Section II. A Short Primer on Medical Savings Accounts

A. Internal Revenue Code Basics

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.

Section 104 of the Code. Section 104 provides that medical expenses paid or reimbursed through health insurance are not taxable to the insured individual. It applies to fully insured group and individual insurance.
Section 105 of the Code. Section 105 provides that medical expenses paid or reimbursed from self-insured group health plans, including health FSAs, HRAs, and VEBAs, are not taxable to employees or their dependents. Keep in mind that VEBAs which reimburse medical expenses are typically HRAs, so most of the same rules apply to them.
Section 106 of the Code. Section 106 provides that employer contributions to health and accident coverage are not taxable to employees, including the payment of insurance premiums by employers. Section 106 also applies to employer contributions to HRAs (including VEBA-HRAs) and health FSAs.[2]
Section 223 of the Code. Section 223 governs HSAs. It includes a lot of detail on what constitutes an HSA-eligible high deductible health plan (HDHP), and what other types of benefits you may or may not offer below the HDHP deductible.
Section 125 of the Code. Section 125 authorizes cafeteria plans, which allow employers to offer employees a choice between certain taxable and nontaxable benefits. Most of what you need to know is described in “proposed” cafeteria plan rules from 2007.[3] Propose rules don’t have the force and effect of law, but they indicate how the IRS interprets the law, and you may rely on them to determine which benefits are taxable or nontaxable. We’ll address how cafeteria plans interact with medical accounts in this module, but we’re not going to do a deep dive on cafeteria plans generally. That’s a much larger topic that would require a separate module.
Section 213(d) of the Code. Section 213(d) provides the definition of “medical care” that is used in all these statutes and their underlying regulations. It’s an important statute because only medical care expenses may be reimbursed tax-free from an HSA, VEBA, HRA, or health FSA. What qualifies as medical care changes over time depending on interpretations of this statute by the courts and the IRS.

[1] The Code of Hammurabi is a Babylonian legal text composed during 1755–1750 BC by Hammurabi, sixth king of the First Dynasty of Babylon. Some of us felt like Hammurabi while preparing this module, but it gives us hope that our text may still be read far into the future.

[2] Employers may contribute to health FSAs through employer “flex credits”; more on that later.

[3] https://www.govinfo.gov/content/pkg/FR-2007-08-06/pdf/E7-14827.pdf.

B. High Level Summary of Medical Savings Accounts (Full-Text)

We’ll wrap up our introduction with a whirlwind tour of the basic types of accounts that we’ll address in this module.

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:

Employers must offer an HSA-eligible high deductible health plan (HDHP) and may not offer “disqualifying” coverage.
Employers must make certain that all contributions are made through their cafeteria plan to avoid complex and risky “comparability” rules that may result in excise taxes of 35% of employer contributions.[3]
Employers must ensure that combined employer and employee contributions do not exceed annual contribution maximums.
Employers must report employee contributions to HSAs on each employee’s Form W-2.

B-2. Health Flexible Spending Arrangements (health FSAs).

We’ll begin by noting that, under the 2007 proposed cafeteria plan rules, the “A” in “FSA” stands for “arrangement” rather than “account.”[5] 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).

No matter how much you earn, if you make an FSA election of $2,000 and wake up on December 31^st without having incurred any medical expenses, you might be tempted to fall down a flight of stairs so you can burn it up at the emergency room. Or you could buy $2,000 worth of aspirin. Most employers offer either a 2 ½ month “grace period” to spend down the unused portion of an FSA, or permit rollovers of up to $500 (as indexed) from the unused portion of an FSA.[6] But it’s still common for employees to forfeit unused amounts in health FSAs. We sometimes wonder whether the odds of coming out ahead are better playing blackjack at Mystic Lake.

All that said, health FSAs have a secret power. The entire amount of an employee’s election is available at any time during the year. If an employee elects to set aside $2,000 through salary reduction over the year and incurs $2,000 in medical expenses in a sledding accident on New Year’s Day, they are entitled to the entire amount – even if they quit on January 2^nd. For lower-paid employees living paycheck-to-paycheck, it’s a self-funded safety net.

The maximum health FSA contribution in 2024 is $3,200; because of the prevalence of HRAs, VEBAs, and HSAs in the public sector, most employees do not contribute the maximum to their health FSA. They use it to plug gaps. We doubt that even a roomful of actuaries on Adderall could develop the optimal health FSA election for employees across all pay levels and health conditions. But the better employees understand these rules, the better decisions they will make. We’d love to do a survey someday to see how public employees wrestle with these decisions, and whether they make the right calls.

B-3. Health Reimbursement Arrangements (HRAs).

