Obamacare Forces Changes in Health Spending Accounts

Since its enactment, the Affordable Care Act has made many changes to the rules for deducting medical expenses. Several provisions that go into effect this year will impact the way many people fund their medical care.

Medical expenses will be more difficult to deduct in 2013. In prior years, individuals were allowed to deduct the amount of their medical expenses that exceeded 7.5 percent of adjusted gross income. The deductible portion must now exceed 10 percent, which will decrease the related tax benefit. The law, however, does permit the 7.5 percent limit to continue for those who are 65 or older through 2016.

This reduction in deductible medical expenses makes flexible spending accounts (FSAs) and health savings accounts (HSAs) more valuable in 2013 and later years. These accounts allow employee contributions on a pre-tax basis to pay for qualified medical expenses. This effectively produces a 100 percent deduction for medical costs.

For example, a married couple with adjusted gross income of $100,000 and unreimbursed medical expenses of $2,500 receives no itemized medical deduction. Their medical expenses do not exceed 10 percent of their adjusted gross income. However, a contribution of $2,500 into an FSA or HSA to fund these medical expenses reduces their taxable income by an equal amount.

For 2013, contributions to flexible spending accounts are limited to only $2,500. This limit is subject to an inflation adjustment in future years. Previously, FSAs set up by employers usually set caps ranging from $2,000 to $5,000. While this is a significant decrease in the maximum amount that can be contributed, most studies show that the new limit exceeds the average contribution made to an FSA account in prior years.

Flexible spending accounts also contain a “use-it-or-lose it” feature, in which funds contributed to the account but not used during the year for qualified medical expenses are lost.

There is no carryover for use in later years. Restrictions on the definition of qualified medical expenses — in place since 2011 — increase the chance that contributions will be lost.

Qualified medical expenses exclude over-the-counter medicines or drugs not prescribed by a physician (other than insulin). Prior to 2011, a popular strategy to use funds remaining in FSAs at year end involved purchasing popular over-the-counter items, bought without a prescription.

Health savings accounts also permit individuals to save earnings on a pre-tax basis to fund qualified medical expenses, if the individual has a high deductible insurance plan. HSAs do not have a use-it-or-lose-it feature. Any unused amount can be retained in the account for future use.

Funds withdrawn from an HSA, but not used for qualified medical expenses are subject to income tax and an additional penalty. Since 2011, this penalty has been 20 percent for most. A 10 percent penalty applies to these distributions made after the owner becomes disabled, reaches age 65 or dies.

A number of strategies are available to maximize the benefits of FSAs and HSAs. Here are some pointers:

IRS has clarified that the restrictive definition of medical expenses applies only to over-the-counter medicines and drugs and does not impact equipment, crutches, supplies (such as bandages) and diagnostic services (such as blood sugar test kits).

These over-the-counter items continue to constitute qualified medical expenses payable from these accounts.

IRS also says that prescribed over-the-counter medicines and drugs are qualified medical expenses. Individuals should get a prescription from a doctor for over-the-counter drugs whenever possible to use funds in these accounts. Additionally, the year-end stockpiling strategy for FSAs, can be used to purchase prescribed over-the-counter medicines.

An individual must retain evidence that the over-the-counter items were prescribed. This can be done by retaining a copy of the prescription or a customer receipt.