April 30, 2003

MSA Expansion Would Provide Attractive Tax Shelter to
Healthy, Affluent Individuals
By Edwin Park and Iris J. Lav

Executive Summary

PDF of this report

View Related Analyses

If you cannot access the files through the links, right-click on the underlined text, click "Save Link As," download to your directory, and open the document in Adobe Acrobat Reader.

Few would propose a tax cut targeted toward healthy, affluent people that increases health insurance premiums for those who are sick.  That is the probable consequence, however, of the Administration’s fiscal year 2004 budget proposal to expand Medical Savings Accounts (MSAs) substantially. [1]

Established under a national demonstration project scheduled to expire at the end of 2003, MSAs are tax-advantaged personal savings accounts that are maintained in conjunction with high-deductible health insurance policies.  Funds in MSAs may be used to help pay for health care expenditures that the high-deductible polices do not cover.  These funds also may be retained unused in the MSA accounts and placed in investment vehicles such as stocks and bonds, with the investment earnings accumulating tax-free in the accounts.  Eventually, the funds in these accounts may be withdrawn not only for medical purposes but also for non-medical purposes such as retirement.  As a result, MSAs can be used as a tax shelter.[2]

MSA use currently is limited.  MSAs may be set up by self-employed individuals and people employed at small businesses.  Small firms may offer MSAs and high-deductible plans and make tax-advantaged deposits into their employees’ MSA accounts, or individuals employed at such firms may establish MSAs themselves and make their own deposits into them.  Deposits into MSAs by individuals are tax deductible.

The Administration has proposed to greatly expand MSAs.  Proponents of large-scale expansion argue that it would increase health insurance coverage and thereby reduce the ranks of the uninsured.  But most health analysts disagree.  Leading analysts and research institutions have concluded that the effect is likely to be the reverse.

In particular, an array of analyses by respected research institutions has found that widespread use of MSAs could adversely affect the employer-based health insurance market by causing the cost of traditional, low-deductible insurance coverage that provides comprehensive benefits to spiral.  As a result, significant numbers of employers might no longer be able to afford to offer traditional plans.  The loss of such plans would place in jeopardy large numbers of older and sicker employees, who particularly need such coverage.

The national MSA demonstration project has produced no evidence to dispel the disturbing findings that emerge from this body of research.  Despite these strong warnings, the Administration’s budget proposes to repeal most current protections and limitations related to MSAs, to make MSAs more lucrative as tax shelters for affluent, healthy individuals — and hence more attractive to such individuals — and to allow unlimited expansion of MSAs across the country.  These MSA expansions have long been pushed by insurance companies that sell MSA policies and conservative policy institutions.  The MSA proposals would cost the Treasury $5.7 billion over ten years, according to the Joint Committee on Taxation.

The research on MSAs suggests that strong caution should be exercised with respect to these proposals.  The risks that the proposals present stem from the following factors.

1.      Widespread use of MSAs could jeopardize coverage for substantial numbers of Americans in traditional health insurance by causing premiums for traditional insurance to rise markedly; research by the RAND Corporation, the Urban Institute, and the American Academy of Actuaries has found that premiums for traditional insurance could more than double if MSA use becomes widespread.

2.      Despite these risks, the Administration’s proposals are designed to lead to substantially expanded MSA use, through elimination of all limits on the use of MSAs and changes in MSA rules that would make MSAs more lucrative as tax shelters.

The likely result of the Administration’s proposals would be substantially increased MSA use.  That, in turn, would likely drive up premiums in the traditional health insurance market.

3.      Another reason that MSA use is likely to become more widespread under the Administration’s proposals is that these proposals would be likely to lead a substantial number of employers to substitute MSAs and high-deductible insurance policies for traditional comprehensive employer-based insurance.

4.      Finally, if this proposal becomes law, growing numbers of employers who do not initially seek to replace traditional comprehensive health insurance with MSAs may ultimately conclude they have little choice but to scale back comprehensive coverage significantly or eliminate it.

In short, if the Administration’s MSA expansion is approved, there is high risk it will ultimately lead to comprehensive employer-based group insurance becoming less affordable and less widely available.  That would cause more people, especially those who are older and sicker and most in need of traditional comprehensive insurance, to become underinsured or uninsured.  These adverse effects are likely to outweigh substantially any modest gains in coverage that an MSA expansion otherwise might produce.