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.[7] 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.[8] Most HRAs do not let you keep your accumulated savings when you terminate employment, but HRAs are subject to COBRA[9] and Minnesota continuation coverage. If you elect continuation coverage for your group health plan coverage, the HRA will typically come with it.[10]

HRAs are “group health plans” under federal law, and as such, they are also subject to the Affordable Care Act (the “ACA”). Standalone HRAs for active employees cannot meet the requirements of the ACA because they are subject to annual limits and do not provide unlimited, no-cost preventive care. Accordingly, they must be “integrated” with major medical group health plans that meet these requirements.[11]

HRAs must generally be integrated with group health plans of the employee/plan participant’s employer. If a plan participant’s spouse or dependent is not enrolled in the same group health plan as the employee, the HRA may be treated as integrated with the group health plan of the spouse’s or dependent’s employer. If the spouse or dependent of a plan participant has no insurance or is enrolled in an individual policy of insurance, they may not be reimbursed for medical expenses from the employee/plan participant’s HRA.[12]

There are many types and species of HRAs. For example, one HRA we’re aware of only reimburses out-of-pocket medical expenses incurred with “top doctors” within the plan’s provider network (to help control costs and improve outcomes). Another HRA only reimburses expenses incurred for fertility treatments such as egg extraction and freezing. Still another species of HRA reimburses premiums for individual policies of insurance. These include “ICHRAs”[13] and their second cousin twice removed, “QSEHRAs.”[14] ICHRAs and QSEHRAs may be integrated with individual insurance policies to meet ACA requirements, including, in the case of ICHRAs, the employer shared responsibility rules (such as affordability) that apply to Applicable Large Employers.[15]

ICHRAs and QSEHRAs are not commonly offered in the public sector because policies in the individual market tend to have high deductibles and narrow provider networks. But we’ve seen them used in pinch when other options fell through, such as when certain small employers received 50% increases in group health plan rates from the Public Employee Insurance Plan (“PEIP”). ICHRAs are subject to complex rules designed to limit the ability of employers to “carve out” individuals with high claims and put them in individual policies while maintaining a group health plan for others. Because of the limited interest (and complexity), we’re not going to do a deep dive on these products other than to say they are a potential lifeline. If and when we do dive into ICHRAs, we’ll do it in a separate module.

B-4. Voluntary Employee Benefits Associations (VEBAs).

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.[16] 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.

The most common form of VEBA-HRA in Minnesota[17] includes separate plans for active and retired employees. The VEBA plan for active employees will typically be funded by monthly contributions, though other funding timelines are permissible. The VEBA plan for retired employees is typically funded shortly after termination based on (1) the balance of the former employee’s account in the VEBA plan for active employees, and (2) a fixed percentage of accumulated benefits such as unused sick, vacation and severance pay. Because the VEBA is funding an HRA, and HRAs are group health plans, the arrangement is subject to rules applicable to group health plans, including IRS nondiscrimination rules, though retiree VEBAs are exempt from certain market reform rules under the ACA.[18] Just like HRAs, employees may not choose between cash and VEBA contributions; that decision must be made by the employer. VEBAs in effect before 2008 may also reimburse medical expenses (on a taxable basis) for beneficiaries following an accountholder’s death if there not a surviving spouse or eligible dependent.[19]

B-5. The Health Care Savings Plan (HCSP).

The Minnesota State Retirement System offers funded medical accounts through its Health Care Savings Plan (HCSP). [20] The HCSP is not a VEBA but relies on similar laws exempting units of state and local government from income tax on interest and investments.[21] It’s a post-employment plan that may be funded through employer and employee contributions while actively employed, and with accumulated severance upon termination of employment. It follows some of the same basic rules as VEBA-HRAs (for example, it is treated as minimum essential coverage (MEC) subject to Form 1095-B reporting).[22] The primary differences between VEBA-HRAs and the HCSP appears to be that the HCSP is only used for the reimbursement of medical expenses after termination of employment, while most VEBA-HRA programs offer health reimbursement arrangements to both active and former employees.

Take Quiz

[1] Banks and non-bank HSA providers serve as custodians or “directed trustees” (pretty much the same thing) to limit their responsibility to individual accountholders.

[2] Over the years, we’ve reviewed reports from HSA custodians which show that most accountholders leave their money in cash rather than investing any portion of their balance. This is especially true for public employees (they tend to be a little more conservative). If accountholders plan to spend down their accounts each year, that may make sense. If they intend to save at least a portion of their account for medical expenses in retirement, and they should, leaving all their funds in cash is a big mistake in the long run. Banks have no incentive to encourage investments because they make more money when people leave their accounts in cash (money held in cash is used by banks for making loans and other investments). We’ll get off our soap box now, but employees need regular education on HSAs to keep them on the right path.

