiaries as of January 2000.
  • The Health Insurance Portability and Accountability Act (HIPAA), enacted in 1996, established a national test of MSAs in the private health insurance market. Effective January 1, 1997, MSA plans were available to individuals and families eligible for such coverage under the terms of the HIPAA. At the start of 1999, about 50,000 MSA plans had been purchased.
  • By the end of 1998, 26 states had enacted laws allowing the use of some type of state-specific MSA plan, and others were considering similar legislation. Most MSA plans authorized under state law provide state income tax advantages.
  • A small number of public and private employers offer their employees health care benefit plans that are similar in a number of respects to MSA plans. However, unless operation of these private plans is in accordance with specific state or federal tax law, such plans cannot provide any income tax advantages for employees.

How is the use of a state-authorized Medical Savings Account plan taxed?

Medical Savings Account plans authorized through state legislation alone can provide a state tax advantage to holders of such plans, but they cannot provide any federal tax advantages.

  • Neither the contributions of an individual to an MSA plan nor the interest earned by the account are subject to individual state income taxes.
  • Spending on allowable medical expenses from an MSA is not included in taxable income.
  • Under most state laws, non-health care spending from an MSA is taxed as income, and many states impose an additional tax penalty on such spending.
  • Some state-authorized MSA plans do not require the usual linkage of the savings account with a high-deductible health insurance policy.

How is the use of a federally authorized Medical Savings Account taxed?

For MSA plans established under the HIPAA and the BBA:

  • Deposits into an MSA plan's savings account are not subject to individual federal income taxation at the time of deposit.
  • Interest income earned by an MSA plan savings account is not subject to federal income taxation.
  • As long as savings account funds that are part of an MSA plan are spent on allowed medical expenses, such spending by an individual or family remains free of taxation.
  • Spending from an MSA not made on health care is subject to taxation. Under certain circumstances, unqualified spending is also subject to an additional financial penalty.
  • The savings account must be linked with a high-deductible health insurance policy.

How does the HIPAA private market Medical Savings Account demonstration work?

The HIPAA, signed into law on August 21, 1996, includes a national demonstration of MSAs that is intended to test their effect in the private health insurance system.

  • Starting January 1, 1997, MSAs providing either individual or family coverage could be established nationwide. These plans are available to the self-employed and, if offered by the employer, to workers in businesses with fifty or fewer employees. In May 1999, the HIPAA demonstration reached the maximum number of MSA plans that it permits, 750,000. According to the latest count available from the Internal Revenue Service, a little over 50,000 HIPAA-authorized MSA plans had actually been established through December 31, 1998.
  • After purchasing a high-deductible insurance policy, individuals or employers (but not both) can make deposits into the MSA plan's savings account.
  • For individuals, the cost of the annual insurance deductible ranges from $1,550 to $2,350; for families, the range is $3,100 to $4,650.
  • For individuals, no more than 65 percent of the cost of the insurance deductible can be deposited into the plan savings account each year; for families, the annual limit is 75 percent.
  • Savings account deposits and interest earned are free of federal income taxation. Qualified spending from an account is also free of taxation.
  • Nonmedical spending from MSAs is subject to both federal income taxation and an additional 15 percent tax penalty. (For those age 65 or older or disabled, no additional tax penalty is imposed.)
  • The HIPAA MSA demonstration ends after four years (i.e., at the end of 2000). If new private market MSAs are to be available through employers (and to the self-employed) after that time, Congress must pass new private market MSA legislation.

How does the Medical Savings Account demonstration in the Medicare program work?

The Balanced Budget Act of 1997 includes new health insurance options for Medicare beneficiaries, called Medicare+Choice plans. One Medicare+Choice plan is an MSA.

  • Starting January 1, 1999, up to 390,000 MSAs could be established nationwide. Any Medicare beneficiary is eligible to acquire an MSA. (However, as of January 2000, no MSA plans are yet being offered to Medicare beneficiaries.)
  • Every year the Medicare program will determine the dollar amount it will make available as payment for one year of a beneficiary's program benefits, similar to the way per capita payments to managed care organizations are determined.
  • A Medicare beneficiary wishing to acquire an MSA plan will first choose a high-deductible health care insurance policy, from the private market, to link with the savings account. The annual insurance deductible may not exceed $6,000.
  • At a minimum, all MSA plan insurance policies must cover the standard Medicare Part A and B benefits. Insurers determine what, if any, additional health care services will be covered by the policy.
  • Medicare will pay the premium cost of the insurance directly to the company selling the policy.
  • Medicare will then deposit into the beneficiary's Medicare+Choice MSA plan savings account the difference between the premium cost and the annual benefit payment it has determined it will provide for the beneficiary.
  • Beneficiaries may not make out-of-pocket deposits into their MSA plan savings accounts.
  • Savings account deposits and interest earned are free of federal income taxation. Qualified spending from an account is also free of taxation.
  • Payments for Medicare-covered health care services made by the beneficiary from the MSA plan savings account will be credited toward the cost of the insurance policy's deductible. At the insurer's option, payments for supplemental benefits included in the policy may also be credited toward the deductible.
  • If the amount in an MSA plan savings account is less than 60 percent of the cost of the insurance policy deductible, nonmedical spending from MSAs is subject to both federal income taxation and an additional 50 percent tax penalty.
  • If the amount in the savings account exceeds 60 percent of the cost of the insurance deductible, amounts above the 60 percent threshold may be used penalty-free for any purpose, although such spending will be taxed as income.
  • There are no "balance billing" restrictions associated with Medicare+Choice MSA plans; beneficiaries choosing an MSA plan will be obligated to pay from the savings account whatever fees providers wish to charge.
  • Beneficiaries choosing the MSA option are not permitted to also purchase a Medicare supplemental (Medigap) insurance policy.
  • The Medicare MSA demonstration ends after four years (i.e., at the end of 2002). If Medicare MSAs are to remain available after that time, Congress must pass new Medicare MSA legislation.

