Edward A. Zurndorfer, Certified Financial Planner

Among the benefit choices that federal employees have to make between now and the close of business Dec. 12, 2011 -- the end of the 2011 Federal Benefits Open Season -- is which health insurance plan they plan to be covered by during 2012. If they are satisfied with their current plan offered through the Federal Employees Health Benefits Program (FEHB), they need not do anything and they will retain that same FEHB plan for 2012. If they want to change their FEHB plan, they must select a new FEHB plan by close of business Dec. 12.

Federal employees should not focus solely on their insurance premium cost as a means of selecting an FEHB health insurance plan. The Office of Personnel Management (OPM) announced that premiums for FEHB plans will increase on average for 2012 by only 3.8 percent, about one-third the increase in private company group health insurance plans. But the less than expected premium increase in FEHB plans conceals the fact that many employees will be paying more in out-of-pocket expenses for their medical-oriented expenses during 2012. Out-of-pocket expenses include higher deductibles, co-payments and co-insurance. The question for employees is therefore: What is the most tax-advantaged way to pay these out-of-pocket expenses?

Federal employees can choose one of two tax-advantaged approaches to pay their out-of-pocket medical-oriented expenses. The first way is through participation in a health care flexible spending account (HCFSA), through a program called FSAFEDS. Information on HCFSAs can be obtained at http://www.fsafeds.com. With a HCFSA, during 2012 an employee can set aside to their HCFSA a minimum $250 and a maximum $5,000 that is deducted from their gross salary. Employees can participate in a HCFSA and enroll in any type of FEHB plan including a: (1) Fee-for-Service (FFS); (2) Health Maintenance Organization (HMO); or (3) Preferred Provider Organization (PPO) plan.

Editor's note:  To download a comparison chart of HCFSAs, LEX HCFSAs and HSAs, click here (1 page PDF).

But there is no requirement that the employee be enrolled in a FEHB plan in order to participate and contribute to a HCFSA. For example, a full- or part-time employee could be enrolled in the Uniformed Services' group health insurance plan (TriCare Prime or Standard) or through a spouse's private company health insurance plan and still be eligible to participate in a HCFSA.

Any qualifying out-of-pocket medical, dental or vision expenses -- that includes deductibles, co-payments, eyeglasses, orthodontic care - will be reimbursed from the employee's HCFSA to pay for the qualifying medical-oriented expenses of the employee and tax dependent family members. The advantage with a HCFSA is that the employee uses pre-taxed salary to pay for their and their family's qualifying out-of-pocket expenses.

One disadvantage associated with a HCFSA is that there is a "use or lose" policy. Employees who have HCFSAs must use all of their allotted funds in the HCFSA no later than March 15 following the end of the previous plan year, Dec. 31. For example, employees who in enroll in the HCFSA for 2012 must use their allotted HCFSA funds no later than Mar. 15, 2013. Otherwise, they will forfeit their unused funds. Employees who leave or retire from federal service with any funds remaining in the HCFSA will also lose those funds.

Employees who are enrolled in the HCFSA during the current plan year must re-enroll for the 2012 plan year between now and Dec. 12 on the Web site www.fsafeds.com. Enrollment in a HCFSA does not carry over from one plan year to the next plan year.

The other tax-advantaged way employees can pay their out-of-pocket medical expenses is through a Health Savings Account (HSA). Most employees are familiar with traditional individual retirement arrangements (IRAs) with respect to saving for their retirement. It may be easier to understand what a HSA is if the HSA is considered as an IRA for "medical and dental expenses". While the purpose of the traditional IRA is to save in order to pay for one's expenses during retirement, the purpose of the HSA is to pay for one's qualifying medical expenses both currently and later, and if any funds remain in the HSA, throughout one's retirement years.

 One difference between a HSA and a traditional IRA is that employee contributions to a HSA are always "pre-tax" (tax deductible); however, not all traditional IRA contributions are tax deductible (such as nondeductible, traditional IRAs). Furthermore, withdrawals from a HSA are tax-free provided these withdrawals are used to pay eligible medical and dental expenses. On the other hand, all withdrawals from a deductible, traditional IRA are fully taxable.

