BILL ANALYSIS Ó AB 1510 Page 1 Date of Hearing: April 9, 2012 ASSEMBLY COMMITTEE ON REVENUE AND TAXATION Henry T. Perea, Chair AB 1510 (Garrick) - As Introduced: January 12, 2012 Majority vote. Tax levy. Fiscal committee. SUBJECT : Income tax: health savings accounts. SUMMARY : Conforms California tax law to federal tax law with respect to health savings accounts (HSAs) for taxable years beginning on or after January 1, 2013. Specifically, this bill : 1)Allows eligible individuals to claim an above-the-line deduction related to their contributions to HSAs in computing their adjusted gross income (AGI). 2)Treats an HSA as a tax-exempt trust for tax purposes. 3)Excludes from the gross income of the employee any contributions to an HSA made by an employer on the employee's behalf. 4)Includes HSAs as an approved option in a nontaxable cafeteria plan for employee benefits created by an employer. 5)Adopts federal changes enacted in 2006 that enhance the HSAs by: a) Permitting the funds remaining upon termination of health flexible spending arrangements or health reimbursements arrangements to be transferred to HSAs. b) Revising the annual deductible limitation on contributions to HSAs to disregard the amount of the annual deductible under the high deductible health plan (HDHP). c) Modifying the cost-of-living adjustments for Consumer Price Index for a calendar year to use the 12-month period ending on March 31 of the calendar year rather than the 12-month period ending on August 31, of the preceding calendar year. AB 1510 Page 2 d) Eliminating the requirement to prorate the amount of HSA contribution based on the number of months of enrollment in an HDHP for an individual who becomes covered under the HDHP during the taxable year in a month other than January. e) Enacting an exception to the requirement for comparable contributions by employers to permit employers to make larger contributions for non-highly compensated employees than for highly compensated employees. f) Permitting participants to make a one-time distribution from an individual retirement account (IRA) to fund an HSA. g) Allowing a taxpayer to rollover the balance of an existing Archer medical savings account (Archer MSA) to an HSA for taxable years beginning on or after January 1, 2013, without penalty. h) Imposing a penalty for a disqualified distribution equal to 2 % of the distribution amount, rather than 10% as provided by federal law. i) Not conforming to the federal 6% excise tax on excess contributions. j) Imposing a $50 penalty for failing to make required reports by the HSA trustee or other person providing an individual with an HDHP. 6)Takes effect immediately as a tax levy. EXISTING FEDERAL LAW : 1)The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (Public Law 108-173) established HSAs, beginning in tax year 2004. 2)Defines an HSA as a tax-exempt trust or custodial account created exclusively to pay for the qualified medical expenses of the account holder and his/her spouse and dependents. 3)Allows any balance in an HSA to grow on a tax-free basis. 4)Allows individuals with an HDHP, and no other health plan other than a plan that provides certain permitted coverage, to AB 1510 Page 3 establish an HSA. 5)Allows a deduction for contributions to HSAs when computing AGI, if made by an eligible individual. Distributions from an HSA for qualified medical expenses of the eligible individual, spouse or dependents are not includible in gross income. 6)Defines "qualified medical expenses" as medical expenses including expenses for diagnosis, cure, mitigation, treatment, or prevention of disease, including prescription drugs, transportation primarily for and to such care, and qualified long-term care expenses. Distributions made for non-qualified medical expenses are includible in gross income and also subject to an additional 20% penalty, unless the distributions are made after death, disability, or after the individual attains the age of 65. 7)Specifies that medical expenses paid via distributions that are excludable from income may not be claimed as medical expenses for purposes of reporting itemized deductions. 8)Excludes contributions to an HSA from income and employment taxes if made by the employer. Eligible individuals include those covered by high-deductible health plans and, in general, are not eligible for other health coverage. 9)Specifies the maximum aggregate annual contribution that may be made to an HSA by or on behalf of the eligible individual, which is the lesser a) 100% of the annual deductible under the HDHP, or, b) $3,100 in the case of self-only coverage and $6,250 in the case of family coverage for 2012 tax year. Those limits are indexed for inflation. 10) For taxable year 2012, a HDHP is a health plan that has an annual deductible that is at least $1,200 for self-only coverage or $2,400 for family coverage and that has an out-of-pocket expense limit that is no more than $6,050 in the case of self-only coverage and $12,100 in the case of family coverage. 11)Allows employers to make larger HSA contributions for non-highly compensated employees than for highly compensated employees. 