PUBLIC EMPLOYEE FORUM ON
GASB STANDARDS 43/45
Funding for Retiree Health Care:
Comparison of Vehicles
February 7, 2006
Terry A.M. Mumford & Mary Beth Braitman
Ice Miller LLP
One American Square, Suite 3100
Indianapolis, Indiana 46282-0200
(317) 236-2100
www.icemiller.com
Retiree Health Care Vehicles: Goals/Considerations
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Tax-Free Contributions
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Tax-Free Earnings
Tax-Free Benefits/Distributions
If Pre-Funding– How to Satisfy GASB Requirements
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Employer and employee contributions
Irrevocable trust
Protected from creditors
For exclusive benefit of retirees and beneficiaries
With assets used for paying benefits in accordance with substantive plan
With appropriate fiduciary provisions
How to Satisfy Internal Revenue Service Requirements
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Retiree Health Care Vehicles: Goals/Considerations (cont’d)
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Availability
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Post-Retirement
Disability
Termination
While Active
Additional Issues To Consider
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Integration with pension fund benefits
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deductions for $3,000 exclusion
Communication and administration issues
Medicare Part D subsidy and coordination
Cost containment/cost management issues
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Funding Options
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401(h) Qualified Medical Account
VEBA (voluntary employees’ beneficiary
association)
Governmental Trust
Health Reimbursement Arrangement (“HRA’s”)
Heath Savings Account (“HSA’s”)
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401(h) Qualified Medical Subaccounts
$
Employer Contributions
$
Qualified Medical
Account 401(h)
Employee Contributions
Individual Accounts for Each
Employee (DC)
OR
Pooled fund for All Participants (DB)
Medical Expense Reimbursement
Premium Reimbursement
Medical Expense Payments
Premium Subsidy
Process
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Must be part of “qualified retirement plan”
Must have a separate account for funding, actuarial and recordkeeping purposes
Secure IRS determination letter
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Advantages of a 401(h) Account
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Satisfies GASB requirements.
The only method that permits a qualified pension plan to provide
tax-free medical benefits.
May be structured to include employee contributions, as well as
employer contributions.
Employer can fund the 401(h) on pre-retirement basis.
Permits carry over of account balances from year to year.
Accounts are not maintained on an annual “use it or lose it” basis.
Must have separate accounting for contributions, benefits, and
earnings, but can be invested with general pension fund assets
Payments to and distributions from 401(h) account for medical
expenses are not taxable to employee/retiree.
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Disadvantages of a 401(h) Account
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IRS imposes limits on funding 401(h) accounts.
Limited usage – distributions may only be made
for qualified medical expenses.
Code Section 401(h) benefits are available only
for retired employees, their spouses, or their
dependents.
Must have formal legal structure.
May not transfer money between pension
reserves and 401(h) reserves (except if qualify
for and follow Code Section 420).
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VEBA
$
$
Employer Contributions
VEBA
501(c)(9) Trust
Employee After-Tax
Contributions
Individual Accounts
for Each Employee (DC Basis)
Pooled Fund
for all Participants (DB)
Medical Expense
Reimbursement
Premium Reimbursement
Medical Expense
Payments
Premium Subsidy
Process
• Create employee association trust
• Integrate with existing health coverage/structure
• Secure IRS ruling
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VEBA Advantages
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Satisfies GASB requirements.
Employer may fund pre-retirement, but is not required to
pre-fund retiree medical accounts (funding can be
bargained).
In addition to contributions by an employer, employees may
also make after-tax contributions.
Formula for funding could be based on cash out value of
certain accumulated days at retirement.
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Can carry account balance from year to year – need not be
on an annual “use it or lose it” basis.
Payments to and distributions from VEBA for qualified
medical benefits would not be taxable to employee/retiree.
– HRA structure must follow IRS guidance.
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VEBA Disadvantages
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May only be used for certain specified purposes
(e.g., medical expenses). The benefits provided
through the VEBA must be to safeguard or
improve health, or to protect against a
contingency that interrupts or impairs earning
power.
Retirees may not elect to receive cash.
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Governmental Trust
$
Employer Contributions
Governmental Trust
$
Employee Contributions
Reimbursement of Medical Expenses and
Premiums
Process
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Establish separate governmental fund trust
– 115 trust
– Integral part trust
Establish administrative process
Secure private letter ruling to assure IRS approval of structure and tax treatment
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Advantages of Governmental Trust
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May be designed to satisfy GASB requirements.
Permits carry over of account balances.
Would permit post-tax employee contributions.
Employer payments to fund the governmental trust are not taxable to the
employee.
Distributions from governmental trusts for qualified medical expenses are not
taxable to the employee/ retiree.
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HRA structure must follow IRS guidance.
Can be structured to provide very different benefits. Examples include:
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Can have fixed contribution and fixed amount available for medical expenses per
month for life.