To be eligible for and to contribute to a HSA, a FEHB participant must be enrolled in a High Deductible Health Plan (HDHP), have no other health insurance coverage other than a HDHP, and not be claimed as a dependent on someone else's tax return. "Other" coverage that would cause HSA ineligibility is participation in a health care flexible spending account (HCFSA) such as participating in the Federal HCFSA program, having TriCare coverage, being enrolled in Medicare, or having coverage through a spouse's non-HDHP health insurance plan.

A HDHP has the following features:

• Higher annual deductibles than traditional health plans (during 2012 minimum deductible of $1,200 for self only coverage and $2,400 for self and family coverage).
• Have annual out-of-pocket limits which do not exceed $6,050 for self only coverage and $12,100 for self and family coverage during 2012.
• Depending on the type of HDHP elected, an enrollee has the choice of using either network or out-of-pocket providers.
• With the exception of preventive care, the annual deductible must be met before the health plan benefits are paid.

A FEHB participant who chooses to enroll in a HDHP and a HSA will in fact pay higher premiums compared to someone who enrolls in a standard "fee-for-service" plan or an HMO. This is because in the FEHB a portion of the HSA owner's insurance premium will automatically be credited to the FEHB participant's HSA. Furthermore, the HSA owner can make additional tax deductible contributions up to the total maximum for the year. These additional contributions will appear on the employee's federal income tax return as an "adjustment to income" (2011 IRS Form 1040, line 25 and IRS Form 8889). Employees over the age of 55 are allowed to make additional "catch-up" contributions during 2012 of as much as $1,000.

Tax-free withdrawals from a HSA can be used to pay for qualified medical expenses (as defined in Internal Revenue Code Section 213(d)). Qualified medical expenses are listed and defined in IRS Publication 502, Medical and Dental Expenses, available for download from the IRS Web site at http://www.irs.gov. Withdrawals from HSAs may be used to pay for non-health related expenses; however, these withdrawals are subject to income tax and if the HSA owner is younger than age 59.5, are subject to an additional 10 percent tax penalty on the amount withdrawn.

Unlike a HCFSA, any unused funds in a HSA are not forfeited and can be rolled over for use in future years. HSA funds are also invested and earn interest or dividends. Depending on which HDHP is chosen and its associated HSA managed by a custodian, the interest rate and dividend yield will vary. Earnings - interest or dividends - are tax-free provided when they are withdrawn they are used to pay for qualified medical expenses.

FEHB participants own their HSAs, even if they change health plans during a subsequent FEHB open season (they change from a HDHP to non-HDHP) or if they leave federal service and lose their FEHB HDHP. Once the HSA owner is no longer covered by an HDHP, the owner can no longer contribute to his or her HSA. However, even if the individual is no longer participating in a HDHP through the FEHB or has left federal service, any qualified medical expenses may be paid from the individual's HSA. In other words, a HSA follows an employee who leaves or retires from federal service and can be used to pay qualifying medical expenses both currently and in the future, including throughout one's retirement years.

Upon the death of the HSA owner, the HSA will pass to a surviving spouse or to a named beneficiary. These individuals may then use the inherited HSA to pay for their qualifying medical expenses. If there is no named beneficiary, then the money is disbursed to the participant's estate and is taxable.

The advantages and flexible features of HSAs (without many of the limitations associated with HCFSAs) may explain HSA popularity with many private employers who have adopted HDHPs and HSAs over the last four years. Nevertheless, the question remains as to which type of individual would be most attracted to a HSA. In general, those single individuals and married individuals with family members who are generally healthy and who make infrequent visits to doctors and specialists are candidates for a HDHP and HSA.

As federal employees analyze the various FEHB plans available to them for 2012, HSAs offer another opportunity for employees to help pay for some of their out-of-pocket medical expenses in a tax-advantaged manner. Nevertheless, employees also need to carefully consider choose a health plan and in particular whether their (and their family's) medical needs will be properly met when deciding whether or not to enroll in a HDHP associated with a HSA.

For many federal employees, enrolling in a FEHB HDHP may not make sense, particularly if the employee and/or enrolled family members make frequent visits to their doctors and specialists.

Employees are not eligible to enroll in both a HSA and a HCFSA. But employees who enroll in a HSA are eligible to enroll in a "limited expense" HCFSA (LEX HCFSA). A LEX HCFSA reimburses employees only for eligible dental and vision expenses. Information about the LEX HCFSA may be obtained at http://www.fsafeds.com.

Posted:  11/28/2011

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  He is an instructor at federal employee retirement seminars throughout the country and writes numerous columns and books on federal employee benefits.

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