The remainder of this analysis examines these issues in more detail.


Is it Desirable to Shift Health Insurance to Less Comprehensive Coverage?

The Administration’s proposal should be seen as part of a broader agenda to shift health insurance coverage more to high-deductible plans with less comprehensive benefits.  The Administration has criticized traditional, low-deductible health insurance that provides comprehensive benefits and limits co-payments to relatively modest amounts, arguing that consumers may unnecessarily use health-care services because they are too heavily shielded from the economic costs.[3]

Yet for most low- and middle-income individuals and families — especially those who are older and sicker — high deductibles, significant cost-sharing, and lack of coverage of essential medical services can lead to prohibitive out-of-pocket expenses that discourage access to medically necessary care.  In addition, substantial premiums and cost-sharing have a disproportionate impact on lower-income families and individuals and their use of medical services when such services are needed, since these people have less disposable income available for out-of-pocket health-care expenses.

Recent studies by the Commonwealth Fund heighten these concerns.  One study found that so-called “bare-bone” health plans — which generally are comparable to the high-deductible plans provided with MSAs — can leave some lower-wage individuals and families with catastrophic costs well in excess of their annual incomes.[4]  Another Commonwealth Fund study also reported that older individuals who have purchased policies in the individual health insurance market similar to the plans provided with MSAs are twice as likely as comparable individuals with traditional employer-based coverage to fail to see a doctor when a medical problem develops or to skip medical tests or follow-up treatment.[5]


The MSA Demonstration and the Current MSA Rules

The bipartisan Health Insurance Portability and Accountability Act of 1996 established a demonstration to test and evaluate Medical Savings Accounts.  The demonstration was designed to provide information about the effects of MSAs on workers, employers, and insurers and to do so without creating widespread, irreparable harm to the participants or the insurance market as a whole.  Participation in the demonstration is limited to no more than 750,000 participants who are either employees of small businesses (businesses with 50 or fewer employees) or self-employed individuals.  Participants must be enrolled in a high-deductible health insurance policy that meets certain statutory requirements and may take tax deductions for contributions they make to MSAs in amounts up to certain limits.[6]  Other rules governing use of MSAs during the demonstration were designed to assure that these tax-advantaged savings accounts were used largely for the purpose of obtaining medical care and would not become a general-purpose tax shelter.  The demonstration was originally scheduled to run through 2000 but was subsequently extended through December 31, 2003.

The 1996 legislation called for an evaluation by the General Accounting Office to determine the effects of MSAs on the insurance market and consumers.  Among other issues, the evaluation was to study the extent to which MSAs fostered “adverse selection” — a situation in which younger and healthier individuals find MSAs financially advantageous and choose MSAs while older and less healthy individuals remain in traditional insurance.  Such adverse selection would be highly problematic; if younger, healthier individuals (who generally have below-average medical costs) shift from traditional insurance to MSAs while older, less healthy individuals (who generally have above-average medical costs) remain in traditional insurance, the cost of traditional insurance necessarily rises, making it harder for employers and employees to afford.  The GAO also was charged with studying the effect of MSAs on health care costs, including the cost of health insurance premiums.  The goal was that Congress would be able to examine the results of the evaluation and, on the basis of those results, determine future policy regarding MSAs.

Relatively few individuals have chosen to use MSAs during the demonstration period.  The IRS estimates that in tax year 2001, some 78,900 tax returns reflected MSA contributions.[7]  As a result of this low utilization, the GAO has not been able to conduct a full evaluation of the effects of MSAs.  Nevertheless, one portion of the GAO evaluation has been completed — a survey of insurers.

MSA proponents attribute the lack of popularity of MSAs during the demonstration period in part to various statutory safeguards included in the legislation that may have discouraged participation.  Those rules were put in place to guard against spiraling premium costs due to adverse selection and to prevent abuse of MSAs as a general tax shelter.  MSAs are likely to gain much greater popularity if MSAs are made universally available and the rules are altered substantially to allow more widespread use of the accounts as tax shelters, as would occur under the Administration’s proposal.


The Administration’s MSA Proposal

The MSA proposal in the Administration’s fiscal year 2004 budget would effectively replace the MSA demonstration project with a policy that would make MSAs available to anyone who wants them.  The proposal would:

These provisions of the Administration’s proposal would be likely to increase MSA participation quite substantially.  The Administration’s proposal also would likely expand the use of MSAs as tax shelters.


