“Use It or Lose it” Health Plan Alternatives


Employees often grumble about their "use it or lose it" health plans. In this article we’ll give you some alternatives to consider.

The amounts that are "lost" if not "used" are amounts set aside for health care in a cafeteria plan or other salary reduction arrangement. It’s a way to avoid tax on amounts an employee spends on medical care. If the employee paid the medical expenses directly out of salary, he or she would owe tax on the full salary, with little chance of deducting the expenses under today’s rule limiting deductions to amounts in excess of 7½% of adjusted gross income (AGI). But an employee in a cafeteria plan may set part of the year’s salary aside for medical bills, and not have to pay tax on the amount they set aside.

Example: Assume Janet’s salary (and AGI) are $60,000, and she has $4,000 of medical expenses. If she pays medical bills out of salary, she has no medical deduction and her tax is $11,665. But in a cafeteria plan, she could allocate $4,000 to those medical bills and pay tax on only $56,000, for a tax of $10,665 and a $1,000 after-tax saving.

The Problem

The amount you will set aside for medical expenses generally must be determined before the start of the year (or before you join the plan, if later). The choice can’t be changed later in the year, except upon changes in family size and the like. What you have set aside that you don’t use for medical care can’t come back to you, then or later. That’s the "use it or lose it" problem. If Janet in our example had spent $3,000 on medical bills instead of the $4,000 set aside, she would get no refund of the unspent $1,000.

"Use it or lose it" pushes some employees into a frenzy of year-end outlays, to spend their account balances on whatever might qualify as a medical expenditure, such as designer eyeglasses.

Note: Some employees wonder what happens to amounts they "lose". These amounts don’t go back to the employer-or not exactly. The employer can distribute forfeited amounts as "dividends" to participants generally (not based on the amount, if any, the dividend recipient forfeited) or use them in other ways for medical expenses of participants generally.

There’s a technical legal reason for "use it or lose it". The general tax rule is that if your employer gives you a choice to take either cash or a tax-free employee benefit, you are taxed on the cash whichever you actually choose. Cafeteria plans are an exception, but only if you make your choice of the tax-free benefit before the year (or your participation) begins.

Don’t blame IRS for "use it or lose it". Blame Congress, if anyone. It’s in the law and some lawmakers want to change it. (But not the Bush Administration, which instead is pushing health savings accounts, discussed later.)

What’s the solution? Many recognize that "use it or lose it" causes waste of medical care dollars, by provoking marginal medical expenditures at year-end. A recent IRS ruling refines the "health reimbursement arrangement" (HRA), which IRS designed as a partial cure. Here, an employer may offer employees a fixed sum or percentage of pay in a personal account, from which employees withdraw for medical expenses. Amounts they don’t use can carry over for medical expenses in later years, to add to whatever the employer may contribute in those years. Any balance left in the account at the employee’s retirement can be used for health care in retirement, including health care for a spouse, surviving spouse, and dependents.

Does the HRA solve the problem? Well, not for everyone. The "use it or lose it" rule applies to cafeteria plans, which may run entirely on the employee’s money (through salary reductions). HRAs must run on the employer’s money (employer contributions on top of employee pay), so some employers will stay away.

Note: The new IRS ruling okays the partial forfeiture (to the employer) of the unused balance and carryover of the rest. Their thinking must be that the partial forfeiture reduces the employer’s cost, but the partial carryover feature still encourages employees to be cost-conscious, since the more that’s unspent, the more that carries over for future use.

Health Savings Account (HSA)

Health Saving Accounts, which began in 2004, lets you make tax-deductible contributions to your own IRA-like savings account, if you have high-deductible health insurance (HDHI). Amounts you withdraw from the account for medical bills are tax-free, so in effect your medical expenses—apart from HDHI premiums — are fully deductible. With a HSA, you are paying the full cost of your health care (with tax relief), but your employer, if it wants to, can share your cost by contributing to your HSA or your HDHI premium.

For employees but even more for employers, health care plans can be a maze. Do you as employer want a cafeteria plan run through the company at (entirely or partly) the employee’s expense, as with the "use it or lose it" feature? Or as a HRA, running through the company at the company’s expense? Or as a HSA, running through the employee at the employee’s expense, but maybe with an employer contribution?

Tip: Health care plan design may be today’s most complex and costly employee benefit challenge. Please call us for professional guidance.

About Chuck Chuckuemeka

Chuck is managing partner of Chuckuemeka & Associates, a nationally focused CPA firm specializing in Accounting, Auditing, Consulting and Tax Advising.

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