Guest Article

(From the February 12, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Administration Releases FY '08 Budget Proposals

The Bush Administration on February 5, 2007 released its proposed budget and revenue proposals for fiscal year 2008, including a number of proposals relating to employee benefits. Back again, with only minor changes, are the Administration's proposals to replace 401(k), 403(b), and governmental 457 plans with Employee Retirement Security Accounts (ERSAs), and to replace the current panoply of tax-favored individual savings vehicles with Retirement Savings Accounts (RSAs) and Lifetime Savings Accounts (LSAs). But the Administration's proposals relating to health and welfare benefits, anchored by the new standard deduction for health insurance proposal, look dramatically different than previous proposed budgets.

Next to the addition of the standard health insurance deduction proposal, some of the biggest benefits-related differences between this year's and last year's proposed budgets relate to health savings accounts (HSAs). Some of the HSA proposals from last year's proposed budget were enacted as part of the Health Opportunity and Patient Empowerment Act of 2006. As a result, the Administration has replaced those proposals with a series of new proposals to enhance HSAs.

The following summary of the relevant tax provisions in the Administration's budget is based on descriptions provided in the Treasury Department's "Blue Book." The Blue Book, which includes summaries of all revenue proposals in the Administration's budget, can be downloaded from the Treasury Department's Web site, at www.treas.gov/offices/tax-policy/library/bluebk07.pdf. Other budget documents are available from the Office of Management and Budget's Web site, at www.omb.gov.

HEALTH AND WELFARE BENEFITS

New Standard Deduction for Health Insurance

Summary: The President's budget proposes to replace the existing income exclusion for employer-provided health insurance, the self-employed premium deduction, and the itemized deduction for medical expenses (except for those enrolled in Medicare) with a new standard deduction for health insurance (SDHI). Additionally, the budget proposes to repeal rules permitting employees to pay out-of-pocket medical expenses on a tax-favored basis through health flexible spending arrangements (FSAs) and health reimbursement arrangements (HRAs). Health Savings Accounts (HSAs) would be retained.

The SDHI generally would be available to all families who purchase "qualifying health coverage," whether directly or through an employer. The SDHI would not be available to individuals enrolled in Medicare, Medicaid, or SCHIP. Additionally, individuals could not claim the SDHI if they claim the health coverage tax credit (HCTC), or use HSA or Archer Medical Savings Account (MSA) distributions to pay premiums. In 2009 the SDHI would be $15,000 for family coverage and $7,500 for single coverage, and adjusted for general price inflation in subsequent years. Eligibility for the SDHI -- which would apply for purposes of both income and payroll taxes -- would be determined on the first day of each month. The SDHI available to an individual would be reduced by one-twelfth for each month s/he does not have "qualifying health coverage." However, an individual could claim the full SDHI s/he is eligible for, regardless of the cost of his or her "qualifying health coverage."

"Qualifying health coverage" would have to meet certain minimum requirements, including the following:

Some states may impose coverage mandates that are more stringent than the minimum requirements for "qualifying health coverage." The SDHI proposal would not pre-empt these state mandates.

Because the proposal would repeal the income exclusion for employer-provided health benefits, employers would have to report the value of such benefits as income on employees' Forms W-2. These amounts also would be subject to income and withholding taxes. However, employers would be permitted to exclude a pro-rated portion of the SDHI for employment tax purposes for employees with "qualifying health coverage." Employees could adjust their withholding and estimated taxes to reflect the SDHI.

Significantly, employers could continue taking a deduction for the cost of providing health benefits to their employees.

Analysis: The Administration believes the SDHI proposal would help control health insurance costs by eliminating the tax incentive to purchase more expensive insurance, and "level the playing field" between individuals who get health insurance through their employers and those who purchase it on the individual market. The Administration also believes it will increase the number of Americans with health insurance by three to five million people -- a significant number, but not enough to dramatically reduce the number of uninsured Americans, which now stands at 47 million. The proposal would cost approximately $135 billion over the first five years, but only $33 billion over ten years, according to Administration estimates.

Improve the Health Coverage Tax Credit

Summary: The President's budget proposes a variety of changes to the Health Coverage Tax Credit (HCTC) available to certain trade-displaced workers and individuals between the ages of 55 and 64 receiving pension benefits from the Pension Benefit Guaranty Corporation (PBGC). For example, the proposal would permit certain spouses of HCTC-eligible individuals to claim the HCTC when the HCTC-eligible individual becomes entitled to Medicare coverage. The spouse would have to be at least 55 years old and meet other HCTC eligibility requirements. The proposal also would clarify that individuals who elect one-time lump-sum payments from the PBGC and certain alternative PBGC payees, would be eligible for the HCTC.

HEALTH SAVINGS ACCOUNTS

Plans with 50 Percent Coinsurance as HDHPs

Summary: The President's budget proposes to permit individuals to fund HSAs if they are covered by health plans with a 50 percent (or higher) coinsurance requirement even if those plans do not meet the minimum deductible requirements for high-deductible health plans (HDHPs). The plan would have to satisfy all other requirements for HDHPs and meet other guidelines established by the Treasury Department.

Medical Expenses Incurred Before HSA Established

Summary: Current rules preclude favorable tax treatment for HSA distributions used to pay otherwise appropriate medical expenses incurred before the HSA was established. The President's budget proposes to allow HSA funds to be used to pay medical expenses incurred on or after the first day of HSA eligibility in a particular year so long as the HSA is established no later than the date for filing the tax return for that taxable year.