12)Includes the balance remaining in an HSA after the death of the eligible individual in the gross estate of the decedent AB 1510 Page 4 unless the decedent's spouse is the beneficiary of the HSA. In that case, the HSA balance is deducted in computing the taxable estate and the HSA passes to the surviving spouse, subject to the general restrictions on, and taxation of, distributions. 13)Imposes numerous reporting requirements related to HSAs. Employer contributions to the HSAs must be reported on the employees Form W-2. In addition, the trustee of the HSA must report information on distributions, contributions, and other required information to the Secretary of the Treasury. Health insurance providers must report information as required by the Secretary of the Treasury. 14)Authorizes a direct transfer of funds from the health Flexible Spending Arrangements (FSAs) or Health Reimbursement Arrangements (HRAs) to an HSA, but limits the amount that may be transferred to an amount equal to the lesser of a) the balance in the health FSA or HRA as of September 21, 2006, or, b) the balance in the health FSA or HRA as of the date of the transfer. 15)Authorizes a one-time contribution to an HSA of amounts distributed from an IRA as a direct trustee-to-trustee transfer. Excludes the transfer amount from the gross income of the accountholder and from the 10% penalty on early IRA distributions. 16)Allows tax-exempt medical accounts called Archer MSAs. The Acher MSAs create a tax-exempt trust or custodial account for the benefit of the account holder. Rules similar to those for IRAs apply to Archer MSAs. Participants of Archer MSAs are able to transfer or roll over their balances from an Archer MSA to a new HSA. This transfer specifically is not treated as a disqualifying distribution. EXISTING STATE LAW: Allows tax-benefited growth and use of funds for qualified medical expenses, conforming to the federal rules for Archer MSAs. However, California has not adopted the HSAs created as part of the 2003 federal legislation. Due to the lack of conformity, California taxpayers will be disadvantaged financially if they roll over (transfer) their Archer MSAs to HSAs. Although specifically approved for federal tax purposes, the transfer is a disqualified distribution for California tax purposes, includable in income and subject to tax AB 1510 Page 5 as well as an additional 10% penalty. Similarly, transfers of funds from IRAs will be treated as income subject to tax, and potentially subject to the 2 % penalty for early distribution. FISCAL EFFECT : The Franchise Tax Board (FTB) staff estimate a revenue loss from this bill of $33 million in fiscal year (FY) 2012-13, $65 million in FY 2013-14, and $70 million in FY 2014-15. COMMENTS : 1)The author states, "Health Savings Accounts ÝHSAs] were created with the passage of the 2003 Medicare bill signed by President Bush. HSA's allow for individuals to plan ahead for qualified medical expenses on a tax free basis. HSA's have also been used to defray the costs associated with High Deductible Health Plans. HDHP's & HSA's give individuals further flexibility when determining what type of health care coverage is best for them. HSA's and HDHPs offer consumers security, affordability, flexibility and they are 100% portable. By encouraging contributions to HSAs we make insurance that much more affordable. "A recent Kaiser Family Foundation survey found that 79 percent of participants believe that allowing individuals to shop around for the best prices they can get for health care and health insurance would be very (37%) or somewhat (43%) effective at controlling health care costs. "AB 1510 encourages the use of HSA's by allowing for a tax deduction for contributions made to an HSA by, or on behalf of, an eligible individual. AB 1510 would extend the option of contributing to any eligible HSA to employers who may be interested in exploring cost-effective ways to help employees defray medical expenses. "Encouraging the uninsured to purchase health insurance by allowing this tax deductible option, will reduce the number of uninsured, and accordingly, reduce costs associated with providing healthcare to the uninsured. Reducing healthcare costs will make healthcare insurance more affordable for all. Furthermore, allowing employers to contribute to AB 1510 Page 6 tax-deductible HSAs on behalf of their employees provides a low-cost mechanism to offer their employees an additional benefit. Many employers would provide some form of health benefit to their employees if it were cost efficient. "Additionally, Ýi]individuals who are self-employed tend to have one of two health insurance options - a HSA or nothing - by conforming with federal HSA provisions, small businesses will benefit in two ways: First, Ý] those who already contribute to a HSA, will be able to keep more of their money, which can then be put back into their business. Second, those who do not currently have health insurance will likely be encouraged to contribute to a HSA due to the tax benefit. This is good for small business, the individual and the State. "Further, lower income may appreciate a refundable tax credit for health care expenses, while the middle class may be convinced to obtain coverage if they can apply tax deductions for health care expenses, including premiums. These tax incentives would be conditioned on individuals' maintaining at least a HSA - compatible high deductible plan throughout the year. Allowing health insurers to develop a minimum benefits plan will require additional legislation to afford the market the flexibility to actually meet the needs of consumers. "This is a simple conformity measure, bringing California in line with federal HSA provisions. Given our current healthcare crisis and impending Federal changes, we should be creating options for people to save for future healthcare costs unknowns, and AB 1510 creates one such option." 