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Health Reimbursement Arrangements

An alternative health care arrangement, on which the IRS has recently released some favorable tax guidance, may now offer employers an alternative to costly health maintenance organization (HMO) and preferred provider organization (PPO) insurance plans.

Health reimbursement arrangements (HRAs) offer employers the possibility of reining in health care costs. We expect you’ll be hearing more about HRAs in the near future, so we want to brief you on how they operate.

An HRA is an arrangement through which an individual health care reimbursement account is set up with a fixed annual amount for each covered employee. These accounts are similar to a health care flexible spending account (FSA) because employees can submit their out of pocket medical expenses and get reimbursed from the accounts. However, there’s a significant difference. An FSA is funded with the employee’s money that is set aside on a pre-tax basis, while HRAs must be funded solely by the employer. Contributions an employer makes to the employees’ HRA accounts are tax deductible and if some relatively straight-forward rules are satisfied, any reimbursements from the accounts are nontaxable to the employees.

Any unspent money in an HRA at year end can be carried forward from year to year until it is needed (even if the employee retires or leaves the company in the mean time). With an FSA, if an employee misjudges how much to put in the account and has some left over at year end, the excess reverts back to the employer.

At this point you may be wondering, why would an employer who currently offers a FSA (that’s funded by employee contributions) want to switch to or add on HRA accounts (that must be funded solely by the employer)? The key is what comes with the HRA.

Employers who are setting up HRA accounts are also switching to high deductible major medical plans. For example, let’s say the plan has a $2,000 deductible for singles and a $4,000 combined deductible for a family. An employer might put $1,000 annually into an HRA for someone who had employee-only coverage and $2,000 annually for someone with family coverage. The idea is that an employer’s savings from switching to a high deductible plan will more than offset the cost of setting up the HRA accounts. If this works, the employer saves money.

Employees can also come out ahead with the combination of an HRA and a high deductible plan if their total expenses for the year are less than what their employer puts in their HRA account. They’re allowed to bank the excess and carry it over to a future year. In fact, this result is touted as one of the big benefits of HRAs. It is suppose to give employees a greater incentive to make cost-effective decisions when they purchase health care services because if they exceed their HRA account balance, the next layer of medical expenses comes straight out of their pocket. Thus, the bottom line is HRA accounts have the potential to save employer’s money and perhaps help rein in health care inflation by making employees better health care consumers.