Can have fixed contribution and variable amount available for medical expenses
per month for life (set annually)
Can have actuarially determined contribution and fixed (or non-fixed) amount
available for medical expenses for life.
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Disadvantages of Governmental Trust
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Limited usage in order to preserve tax benefits
for retirees.
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Health Reimbursement Arrangement
$
Health
Reimbursement
Arrangement (“HRA”)
Employer Contributions
Individual Accounts for Each Employee
Reimbursement of Medical Expenses and Premiums
Process
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Requirements for HRA’s are set out in IRS Revenue Ruling 2002-41; IRS Notice 2002-45 (June
26, 2002); IRS Revenue Ruling 2006-36; IRS Revenue Ruling 2006-45; FSLG Newsletter (July
2006); IRS Notice 2006-69 (July 13, 2006).
Requires establishment of an administrative structure.
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Advantages of HRA
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Can be pre-funded by the employer during an employee’s
working career.
Payments to HRA are not taxable to employee. Benefits from
HRA are not taxable to employee when paid.
– Must follow IRS guidance.
May carry HRA unused balance over from year-to-year. No “use
it or lose it” annual requirement.
Can also be maintained after termination or retirement.
May set maximum dollar amount that may be used in a “coverage
period”.
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Disadvantages of HRA
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No employee contributions permitted.
Limited usage - distributions may only be made for qualified
medical expenses or premiums for accident or health coverage
for current employees, retirees, and COBRA beneficiaries and
their tax dependents and spouse.
Medical expense must be substantiated by administrator.
May not be used to fund general retirement benefits, life
insurance, or death benefits, and may not be cashed out.
The HRA will itself be subject to COBRA requirements.
Code Section 105(h) non-discrimination rules apply.
Will generally satisfy GASB provisions for pre-funding defined
contribution benefits.
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Health Savings Account
$
Employer Contributions
$
Health Savings Account (“HSA”)
in conjunction with High
Deductible Health Plan
Employee Contributions
Qualified Medical Expenses (nontaxable)
Other Expenses (may be
taxable, with potential
10% penalty) unless
exception applies
Process
• Employer adopts High Deductible Health Plan (“HDHP”)
• Employer or Employees establish Health Savings Accounts (“HSA”)
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Health Savings Account Basics
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A Health Savings Account (“HSA”) may be
established by anyone who:
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is covered by a High-Deductible Health Plan
(“HDHP”),
is not covered by another non-HDHP (this includes
medical flexible spending accounts and HRAs),
is not enrolled in Medicare, and
may not be claimed as a dependent on another
person’s tax return.
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Health Savings Account Basics (cont'd)
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An HDHP is a health plan that meets certain
conditions and has a minimum deductible, with a
maximum out-of-pocket expense limit.
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For 2007, minimum deductible is $1,100 for
individual coverage and $2,200 for family coverage.
For 2007, maximum out of pocket amount is $5,500
for individual coverage, and $11,000 for family
coverage.
New law requires Department of Treasury to publish
COLA increases to these amounts by the June 1 prior
to the year the increases take effect so employers can
plan for the next year.
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What are contribution limits for HSAs?
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Annual HSA contributions may not exceed:
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$2,850 for single coverage, or
$5,650 for family coverage
New law requires Department of Treasury to
publish COLA increases to these amounts by the
June 1 prior to the year the increases take effect
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What are contribution limits for HSAs? (cont'd)
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Note that beginning in 2007, annual
contributions are no longer limited by the
individual’s HDHP deductible.
“Catch-up” contributions are permitted between
55 and 65
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Currently $800/year, increasing to $1,000 in 2009
Must be at least 55 by the end of the tax year
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What are contribution limits for HSAs? (cont'd)
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Usually, annual contribution limit is prorated for
the months an individual is actually HSA
eligible. However, new mid-year enrollee rule
allows individuals to contribute full year’s
annual maximum if individual is HSA eligible
during the last month of the tax year.
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However, if the individual ceases to be HSA eligible
for any reason (other than death or disability) during
the last month of the tax year and the following
twelve months, all of the contributions that
otherwise could not have been made become subject
to normal income taxes plus a 10% penalty tax.
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How can contributions be made to an HSA?
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Employee contributions outside of a cafeteria
plan.
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Employers must make “Comparable Contributions”
to comparable participating employees or face a
35% excise tax on all employer contributions made
to HSAs.
New law allows employers to discriminate in favor
of non-highly compensated employees.
Employer contributions through a cafeteria plan
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Not subject to comparable contribution rules, but
are subject to cafeteria plan nondiscrimination rules.
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How can contributions be made to an HSA? (cont'd)
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Employee contributions.
Contributions from other individuals.
Archer MSA rollovers.
Rollovers from other HSAs or trustee-to-trustee
transfers.
New – One-time direct rollover from HRAs and
FSAs (“qualified HSA distributions”).
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Does not count against annual HSA contribution
limit.