2)Arguments in Support . Proponents state that HSAs, when combined with HDHPs, present an option for business to provide some health insurance for employees rather than none at all. According to the proponents, use of HSAs help individuals take control of how their health care dollars are spent and enable them to save for future medical expenses and retiree-health expenses on a tax-free basis. Proponents argue that, in fact, HSAs improve upon existing tax-deductible saving options because both the employer and employee may contribute to an employee's HSA without increasing the employee's taxable income. Also, unspent funds roll over from year to year and move with an employee. Proponents also point out that HSAs provide one the fastest AB 1510 Page 7 growing coverage options for those currently lacking health insurance coverage. Proponents argue that, in light of the skyrocketing cost of healthcare, California taxpayers are continually searching for help in easing the high price of health services. Finally, the proponents believe that this measure, by providing conformity to federal tax laws, will save California taxpayers much confusion and heartache in filling out their state income tax forms. 3)Arguments in Opposition . Opponents state that this bill amounts to a tax giveaway for holders of HSAs because they already have the financial resources to afford health insurance. Opponents argue that HSAs in many cases "become a tax shelter for the wealthy who can afford to stash large amounts in an HSA and do not require frequent care." According to the opponents, this bill would do nothing to make health care more affordable for the uninsured and low-income earners. They argue that HSAs are bad health policy because they encourage underinsurance by shifting cost risk to consumers without adequate price transparency in the medical sector, and high-deductible plans undercut basic health care benefits, including reasonable cost sharing. Opponents also argue that HSAs actually limit consumer choice and ultimately cost low- and middle-income workers more money because HSAs must be coupled with HDHPs. Opponents contend that HDHPs are bad for workers as they discourage sick workers and their families from seeking care for routine illnesses, potentially leading to subsequent health care costs that are much higher than they would have been with early treatments. Opponents believe that this cycle of high barriers to care and worsening illnesses hurts working families. Additionally, opponents assert that HSAs hurt the health system as a whole because the health system needs to spread its risk. Taking healthy individuals out of the insurance pool increases the cost to those in need of more extensive health insurance. Opponents also believe that this measure would result in a revenue loss that could impact the provision of critical firefighting and public safety services, at times when California is facing a projected $9.2 billion budget shortfall. Lastly, opponents argue that the Patient Protection and Affordable Care Act (ACA) gives California even more reason AB 1510 Page 8 not to conform to the federal tax law on HSAs. Opponents argue that HSAs are justified as a cost-containment strategy for health care costs. However, opponents point that the ACA contains a number of cost-containment strategies, one of which is ensuring that individuals have access to affordable or subsidized health plans. Thus, because the health plans required by the ACA have to meet standards for actuarial value, cost-sharing limits, comprehensive coverage (that includes essential health benefits), and free preventative care, opponents contend there is no need for California to conform to HSA federal tax law. According to opponents, the "ACA is a much more comprehensive strategy for cost-containment that does not give tax privileges to those that can afford ÝHSAs] while relegating those who cannot to low-quality health plans". 4)HSAs : Under federal law, individuals with a high deductible health plan, and no other health plan other than a plan that provides certain permitted coverage, may establish an HSA. In general, HSAs are tax-exempt trusts or custodial accounts established exclusively to pay for the qualified medical expenses of the account holder, his/her spouse and dependents. Within certain limits, contributions to an HSA are deductible. An HSA is a savings account that provides for tax-deductible deposits and allows tax-free withdrawals, as long as the funds are used for qualified medical expenses. In contrast, a traditional IRA allows tax-deductible contributions but subjects distributions to tax. Further, in the case of a Roth IRA, contributions to the account are taxable, but qualified distributions are tax-free. In addition, both a traditional IRA and a Roth IRA have income limitation restricting eligibility. HSAs have no income restrictions and are available to anyone. 