MSAs and Adverse Selection

MSA proponents usually argue that a number of uninsured taxpayers would gain health insurance if MSA use was more widespread.[10]  The risk that significant numbers of currently insured individuals would lose their insurance if MSA use spreads widely as a result of adverse selection, however, is likely to outweigh any modest gains in coverage that may result from a MSA expansion.

Research by the RAND Corporation, the Urban Institute, and the American Academy of Actuaries indicates that the premiums for coverage under a traditional health insurance policy could at least double, depending on the degree of “adverse selection” that MSAs trigger in the insurance market.[11]  Moreover, evidence from the survey of insurers that was conducted in conjunction with the MSA demonstration project suggests that insurance companies establish premiums for MSAs based on the assumption that adverse selection will take place.  According to the survey report, “Insurers view high deductible plan enrollees as presenting a lower claims risk than enrollees in traditional low deductible plans....Insurers expect relatively better health status and lower service utilization by enrollees selecting high deductible plans and price their products accordingly.”[12]

At the higher premium rates that would result for traditional insurance if MSA use becomes widespread, it is likely that significant numbers of employers either would be unwilling to continue offering their employees traditional insurance or would feel compelled to increase the share of the premium costs that employees must bear, which could make traditional insurance unaffordable for some workers.  Rapidly increasing health care costs and the current economic slump already have moved some employers to offer less comprehensive health insurance coverage to their workers and/or increase the portion of the cost of insurance that their workers must shoulder.  A Commonwealth Fund survey found that 41 percent of workers reported being charged increased employee premiums in 2002, receiving fewer benefits under their policies, or being required to make larger co-payments for services used than the year before.[13]

Moreover, as a result of rising health care costs, an increasing number of larger firms already are starting to offer a package that combines health accounts similar to MSAs (except that they lack the tax advantages of MSAs) with high-deductible insurance policies, in lieu of offering traditional insurance.[14]  As with MSAs, these health accounts can be used to help defray the higher out-of-pocket medical costs that are associated with high-deductible plans.  The employers that have instituted this policy generally have concluded that the contributions they make to these health accounts and high-deductible plans cost them less than continuing to subsidize a substantial percentage of the premium costs of traditional low-deductible, comprehensive insurance.

Today, employees who are offered these health accounts cannot make tax-deductible contributions to them; only their employers can contribute funds to these health accounts.  In addition, employees are not permitted to withdraw these funds upon retirement for non-medical purposes.  In these respects, these health accounts are less attractive than MSAs.  They lack MSAs’ tax advantages.

But this suggests that if MSAs were made broadly available and their tax-shelter benefits were enlarged, as the Administration has proposed, their use by employers might become quite widespread.  MSAs would add substantial tax-shelter advantages to the type of health accounts that some firms already are starting to offer.  The Administration’s MSA proposal likely would induce a considerably larger number of firms to pursue this course and to begin offering MSAs and high-deductible plans.  If that occurs, MSA use is likely to become much more widespread, and adverse selection more prevalent.

The higher premiums for traditional insurance that would likely result from the adverse selection this would engender would accelerate the movement from traditional health insurance to high-deductible, less-comprehensive coverage.  This should be of concern: a recent study from the Employee Benefit Research Institute concludes that the loss of comprehensive coverage would leave many people who need significant amounts of health care, such as individuals with chronic conditions, little recourse but to become underinsured or uninsured.[15]


Use of MSAs as Tax Shelters

MSAs bear similarities to tax-deductible Individual Retirement Accounts: contributions to MSAs are deductible from income; the contributions can be left in the accounts for years and invested in stocks, bonds, or similar assets; and tax is deferred on the amounts that the accounts earn (i.e., earnings on an MSA account compound free of tax).  Furthermore, while deposits and earnings are never taxed if MSA funds are used to pay medical costs, the tax advantages of MSAs can be substantial even if the funds in the accounts are later withdrawn and used primarily or exclusively for non-medical purposes.  If deposits are held until retirement age, there is no penalty for withdrawal for non-medical purposes.  Even if funds are withdrawn for non-medical purposes before retirement age, there are a number of circumstances under which the value of the tax-free compounding of the deposits over a number of years would outweigh the penalty that must be paid for a non-medical withdrawal.

