When we refer to the “Code” in this module, we’re not talking about the Code of Hammurabi.[1]  We’re talking about the Internal Revenue Code.  In the public sector, medical accounts are primarily governed by the Code as interpreted by the courts and by the IRS through rules and related guidance.

We include a lot of footnotes in this module, and we suspect that some of you may google them.  Be careful, especially with IRS Notices that include extended Q&As, because the laws have changed over the years and the IRS does not update old guidance to reflect law changes.  It’s our job to bring you the most current interpretations.  If you do jump to the source guidance, you’ll notice that the IRS throws out citations to the Code like chefs throw food to customers at a hibachi grill.  To give you a head start, we’re including a beginner’s guide to a “short list” of the main provisions of the Code that apply to medical savings accounts.  You don’t have to memorize them, and feel free to skip this part for now.  But you might find this page useful later.

B-1. Health Savings Accounts (HSAs). An HSA is a tax-exempt account established for the purpose of paying medical expenses, though they may also be used to supplement retirement savings.[1] They are offered by banks and non-bank trustees and custodians approved by the IRS.  HSA custodians typically require account holders to hold a minimum amount in cash but permit them to invest their balances above that threshold in mutual funds.[2] HSA custodians offer cards that can only be used for medical expenses, but accountholders must also be provided a method for withdrawing cash.  Employees who withdraw cash from an HSA must maintain receipts of valid medical expenses in case they’re audited, but it’s none of the employer’s business how they use their funds.  If an employee wants to use their HSA to buy motorcycle parts, that’s between the employee, the IRS, and God.

HSA programs are not employee benefit plans, and an employer’s responsibility for HSAs is limited.  But employers still have some responsibilities, and they are not as easy as they look:

We’ll begin by noting that, under the 2007 proposed cafeteria plan rules, the “A” in “FSA” stands for “arrangement” rather than “account.”[1]  The arrangement is a bet made by employees prior to the beginning of a plan year.  The bet is whether they will be hit by a train in the coming year and need the money they set aside in the FSA for out-of-pocket medical expenses.  The amount they can “win” is the tax savings from paying medical bills with pre-tax dollars rather than from post-tax savings.  It’s a little weird. 

Lower-paid employees who elect to make salary reduction contributions to an FSA will not save much in taxes because they pay less taxes.  A salary reduction election will also reduce the amount they may eventually receive from Social Security.  For this reason, FSAs are a better deal for highly paid employees (who may save more on taxes if they use the amount they set aside). 

Most HRAs are unfunded (sometimes called “notional”) accounts that reimburse employees for medical care expenses up to a maximum dollar amount for a coverage period (typically, the same plan year as the employer’s group health plan).  By unfunded, we mean the employer reimburses HRA expenses as they occur.  Unlike an HSA, where the available balance is determined by contributions and investment returns, HRAs allow employees to be reimbursed for medical expenses up to the maximum annual limit at any time during the year.  HRAs are strictly limited to the reimbursement of medical expenses, which may be paid through use of a debit card that may only be used for medical expenses, or by submitting claims manually to a TPA along with receipts and, where an item has both medical and non-medical uses, a doctor’s note of medical necessity. 

The unique feature about HRAs is that unused amounts in the account roll over into the following year and may be used for the reimbursement of medical expenses in addition to the annual HRA limit established by the employer for that year.[1]  Employees who don’t spend the entire balance may eventually build a substantial “nest egg” for medical expenses in the future, at least while the employee remains employed.  Another unique feature of HRAs is that they may only be funded by employers – no employee contributions are permitted.[2]  Most HRAs do not let you keep your accumulated savings when you terminate employment, but HRAs are subject to COBRA[3] and Minnesota continuation coverage.  If you elect continuation coverage for your group health plan coverage, the HRA will typically come with it.[4]

VEBAs are trusts that may be used for a wide range of health and welfare benefits.  They were widely used in the private sector for decades, partially due to advantageous tax laws.  But the tax laws changed to strictly limit the amount of funds that could accumulate tax-free, and VEBAs fell out of favor with most private sector employers. 

Because public sector employers are not subject to most taxes, VEBAs remain a feasible way to fund employee health and welfare benefits.  In some states, including Minnesota, VEBAs are commonly used to offer “funded” HRAs for political subdivisions.[1]  The arrangements we’ve designed are strictly limited to units of local government, and no participation is allowed by private sector or nonprofit employers if they are not governmental entities.  VEBA-funded HRAs allow employees to “vest” in these benefits and retain them following termination of employment.  Like HSAs, most VEBA-funded HRAs allow employees to hold their balances in cash or choose among an array of investment alternatives.   VEBA-HRAs are also more similar to HSAs than traditional HRAs because employees may only access amounts contributed to their accounts, though employers may agree to accelerate VEBA contributions up to the annual contribution in personnel policies and collective bargaining agreements.