Deducting Medical Savings Accounts

Under a pilot program that began in 1997 and that has been extended through the end of 2003, employees of small businesses (50 or fewer employees) and self-employed individuals can set up Archer Medical Savings Accounts (MSAs) to pay health care expenses, provided the accounts are used in connection with high-deductible health insurance. In 2001, the deductible must be a minimum of $1,600 for individual coverage and $3,200 for family coverage, and can be as high as $2,400 for an individual and $4,800 for a family.

The deductible amounts are indexed for inflation each year. In 2002, for example, the deductible must be a minimum of $1,650 for individual coverage and $3,300 for family coverage, and can be as high as $2,500 for an individual and $4,950 for a family.

MSAs are similar to IRAs in the sense that each employee or eligible individual (including the small business owner) can make tax-free contributions to an account. Earnings on the account are not included in taxable income. 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, including the deductible and co-insurance required under the high-deductible insurance plan. Total annual contributions are limited to 65 percent of the deductible for individuals and 75 percent of the deductible for families. Any unused money in the account 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.

The health insurance feature of the MSA would be treated like any other health insurance. Benefits you pay for your employees are reported as deductible employee benefits on Line 14 of the Schedule C, and your own benefits would be included on Line 28 of your Form 1040. In 2001, 60% of your own premiums would be deductible.

Contributions to the MSA account itself are deductible from the individual's gross income, and contributions made by an individual's employer are excluded from the employee's income (unless made through a cafeteria plan).

If you make contributions to your employee's MSA accounts (i.e., other than what they voluntarily have deducted from their paychecks), you must do so at a uniform rate or dollar amount. If so, you can deduct the contributions as employee benefits on Line 14 of the Schedule C. Contributions may be made for a tax year at any time until the due date of the return for that year (not including extensions). The employer's contributions must be reported on the employee's W-2.

Contributions you make to your own MSA are reported on a special IRS Form 8853, Medical Savings Accounts and Long-Term Care Insurance Contracts, and the deductible amount is transferred to Line 25 of your Form 1040.