MSAs do, however, differ from IRAs in a key respect — there are no income eligibility limits on MSAs that prevent wealthy people from using them as tax shelters.[16]  As a result, opening up MSAs to all individuals and increasing the amount of tax-deductible contributions that may be made to them, as the Administration’s proposal would do, would enable high-income taxpayers who cannot use IRAs because of the income limits to begin using MSAs as significant tax shelters.

When the MSA demonstration was starting, a number of financial experts pointed out the possibilities for use of the accounts as tax shelters for those with high incomes.[17]  A New York Times article profiled a relatively well-off MSA holder who chose to pay medical expenses with other funds, leaving his MSA deposits to grow tax-free.[18]

The survey of insurers conducted under contract with the GAO indicates that the MSA market has indeed developed in a manner that reflects the attractiveness of MSAs as tax shelters to affluent individuals.  The survey reported on “insurers’ perceptions that MSA enrollees are using their accounts primarily as tax-sheltered savings vehicles rather than as sources of tax-sheltered funds for paying medical expenses.”[19]  The survey also noted that MSA insurers reported that they are targeting highly paid professionals and other types of more affluent individuals (like farmers and ranchers and people in partnership firms, such as legal and medical practices) in marketing MSAs.

Making MSAs more widely available would increase their use as tax shelters, especially by affluent individuals who would benefit the most from the tax shelters and who tend to be in better-than-average health.


MSAs and Employer-Based Coverage

Over time, “adverse selection” would drive up premiums and probably result in more employers concluding they could no longer afford to offer traditional health insurance.  Making MSAs widely available is likely to result in more employers offering MSAs and high-deductible health insurance policies in lieu of more comprehensive group policies.

Employers have traditionally been concerned about their ability to recruit and retain higher income managers if the health benefits they offer are not comprehensive.  The expanded availability of MSAs could change that.  The individuals who would be least affected by employers switching to MSAs and high-deductible policies would be higher-income taxpayers who could afford to contribute a portion of their wages on a tax-deferred basis to MSAs and who would benefit most from the MSA tax break because they are in a high tax bracket.  For these individuals, the tax shelter benefits from MSAs would tend to outweigh the greater out-of-pocket costs associated with high-deductible plans, making the MSA/high-deductible package an attractive one.

The Administration’s proposal also includes changes that would vitiate current MSA rules that prevent employers from setting up MSAs in a manner that primarily benefits highly paid executives and effectively discriminates against lower-paid employees.  Under the current MSA rules, deposits can be made in an MSA account either by an employer or an individual, but not by both in the same year.  Current rules also include nondiscrimination provisions that require employers to make comparable contributions to MSA accounts for all participating employees.

The Administration’s proposal would change how MSAs operate by allowing both employees and employers to make deposits in an MSA in the same year.  That would render the nondiscrimination rules largely meaningless.  An employer could replace traditional insurance with MSAs and high-deductible policies and make small deposits in the MSA accounts of all employees.  Higher-income employees could then add substantial funds to their accounts on a tax-deferred basis to pay for the increased cost-sharing and lesser benefits provided under the high-deductible plan and to take advantage of the tax-sheltering opportunities that MSAs provide.  Most lower-paid staff, by contrast, would not be able to afford substantial contributions.  As a result, older and sicker workers who are not affluent could face serious obstacles in accessing essential health care services.



The Administration’s proposal would both make MSAs much more widely available and make them more attractive as tax shelters.  This would likely lead to much more widespread use of MSAs by healthy, younger individuals, especially more affluent ones.

Because it could lead to much more widespread MSA use, the proposed MSA expansion risks causing extensive “adverse selection” and significantly weakening comprehensive employer-based insurance.  The shrinkage of comprehensive employer-based coverage could cause serious problems for many health care consumers, particularly older and sicker workers.

The proposal also would be likely to lead to greater abuse of MSAs as tax shelters.  Overall, the proposals to make MSAs more widely available and more lucrative as tax breaks would likely worsen the health insurance status of older and sicker Americans, while reducing federal revenues and adding to the deficit.

The Center on Budget and Policy Priorities is grateful to the Nathan Cummings Foundation for its support of this analysis.