5)Tax Incentive for High-Income Taxpayers . In its 2008 report, the United States (U.S.) Government Accountability Office (GAO) found that the median income of tax filers reporting an HSA contribution in 2005 was $139,000 and 59% of those tax filers contributing to HSAs had an AGI of $60,000 or more. It appears that HSAs disproportionately benefit high-income individuals. According to the report, many HSA participants appear to be using their accounts purely or primarily as a tax shelter rather than paying for out-of-pocket health care costs. The GAO found that, "a stunning 41 percent of tax filers reporting HSA contributions in 2005 did not withdraw AB 1510 Page 9 any funds from their accounts at any time during the year." In recent Congressional testimony, the GAO stated that "this was consistent with the view held by industry experts that many HSA users are people who primarily use their HSAs as a tax-advantaged savings vehicle." 6)The Recent Federal Health Care Reform and Its Effect on HSAs . The ACA passed in March of 2010 requires most citizens and legal residents of the U.S. to have health insurance by January 1, 2014. The legislation outlines the minimum coverage and essential health benefits that need to be provided for a plan to qualify for the mandated coverage; ultimately, these requirements could limit the types of plans offered to individuals. The ACA does not greatly affect HSAs. Instead, the ACA affected HSAs in two minor ways. First, ACA Section 9003 established a new uniform standard for medical expenses. Effective January 1, 2011, only prescribed medicines and drugs are considered "qualifying medical expenses" and are subject to preferred tax treatment. Secondly, the ACA increased the tax penalty on HSA distributions for unqualified medical expenses from 10% to 20%. Given the minor changes in HSAs treatment under the ACA, previous policy objections to HSAs have not yet been overcome. The ACA may reduce the need for HSAs given the expansion of Medicaid coverage. Individuals who would have signed up for an HSA may not do so if they are able to purchase more affordable health care or are covered under Medicaid. Conversely, the ACA may also encourage the use of HSAs. Assuming the ACA is upheld, most people will be required to have health insurance by 2014. Businesses with 50 or more full-time employees will have to offer health insurance plans. Thus, individuals and companies might opt for high deductible plans which can be coupled with HSAs. Some experts state that, HDHP coupled with HSAs will be the most affordable plans that meet the requirements for minimal essential coverage. On March 28, 2012, U.S. Supreme concluded a three day review of the ACA. During oral arguments, the high Court considered: a) whether it was appropriate to hear the case before the penalties for not obtaining health insurance take effect; b) the constitutionality of the ACA's individual mandate; c) whether the rest of the ACA will remain in effect if the AB 1510 Page 10 individual mandate if found to be unconstitutional; and d) the constitutionality of Medicaid's expansion. A decision is expected later this year. However, because of the ACA's minimal effect on HSAs, the Court's decision is not likely significantly alter this policy analysis. 7)California Adjustments . Currently, only three states (among those that impose an income tax) do not conform to the federal HSA deduction rules: California, New Jersey, and Alabama. Pennsylvania allows a deduction for employer's contribution only. Because California has not conformed to any of the federal HSA provisions, a taxpayer taking a deduction on his/her federal personal income tax return is required to increase his/her AGI on the California personal income tax return by the amount of that deduction. In addition, any interest earned on the HSA account must be added to the taxpayer's AGI for California tax purposes, and any contributions made by the taxpayer's employer to the HSA, must be included in the taxpayer's AGI. 8)Implementation Concerns . This bill does not address the impact of HSAs created before the effective date of this bill. Without addressing the tax treatment of HSAs created before 2012, there might be implementation concerns because part of the HSA will be pre-tax dollars and part will be post-tax dollars. Additional legislation or regulations would be required to provide guidance to the FTB with respect to treatment of qualified and disqualified distributions from such HSAs. Because California is one of only three states that have not adopted federal HSA deduction rules, there may be implementation concerns from employees that move into California from a conforming state. 