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How can contributions be made to an HSA? (cont'd)
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Rollovers may be made between January 1, 2007 and
December 31, 2011.
Rollover is limited to the lesser of: (1) the
individual’s HRA or FSA balance on September 21,
2006; or (2) the individual’s HRA or FSA balance on
day of rollover. Therefore, if individual has $0
balance in HRA or FSA on 9-1-06, that individual
cannot use this rollover rule.
Entire amount of rollover becomes taxable (and
subject to 10% penalty) if individual does not remain
HSA eligible (except for disability or death) for the
month of the rollover plus next twelve months.
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How can contributions be made to an HSA? (cont'd)
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If employer allows rollovers, must allow for all
comparable employees.
New – One-time transfer from IRS (“qualified
HSA funding distribution”).
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Does count against annual HSA contribution limit.
One-time transfer, but may get additional transfer if
convert from self to family coverage in same
taxable year.
Tax rules similar to those applicable to HRA/FSA
rollovers apply if individual does not remain HSA
eligible after the IRA transfer.
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HSA Distributions
• HSA’s can be used to pay for the following
“qualified medical expenses” with no
taxation:
– Medical expenses for account holder, spouse,
and tax dependents,
– COBRA continuation coverage or health plan
coverage while receiving unemployment
compensation,
– Qualified long-term care insurance, and
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HSA Distributions (cont'd)
– For those 65 or older (and who have previously
established an HSA), any health insurance,
Medicare premiums and out-of-pocket expenses
(Part A, Part B, Medicare HMOs, new
prescription drug coverage-Part D), and
employee share of premiums for employer based
coverage.
• But otherwise cannot be used to pay health
insurance or Medigap premiums.
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What rules apply to HSA distributions?
• Distributions may be taken any time (even if not
currently an “eligible individual”).
• Distributions for qualified medical expenses of
eligible individual, spouse, and dependents are
excludible from income.
• Distributions for any other purpose are subject to
regular tax plus a 10% penalty tax.
• Distributions made after death, disability, or
attaining age 65 are not subject to 10% penalty
tax.
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Advantages of HSA’s
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HSA’s are completely portable and owned by the
employee.
Carry-over of HSA amounts from year to year is
permitted.
Employees have flexibility to make their own
elections about contribution amounts (within limits)
and whether to take distributions from HSA.
Employee investment direction of HSA is permitted.
Employee contributions are deductible.
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Disadvantages of HSA’s
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Contributions only permitted if employee is
participating in an HDHP.
Limited employer involvement with the HSA
trustee or custodian.
Governmental retirement plan or employer may
not qualify to be trustee or custodian of HSA’s.
Generally, cannot be used to pay for “general”
health insurance premiums.
Will satisfy GASB provisions for funding
defined contribution benefits.
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Leave Conversion
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“Leave conversion” programs have taken several
different forms to convert a retiree’s unused
vacation, sick, or personal leave into a credit
used to “purchase” a supplemental benefit,
including retiree medical benefit.
This is not a separate type of structure, but is a
way to fund a 401(h) account, 115 Trust, or
VEBA.
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Leave Conversion Design (Example 1)
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Example 1 – Public Safety Local Negotiates Accumulated Sick
and Vacation Leave at Retirement
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Assumes employer pays accumulated sick leave and vacation leave upon
employee reaching retirement.
Local negotiates for employer to adopt the Post Employment Health Plan
(“PEHP”).
Local negotiates that instead of employees being paid for accumulated
sick and vacation leave in cash, with fully taxed benefits (Federal, State,
and if applicable, 7.65% FICA or 1.45% Medicare tax; the buy-outs
would be contributed to PEHP.
Note: individual employee elections to have accumulated sick and/or
vacation leave are not permitted due to constructive receipt of income
issue. The Local’s contract determines the non-elective percentage or
dollar value of accumulated sick and vacation leave contributed to the
PEHP program upon a member retiring.
Member benefits by receiving total value of sick and vacation leave buyout (tax-exempt) and may utilize these contributions from the PEHP
program to pay for medical insurance premium expenses.
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Leave Conversion Design (Example 2)
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Example 2 – Public Safety Local Negotiates Accumulated Sick
and Vacation Leave at Retirement Plus Annual Ongoing
Contribution
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As outlined in Example 1, assumes Local negotiates for sick and
vacation leave to be contributed into the PEHP program in lieu of having
these types of payouts paid to members in cash and being fully taxable.
Local negotiates wage and benefits package for the employer to make an
annual ongoing contribution into the PEHP program on behalf of each
member.
These annual ongoing contributions are in the $25 - $50 per pay range
which equates to $650 - $1,300 annually for each member.
Member benefits by receiving total value of sick and vacation leave buyout (tax-exempt) and may utilize these contributions to the program to
pay for health insurance premium expenses in addition to receiving
annual ongoing contribution into PEHP program which may be utilized
to pay for any qualified health insurance expense.
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