IRS Backs Free-Market Health Care

Published August 1, 2002

A federal tax opinion issued by the Internal Revenue Service (IRS) on June 26 is expected to encourage employers nationwide to adopt a type of consumer-driven health insurance that gives consumers greater control over medical expenditures.

Plans affected by the ruling are generally known as Health Reimbursement Arrangements (HRAs) or Flexible Spending Accounts (FSAs). Such plans allow employees to choose their health care services and pay for them out of tax-favored individual savings accounts funded by their employers.

Victory for Consumers

In a consumer-friendly ruling, the IRS makes clear employees are permitted to carry balances in their employer-funded accounts from one year to the next, without negative tax consequences. “Use it or lose it” no longer applies.

Doug Kronenberg, chief strategy officer at Lumenos, which offers health care benefits services to several Texas employers, said, “This is tremendous news for everyone involved in employee benefits. It removes the concern surrounding potential tax implications with accumulated savings.”

“With this new guidance,” explained Treasury Secretary Paul O’Neill in an IRS news release, “we clear the way for employers to adopt health plans with patient-directed features so that employees have more choice and greater control over their health care coverage.”

According to Greg Scandlen, senior fellow in health policy for the National Center for Policy Analysis (NCPA), “The IRS ruling will enable employers of any size to adopt an MSA-type program as part of their benefit packages. The [prior] inability to get even private letter rulings verifying the HRA approach has inhibited many employers from adopting consumer-driven health benefits programs.”

“This will just open the floodgates and finally allow employees to manage their own health care,” agreed Marianne Fazen, executive director of Dallas-Fort Worth Business Group on Health, a coalition of 130 large employers.

No More “Knots”

While many employers say they support consumer-driven plans as a way to curb health care inflation, few offer such plans. Industry leaders say the main obstacle had been the uncertainty of the tax status of benefits carried over from year to year. With that obstacle eliminated, employers are expected to embrace … and act on … the idea of consumer-driven health care.

Responding to news of the ruling, Grace-Marie Turner, president of The Galen Institute, wrote, “Remember how Sen. Ted Kennedy tied Medical Savings Accounts into knots in the 1996 legislation, allowing only 750,000 of the policies to be sold (too few for a real market to emerge) and strictly limiting their terms?

“Well, this new ruling will allow millions of employers to offer a new form of Medical Savings Account to tens of millions of workers. And workers and their employers, not Sen. Kennedy, will decide the terms.”

Insurance companies, the primary provider of MSA-type plans, now have a viable market for consumer-driven products. Before the IRS guidance, the uncertainty of the tax consequences prevented many companies from marketing MSA plans.

Scandlen points out, “clever vendors who do a good job of packaging the products, provide excellent customer service, and guarantee compliance support for employers, will do very well in the market. The vendors who cannot provide a full-service product probably will not do so well.”

According to Turner, “This is the revolution we all have been waiting for, and this IRS ruling—not an act of Congress—was the key. This is true jujitsu: The IRS, the tax exclusion for employment-based health insurance, and ERISA suddenly are our friends. Imagine that.”

“There are a lot of nuances in how these new policies will be shaped,” says Turner, “involving incentives for preventive care and networks of doctors that agree to lower rates in return for direct payment. But blessedly, companies, and not Washington, will be in charge of making those decisions.”

How it Works

Some workers will choose to stay with a managed care arrangement, like a PPO or HMO, but others will opt instead for the MSA-type accounts, which the IRS calls HRAs, or Health Reimbursement Arrangements.

An employer would deposit part of the money it had been spending on health insurance premiums for an employee into an account the employee could use to pay routine medical bills. The employer would also purchase for the employee a catastrophic insurance policy to cover major medical bills. If an employee’s annual health care cost exceeds the funds in the savings account, traditional health insurance with high deductibles kicks in.

The key element of the IRS ruling allows employees to roll over from one year to the next any amount in the account they have not used. Employees can continue to access the money even after they leave the company or retire.

“While funds can’t be rolled over when an employee changes companies, an employer can set up a plan so that the employee can leave and still have access to the unused funds,” said Bill Sweetnam, benefits tax counsel with the Treasury Department, which oversees the IRS.

There is no cap on the amount employers may contribute to consumer-driven accounts, and the contributions may vary by company. As Scandlen explains, “An HRA may accompany any type of insurance plan, not just a high-deductible one. So an employer could set up an HRA with just $100 contributed every year to help offset an HMO’s copayments, or an employer could establish a truly high-deductible plan of $6,000 and provide a $5,000 annual HRA allowance.

“An employer has wide flexibility in designing an affordable benefits package,” explained Scandlen. “It could provide first-dollar coverage for some medical services, coinsurance for others, and a deductible for still others, and use an HRA to fill in whatever gaps exist.”

Allowing employees to access the funds in their account even after they have left their employer could help them pay COBRA continuation premiums or purchase individual insurance, noted Scandlen. Such access should also help retirees meet their medical expenses.

Cooling off Inflation

With clear guidance from the IRS and favorable results from the handful of pioneering employers who had success with this approach even before the IRS ruling, most industry observers expect a rush by employers to adopt some version of HRA for the 2003 enrollment year.

Fortune magazine recently reported how Humana was able to curb its internal health insurance expenses by offering HRAs to its employees. Humana may see its insurance rates rise as little as 3.7 percent this year, while other employers are facing rate increases of 20 percent or more.

For more information …

See the U.S. Treasury press release at The release links to the full text of the new guidance.