[3] 26 CFR § 54.4980G-1. & I.R.S. Notice 2004-50, Q&A 49.

[5] [Get a better citation or use link] Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

[6] Tread carefully here if you offer HSAs – rollovers and grace periods can disqualify employees from making HSA contributions if not handled correctly. We’ll address this later in the module.

[7] Modern HRAs with rollovers were introduced by Definity Health, a Minneapolis-based startup in 2000. As the attorney for that company at that time, his writer was summoned to Washington D.C. to explain how rollovers were permitted under the tax code before a roomful of IRS and Treasury agents. Some of them were not happy. But shortly after that meeting, the IRS issued Notice 2002-45, which officially authorized HRAs with rollovers. The adventures of employee benefits lawyers are few and far between, but that’s what they said about archeologists before Raiders of the Lost Ark. If you attend an employee benefits seminar and the speaker has a whip, it might yours truly.

[8] As described in Notice 2002-45, employees may not be given a direct or indirect choice between wages and HRA contributions to prevent individuals from using these products to defer taxable compensation.

[9] The official name for COBRA is the “Consolidated Omnibus Budget Reconciliation Act.” That will be on the test.

[10] Some employers may allow you to elect continuation coverage for HRAs separately from the group health plan.

[11] IRS Notice 2013-54.

[12] IRS Notice 2013-54.

[13] “ICHRA” is short for “Individual Coverage Health Reimbursement Arrangement.” ICHRAs are pronounced “ICK-RAs”, not “ITCH-RAs.” Neither name is that great, we’ll give you that.

[14] “QSEHRA” is short for “Qualified Small Employer Health Reimbursement Arrangement.” They are limited to small employers (with fewer than 50 full-time employees) and are somewhat less flexible (for example, an employer offering a QSEHRA may not also offer a health FSA, vision or dental insurance).

[15] An Applicable Large Employer (“ALE”) has 50 or more full-time employees and full-time employee equivalents. For rules on determining ALE status, see our Affordable Care Act module.

[17] For example, the Minnesota Service Cooperative VEBA Plan and Trust.

[18] For example, a retiree VEBA HRA is not subject to the prohibition on annual and lifetime limits, and is not required to provide no-cost preventive care. Cite needed.

[19] Code Section 105(j).

[20] See Health Care Savings Plan Overview, available here: https://www.msrs.state.mn.us/about-hcsp.

[21] Minn. Stat. Sec. 352.98; Rev. Rul. 87-2.

[22] According to the website for the Municipal Employees Retirement System (MERS), their legal counsel has determined that the HCSP may qualify as minimum essential coverage (MEC) under the Affordable Care Act and therefore should be reported to the IRS using forms 1094-B and 1095-B. See here.

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 accountholders 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:

Employers must offer an HSA-eligible high deductible health plan (HDHP) and may not offer “disqualifying” coverage.
Employers must make certain that all contributions are made through their cafeteria plan to avoid complex and risky “comparability” rules that may result in excise taxes of 35% of employer contributions.[3]^,^[4]
Employers must ensure that combined employer and employee contributions do not exceed annual contribution maximums.

Employers must report employee contributions to HSAs on each employee’s Form W-2.

[1] Banks and non-bank HSA providers serve as custodians or “directed trustees” (pretty much the same thing) to limit their responsibility to individual accountholders.

[3] 26 CFR § 54.4980G-1.

[4] See I.R.S. Notice 2004-50, Q&A 49.

B-2. Health Flexible Spending Arrangements (health FSAs)

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.

No matter how much you earn, if you make an FSA election of $2,000 and wake up on December 31^st without having incurred any medical expenses, you might be tempted to fall down a flight of stairs so you can burn it up at the emergency room. Or you could buy $2,000 worth of aspirin. Most employers offer either a 2 ½ month “grace period” to spend down the unused portion of an FSA, or permit rollovers of up to $500(as indexed) from the unused portion of an FSA.[2] But it’s still common for employees to forfeit unused amounts in health FSAs. We sometimes wonder whether the odds of coming out ahead are better playing blackjack at Mystic Lake.

[1] [Get a better citation or use link] Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

[2] Tread carefully here if you offer HSAs – rollovers and grace periods can disqualify employees from making HSA contributions if not handled correctly. We’ll address this later in the module.