Special Rule for HSA Contributions on Behalf of Chronically Ill Employees

Summary: Under the President's budget, employer contributions to HSAs on behalf of chronically ill employees (or on behalf of employees who have chronically ill spouses or dependents) would be excluded from the comparable contribution rules to the extent they exceed comparable contributions for other employees.

Family Coverage and Embedded Deductibles

Summary: In order to be an HDHP, a health plan must have a minimum deductible of $1,100 for single coverage and $2,200 for family coverage. Some family health plans have an overall deductible that meets this minimum deductible, but also have lower embedded deductibles for each covered individual. These health plans generally are not HDHPs under current rules because they can begin paying benefits before the minimum deductible for family coverage is met. The President's budget proposes to change the rules to make these plans HDHPs if each individual embedded deductible is at least the minimum deductible for individual HDHP coverage and the overall deductible is at least the minimum deductible for family HDHP coverage.

Catch-up Contributions

Summary: Eligible individuals who are at least 55 years old can make an additional $800 catch-up contribution to their HSAs each year. In the case of married couples, each spouse must maintain his or her own HSA in order to make contributions -- including catch-up contributions. The President's budget proposes to allow each spouse to contribute the catch-up amount to a single HSA owned by one spouse if both are eligible to make catch-up contributions.

Coordinating HSAs with HRAs and Health FSAs

Summary: The President's budget proposes to allow individuals covered by HRAs or Health FSAs to contribute to HSAs if they otherwise would be eligible to do so. However, these individuals' maximum allowable HSA contribution would be offset by the level of HRA or Health FSA coverage. (Note that the President's SDHI proposal would eliminate HRAs and Health FSAs.)

PENSIONS AND RETIREMENT SAVINGS

ERSAs

Summary: The President's budget proposes to consolidate 401(k), SIMPLE 401(k), Thrift, 403(b), and governmental 457 plans, as well as SIMPLE IRAs and SARSEPs, into a single retirement savings vehicle: the Employer Retirement Savings Account (ERSA). ERSAs would operate under the same rules that now apply to 401(k) plans, but some of those rules would be modified and simplified.

For example, ERSA participants would be subject to the same elective deferral, catch-up, and total contribution limits that now apply to 401(k) participants, and ERSA distributions would be taxed the same as distributions from the account the ERSA would be replacing. However, the nondiscrimination rules for ERSA contributions would be greatly simplified. The actual contribution percentage (ACP) and average deferral percentage (ADP) tests would be repealed, and contributions would be subject to a single nondiscrimination test. Specifically, the average contribution percentage of Highly Compensated Employees (HCEs) could not exceed 200 percent of Non-Highly Compensated Employees' (NHCEs) percentage if the NHCEs' average contribution percentage is six percent or less. In cases in which the NHCEs' average contribution percentage exceeds six percent, the goal of increasing contributions among NHCEs would be deemed satisfied, and no nondiscrimination testing would apply. A design-based safe harbor for satisfying this test also would be available.

The ERSA proposal would not affect defined benefit plans.

Analysis: The ERSA proposal is designed to encourage more employers to adopt retirement plans for their employees by making these plans less difficult (and therefore less costly) to set up and administer. Whether the proposal would actually result in more employers (particularly small employers) adopting plans is an open question, but many of the proposed changes almost certainly would be welcomed by existing 401(k) plan sponsors. The estimated revenue loss associated with the ERSA proposal is $623 million over five years, and $1.484 billion over ten years.

LSAs and RSAs

Summary: The President's budget proposes to replace traditional, nondeductible, and Roth IRAs with two new accounts: Lifetime Savings Accounts (LSAs) and Retirement Savings Accounts (RSAs). In general, these accounts would enjoy the same tax advantages as the current rules afford Roth IRAs. That is, contributions would be nondeductible, but earnings would accumulate tax-free and distributions (subject to certain exceptions that would apply only to RSAs) would not be taxable.

The annual contribution cap would be $5,000 for RSAs and $2,000 for LSAs. The annual contribution cap for both RSAs and LSAs would be indexed for inflation. LSAs could be funded with gifts and other non-wage income (including investment income), but RSAs could be funded only with wage income. RSA contributions would be eligible for the SAVERS credit. No income limits would apply to LSA or RSA eligibility.

All LSA distributions would be tax exempt, as would RSA distributions made after the account owner turns 58, becomes disabled, or dies. Other RSA distributions would be subject to income taxes and a ten percent penalty tax. Neither LSAs nor RSAs would be subject to minimum required distribution rules during the account owner's lifetime.

The proposal would allow existing balances in Coverdell Education Savings Accounts and Qualified State Tuition Plans (i.e., section 529 plans) to be converted to LSAs, subject to limits. Likewise, traditional and nondeductible IRAs could be converted to RSAs (Roth IRAs would be converted automatically). However, because traditional IRAs are funded with deductible contributions, conversions of these accounts would be taxable events.

Analysis: Conversions of traditional IRAs into RSAs would generate revenue in the short-term. But the new LSAs and RSAs could have significant adverse effects on government revenue in the long-term because accumulated earnings generally would not be taxed. According to the Blue Book, the proposals would generate approximately $7.9 billion in additional revenues during the first five years, but lose all of that gain over the next five years. The net revenue effect over ten years would be -$592 million.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879-5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.