End Notes:

[1] U.S. Department of Treasury, General Explanations of the Administration’s Fiscal Year 2004 Revenue Proposals, February 3, 2003.

[2] A penalty applies to the withdrawal of funds from MSAs for non-medical purposes but there is no penalty for withdrawal for retirement.  MSA accounts can serve as a tax shelter even in many cases in which a penalty would apply.

[3] Council of Economic Advisers, Economic Report of the President, February 2002, p. 63; Council of Economic Advisers, “Health Insurance Credits,” February 13, 2002.

[4] Sherry Glied, Cathi Callahan, James Mays, and Jennifer Edwards, Bare-Bones Health Plans: Are they Worth the Money?, The Commonwealth Fund, May 2002.

[5] Elizabeth Simatov, Cathy Schoen, and Stephanie Bruegman, Market Failure?  Individual Insurance Markets for Americans, Health Affairs, July/August 2001.

[6] In tax year 2003, high-deductible plans must have deductibles of not less than $1,700 and not more than $2,500 for individual coverage, and not less than $3,350 nor more than $5,050 for family coverage.  The maximum amount that can be contributed annually equals 65 percent of the health insurance policy’s deductible amount for individual coverage, and 75 percent of the deductible amount for family coverage.

[7] IRS Announcement 2002-90 (October 7, 2002).

[8] The maximum amount that can be contributed would be increased to 100 percent of the deductible.

[9] The minimum deductible would be reduced to $1,000 for individual coverage and to $2,000 for family coverage.  High-deductible plans also would be permitted to provide, without counting against the deductible, up to $100 in coverage for preventive services.

[10] In tax year 2001, about 70 percent of MSA participants reported they were previously uninsured.  This figure appears anomalous.  In prior years, only a minority of MSA participants reported they were previously uninsured.  In tax year 2000, 40 percent of individuals with MSAs were previously uninsured and in tax year 1998, 24 percent of individuals participating in MSAs were previously uninsured.  These are the tax years for which data is available.

[11] Emmett B. Keeler, et. al., “Can Medical Savings Accounts for the Nonelderly Reduce Health Care Costs?” Journal of the American Medical Association, June 5, 1996, p. 1666-71; Len M. Nichols, et. al., Tax-Preferred Medical Savings Accounts and Catastrophic Health Insurance Plans: A Numerical Analysis of Winners and Losers, The Urban Institute, April 1996; and American Academy of Actuaries, Medical Savings Accounts: Cost Implications and Design Issues, May 1995.

[12] General Accounting Office, Medical Savings Accounts: Results from Surveys of Insurers, December 31, 1998, GAO/HEHS-99-34, Appendix, p.14.

[13] Jennifer Edwards, Michelle Doty and Cathy Schoen, The Erosion of Employer-Based Health Coverage and the Threat to Workers’ Health Care, The Commonwealth Fund, August 2002.

[14] Kaiser Family Foundation and Health Research and Educational Trust, Employer Health Benefits: 2002 Annual Survey, September 2002; Melody Simmons, “It’s Your Money, You Decide,” Washington Post.  October 29, 2002; Albert B. Crenshaw, “Proposed Health Accounts May Give Employees More Control,” Washington Post, July 7, 2002; Milt Freudenheim, “A New Health Plan May Raise Expenses for Sickest Workers,” New York Times, December 5, 2001; Employee Benefit Research Institute and Consumer Health Educational Council, Consumer-Driven Health Benefits: A Continuing Evolution, 2002.

[15] Laura Tollen and Robert Crane, A Temporary Fix?  Implications of the Move Away from Comprehensive Health Benefits, Employee Benefit Research Institute, April 2002.

[16] In 2003, people covered by a retirement plan through their place of employment may make tax-deductible contributions to IRAs if their income is below $70,000 for married filers and $50,000 for most other filers.  These levels are scheduled to rise to $100,000 for married filers and $60,000 for singles filers by 2007.  The income limits are higher for “Roth IRAs”: $160,000 for married filers and $110,000 for most other filers.  (Under Roth IRAs, contributions are not tax deductible, but withdrawals at retirement are tax free.)

[17] Vivian Marino, Associated Press release, August 15, 1997.

[18] Margaret O. Kirk, “Medical Accounts: Mixed Reviews,” New York Times, July 5, 1998.

[19] General Accounting Office.