Medical savings accounts, often referred to as MSAs, are a new variation of Flexible Spending Accounts. Both MSAs and FSAs are similar to IRAs in the sense that each employee can make tax-free contributions to an account. But instead of withdrawing the funds at retirement as you would with an IRA, you withdraw them to pay for certain types of medical care. In effect, you're being allowed to pay some of your medical costs with pre-tax dollars, which is a heck of a lot cheaper than paying for it with post-tax dollars.
FSAs have been around for quite some time. Their main drawback is the fact that if an employee places money into an account one year and doesn't use it for reimbursement of medical expenses in that year, he or she loses the money. With an MSA, the money is allowed to accumulate from year to year, to be used in later years when medical expenses are higher or to be saved until retirement.
At present, MSAs that are exempt from federal income taxes are part of a demonstration project that began in 1997 and was scheduled to end in 2000, until Congress decided to renew it in late 2000 for another two years. It's limited to the first 750,000 people who sign up each year and is open only to the self-employed and to businesses with fewer than 50 workers. However, a number of states have MSA laws that permit employers in those states to establish state-tax-exempt MSAs.
Here's how MSAs work. A business may offer its employees, or a self-employed person may purchase, a high-deductible health insurance plan (often referred to as a "catastrophic health plan"). For 2002, the deductible must be a minimum of $1,650 for individual coverage and $3,300 for family coverage ($1,600 and $3,200 for 2001; these amounts may be adjusted periodically for inflation), and can be as high as $2,500 for an individual and $4,950 for a family ($2,400 and $4,800 for 2001; these amounts may be adjusted periodically for inflation). The employer and employee may then make tax-free contributions to an MSA. Total annual contributions are limited to 65 percent of the deductible for individuals and 75 percent of the deductible for families.
Contributions. In addition to the high-deductible health policy, each employee opens up a MSA savings/investment account. Contributions to the account by an individual are deductible from adjusted gross income, and contributions made by an individual's employer are excluded from income (unless they're made through a cafeteria plan). Contributions may be made for a tax year at any time until the due date of the return for that year (not including extensions). Employer contributions must be reported on the employee's W-2. Earnings of the fund are not included in taxable income for the current year.
Withdrawals. Funds may then be withdrawn from the MSA, tax-free, to pay for minor medical expenses — routine checkups, dental exams, eyeglasses, drugs, even minor surgery. Any funds that are left in the MSA at the end of the year remain in the account, and can be used in succeeding years, or saved until retirement. Thus, unlike flexible spending accounts, there is no "use it or lose it" requirement.
If you have few medical expenses over a period of years, the account may grow
to a tidy sum. If funds are withdrawn for nonmedical purposes, a 15 percent
penalty will be assessed (plus the funds will be taxed as ordinary income).
However, after age 65, you may use your MSA monies for any purpose, just like an
IRA, and pay only the tax on withdrawn funds.