Arguments by proponents of MSAs

  • With an MSA plan, health care spending will first have to be made from funds held in a personal savings account. Users of MSA plans will become more highly sensitized to the costs of health care and will learn to shop for the least costly services that will meet their needs.
  • As the sellers of care respond to consumer pressure for the best prices, the widespread use of MSA plans will tend to create price reductions in the health care marketplace.
  • Because there is no insurance "middle man" involved in payments for services made from MSA plan savings accounts, the overall administrative costs of the health care system will be reduced.
  • When using funds from the savings account, individual patients - not government, a managed care provider, or an employer - will have the sole responsibility to make cost-conscious health care spending decisions.

Arguments by critics of MSAs

Increased Private Market Insurance Premiums for Those Not Covered by An MSA

  • MSA plans will be most attractive to individuals who are not likely to have to spend from the savings account - that is, to relatively healthy people.
  • If large numbers of healthy individuals and families acquire MSA plans and move out of existing health insurance risk pools, the individuals and families who remain behind would likely be those who are relatively sicker. Their own health insurance premium costs could rise substantially. 
  • In the "worst-case" response, as non-MSA insurance premium prices increase, individuals and families not covered by MSA plans could find they can no longer afford health insurance coverage.

Increased Medicare Program Costs

  • Many analysts believe the availability of an MSA plan in the Medicare program will oblige Medicare to spend more for beneficiaries who choose an MSA plan than the program would spend if the MSA option were not chosen.

Other Possible Problems with MSAs

  • People using MSA plans may not seek needed medical care; they may be reluctant to spend money from their savings account for preventive and routine services. Putting off minor (and often low-cost) problems early on may lead to major (and high-cost) problems later.
  • Deposits into MSAs and qualified spending from them are to be free of income taxation; widespread adoption of MSA plans could result in tax revenue losses at both the state and federal levels.
  • Unless spending from an MSA plan is made for allowed health care expenses, there are no federal or state tax advantages.
  • In MSA plans, most or all spending from the savings account is to be credited toward the cost of a linked insurance policy's deductible. However, funds in the savings account may not cover the full cost of the deductible, especially in the first few years of using an MSA plan. In such cases, MSA plan users faced with a catastrophic illness would have to pay the remaining cost of their deductibles themselves, significantly increasing their out-of-pocket costs.

Footnotes

  1. See "Medical Savings Accounts: Results From Surveys of Insurers." Washington, DC: GAO/HEHS-99-34 (December 1998). 12.
  2. One study concludes that if 20 percent of workers switched to MSA plans, insurance premiums would rise at least 60 percent for those remaining in more traditional plans. Nichols, et al., Tax-Preferred Medical Savings Accounts and Catastrophic Health Insurance Plans: A Numerical Analysis of Winners and Losers. Washington, DC: The Urban Institute. April 1996. (Monograph #06571-002.)
  3. See, for example, Moon et al., "An Examination of Key Medicare Provisions in the Balanced Budget Act of 1997." Washington, DC: The Urban Institute. September 1997. 15. Medicare will spend a predetermined amount for each beneficiary in an MSA plan, equal to the AAPCC rate for all beneficiaries in a particular geographic area. Because most beneficiaries choosing these plans will likely be relatively healthy, Medicare payments for these beneficiaries could exceed what they would have otherwise been. The Congressional Budget Office estimates that use of the MSA option will increase Medicare spending by $900 to $950 per beneficiary, per year, over Medicare's costs had the beneficiary remained in the traditional (fee-for-service) Medicare program.
  4. The Treasury Department, through the Internal Revenue Service, is monitoring spending from HIPAA-authorized MSA plans. The Medicare program will monitor spending from Medicare+Choice MSA plans.

Written by William F. Decker, AARP Public Policy Institute

May 2000
©2000 AARP
May be copied only for noncommercial purposes and with attribution; permission required for all other purposes.
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