9)Conformity Bill. This bill fully conforms California law to federal HSA provisions beginning with tax year 2013. California does not automatically conform to federal law but instead considers each provision individually. The last California-federal conformity bill was enacted in 2010 ÝSB 401 (Wolk), Chapter 14, Statutes of 2010]. It appears that the omnibus California-federal conformity bill would be a more appropriate vehicle for conforming to the federal HSA provisions. 10)Partial Conformity . An alternative step to full conformity would be to remove the penalty associated with rollovers of AB 1510 Page 11 Archer MSA and IRA funds, which are both allowed tax-free for federal purposes. As mentioned above, the Archer MSA rollover is a disqualified distribution and is subjected to both income tax and a penalty for disqualified distributions. Similarly, the transfer of funds from an IRA is subject to income tax and might be an early withdrawal subject to a penalty (if the transferor/IRA owner is less than age 59 when the transfer is made). California could choose to exempt those distributions or transfers from penalty. 11)Related Legislation . Committee staff notes that the issue of conformity to federal HSA legislation has been proposed in every legislative session since the federal law was enacted. AB 854 (Garrick), introduced in the 2010-11 legislative session, is nearly identical to this bill, but would have applied to taxable years beginning on or after January 1, 2012. AB 854 was held in this committee. AB 1178 (Portantino), introduced in the 2009-10 legislative session, contained a provision similar to the provisions of this bill. AB 1178 was held in the Senate Appropriations Committee. AB 326 (Garrick), introduced in the 2009-10 legislative session, is similar to this bill, but would have applied to taxable years beginning on or after January 1, 2010. AB 326 was held in this committee. SB 353 (Dutton), introduced a bill in the 2009-10 legislative session, is similar to this bill. SB 353 was held in the Senate Revenue and Taxation Committee. SB 1262 (Aanestad), introduced a bill in the 2009-10 legislative session, is similar to this bill. SB 1262 was held in the Assembly Rules Committee. SBX6 13 (Dutton), introduced a bill in the 2009-10 legislative session, is similar to this bill. SBX6 13 was held in the Senate Rules Committee. SBX8 47 (Dutton), introduced a bill in the 2009-10 legislative session, is similar to this bill. SBX8 47 was held in the Senate Rules Committee. AB 1510 Page 12 AB 2292 (Garrick), introduced in the 2007-08 legislative session, is similar to this bill, but would have applied to taxable years beginning on or after January 1, 2008. AB 2292 was held in this committee. AB 84 (Nakanishi/Smyth), introduced in the 2007-08 legislative session, is similar to this bill. AB 84, as amended on March 12, 2007, would have conformed to federal HSA provisions starting with taxable year 2008. AB 84 was held in this committee. AB 142 (Plescia), introduced in the 2007-08 legislative session, is nearly identical to this bill. That bill would have conformed to federal HSA provisions starting with taxable year 2008, which is the same as this bill; however, AB 142 specified a different nonconformity period than this bill. AB 142 was held in the Senate Revenue and Taxation Committee. AB 245 (DeVore), introduced in the 2007-08 legislative session, is identical to AB 142. AB 245 was held in this committee. SB 25 (Maldonado and Runner), introduced in the 2007-08 legislative session, is identical to this bill. SB 25 was held in the Senate Revenue and Taxation Committee. SBx1 10 (Maldonado), introduced in the 2007-08 legislative session, is nearly identical to this bill, except that conformity to the federal HSA provisions would apply starting with taxable year 2006. SBx1 10 failed to pass the Senate Health Committee. 12) FTB's Suggested Technical Amendments . The FTB staff suggests the following technical amendments to address its concerns regarding the unnecessary references. AMENDMENT 1 On page 3, strikeout line 3. AMENDMENT 2 On page 3, line 24, strikeout "as added by", strikeout lines 25 through 26, inclusive, and insert: as AB 1510 Page 13 AMENDMENT 3 On page 3, line 30, strikeout "as added," strikeout line 31, and on line 32, strikeout "and Modernization Act of 2003 (Public Law 108-173)." AMENDMENT 4 On page 3, line 36, strikeout "as added", strikeout line 37, and on line 38, strikeout "and Modernization Act of 2003 (Public Law 108-173)." AMENDMENT 5 On page 4, line 13, strikeout, "as added by," strikeout line 14, on line 15, strikeout "and Modernization Act of 2003 (Public Law 108-173)," and on line 16, strikeout "health savings accounts," and insert: reports. REGISTERED SUPPORT / OPPOSITION : Support United Contractors California Taxpayers Association National Federation of Independent Business California Grocers Association Southwest California Legislative Council California Manufacturers & Technology Association California Association of Health Underwriters California Association of Health Plans California Chamber of Commerce Opposition California Labor Federation Health Access California California Tax Reform Association California School Employees Association Analysis Prepared by : Rosailda Perez / Oksana Jaffe / REV. & TAX. / (916) 319-2098 AB 1510 Page 14