B-3. Health Reimbursement Arrangements (HRAs)

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]

There are many types and species of HRAs. For example, one HRA we’re aware of only reimburses out-of-pocket medical expenses incurred with “top doctors” within the plan’s provider network (to help control costs and improve outcomes). Another HRA only reimburses expenses incurred for fertility treatments such as egg extraction and freezing. Still another species of HRA reimburses premiums for individual policies of insurance. These include “ICHRAs”[7] and their second cousin twice removed, “QSEHRAs.”[8] ICHRAs and QSEHRAs may be integrated with individual insurance policies to meet ACA requirements, including, in the case of ICHRAs, the employer shared responsibility rules (such as affordability) that apply to Applicable Large Employers.[9]

[1] Modern HRAs with rollovers were introduced by Definity Health, a Minneapolis-based startup in 2000. As the attorney for that company at that time, his writer was summoned to Washington D.C. to explain how rollovers were permitted under the tax code before a roomful of IRS and Treasury agents. Some of them were not happy. But shortly after that meeting, the IRS issued Notice 2002-45, which officially authorized HRAs with rollovers. The adventures of employee benefits lawyers are few and far between, but that’s what they said about archeologists before Raiders of the Lost Ark. If you attend an employee benefits seminar and the speaker has a whip, it might yours truly.

[2] As described in Notice 2002-45, employees may not be given a direct or indirect choice between wages and HRA contributions to prevent individuals from using these products to defer taxable compensation.

[3] The official name for COBRA is the “Consolidated Omnibus Budget Reconciliation Act.” That will be on the test.

[4] Some employers may allow you to elect continuation coverage for HRAs separately from the group health plan.

[5] IRS Notice 2013-54.

[6] IRS Notice 2013-54.

[7] “ICHRA” is short for “Individual Coverage Health Reimbursement Arrangement.” ICHRAs are pronounced “ICK-RAs”, not “ITCH-RAs.” Neither name is that great, we’ll give you that.

[8] “QSEHRA” is short for “Qualified Small Employer Health Reimbursement Arrangement.” They are limited to small employers (with fewer than 50 full-time employees) and are somewhat less flexible (for example, an employer offering a QSEHRA may not also offer a health FSA, vision or dental insurance).

[9] An Applicable Large Employer (“ALE”) has 50 or more full-time employees and full-time employee equivalents. For rules on determining ALE status, see our Affordable Care Act module.

B-4. Voluntary Employee Benefits Associations (VEBAs)

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.

The most common form of VEBA-HRA in Minnesota[2] includes separate plans for active and retired employees. The VEBA plan for active employees will typically be funded by monthly contributions, though other funding timelines are permissible. The VEBA plan for retired employees is typically funded shortly after termination based on (1) the balance of the former employee’s account in the VEBA plan for active employees, and (2) a fixed percentage of accumulated benefits such as unused sick, vacation and severance pay. Because the VEBA is funding an HRA, and HRAs are group health plans, the arrangement is subject to rules applicable to group health plans, including IRS nondiscrimination rules, though retiree VEBAs are exempt from certain market reform rules under the ACA.[3] Just like HRAs, employees may not choose between cash and VEBA contributions; that decision must be made by the employer. VEBAs in effect before 2008 may also reimburse medical expenses (on a taxable basis) for beneficiaries following an accountholder’s death if there not a surviving spouse or eligible dependent.[4]

[2] For example, the Minnesota Service Cooperative VEBA Plan and Trust.

[3] For example, a retiree VEBA HRA is not subject to the prohibition on annual and lifetime limits, and is not required to provide no-cost preventive care. Cite needed.

[4] Code Section 105(j).

B-5. The Health Care Savings Plan (HCSP)

The Minnesota State Retirement System offers funded medical accounts through its Health Care Savings Plan (HCSP). [1] The HCSP is not a VEBA but relies on similar laws exempting units of state and local government from income tax on interest and investments.[2] It’s a post-employment plan that may be funded through employer and employee contributions while actively employed, and with accumulated severance upon termination of employment. It follows some of the same basic rules as VEBA-HRAs (for example, it is treated as minimum essential coverage (MEC) subject to Form 1095-B reporting).[3] The primary differences between VEBA-HRAs and the HCSP appears to be that the HCSP is only used for the reimbursement of medical expenses after termination of employment, while most VEBA-HRA programs offer health reimbursement arrangements to both active and former employees.

[1] See Health Care Savings Plan Overview, available here: https://www.msrs.state.mn.us/about-hcsp.

[2] Minn. Stat. Sec. 352.98; Rev. Rul. 87-2.

[3] According to the website for the Municipal Employees Retirement System (MERS), their legal counsel has determined that the HCSP may qualify as minimum essential coverage (MEC) under the Affordable Care Act and therefore should be reported to the IRS using forms 1094-B and 1095-B. See here.