While employees are pleased they can now enroll their older children under their employer’s health plan pursuant to Health Care Reform, some employers must confront challenging tax issues in connection with this new requirement. Specifically, one issue relates to the fact that new federal tax rules for dependent coverage do not apply to health savings accounts (HSAs); another arises because some state tax laws do not follow the new federal rules.
Pre-Health Care Reform Definition of Dependent
Employer health coverage may be provided on a tax-free basis (from a federal tax perspective) to an employee’s spouse or “dependent.” Prior to Health Care Reform, “dependent” meant an employee’s qualifying child or qualifying relative.
An employee’s qualifying child generally includes the employee’s child or other relative younger than the employee, who has not attained age 19 (or age 24 if a full-time student), who lives with the employee, and who does not provide more than one-half of his or her own financial support. The age limitations are waived for a qualifying child who is totally disabled.
An employee’s qualifying relative generally includes the employee’s child, other relative or member of the employee’s household, for whom the employee provides over half of the individual’s financial support and who is not the qualifying child of the employee or any other person.
For purposes of these two definitions, “child” includes the employee’s natural child, adopted child, child placed with the employee for adoption, step-child or foster child.
Expanded Definition of Dependent Under Health Care Reform
Health Care Reform expanded the group of individuals to whom employer health coverage may be provided on a tax-free basis (from a federal tax perspective) by amending the applicable definition of “dependent.” Under the new rule, “dependent” also includes an employee’s child through the end of the year the child attains age 26 (regardless of whether he or she is the employee’s qualifying child or qualifying relative). Again, for this purpose, “child” means the employee’s natural child, adopted child, child placed with the employee for adoption, step-child or foster child. This change to the federal tax law was adopted to facilitate the Health Care Reform mandate to provide medical coverage to an employee’s child until at least age 26.
New Rule Does Not Apply to HSAs
While the new definition of dependent applies to most employer health coverage (including medical, prescription drug, dental and vision benefits, health reimbursement arrangements (HRAs) and medical flexible spending accounts (FSAs)), it does not extend to HSAs. An employee can only obtain tax-free reimbursement from an HSA for his or her child’s uninsured expenses where the child is the employee’s qualifying child or qualifying relative under the pre-Health Care Reform rules.
This wrinkle in the federal tax law can be illustrated by the following example. Assume an employee enrolls her 25 year old son in her employer’s high deductible health plan (HDHP) which is coupled with an HSA. Based on the son’s age, he can be covered under the employer’s HDHP on a tax-free basis under Health Care Reform. However, the employee cannot submit her son’s uninsured expenses for tax-free reimbursement from the related HSA unless the son is the employee’s qualifying child or qualifying relative. The son is too old to be the employee’s qualifying child. Further assume the son does not rely on the employee for the majority of his financial support. As a result, he also is not the employee’s qualifying relative. Thus, if the employee takes an HSA distribution for reimbursement of her son’s uninsured medical expenses, the distribution is taxable and may be subject to the 20 percent HSA penalty tax on early withdrawals.
New Rule May Not Apply Under State Law
While most state tax laws (including Michigan’s) automatically conform with the current federal tax law, a minority do not. States that do not conform to current federal rules generally still apply the pre-Health Care Reform tax rules for dependent health coverage. As a result, some children who are now eligible for tax-free coverage under federal law as a result of Health Care Reform may not be eligible for tax-free coverage under state law.
Some non-conforming states, such as Indiana, Georgia, and California are expected to amend their laws to align with federal law regarding this issue. In other non-conforming states, it is unclear if or when the law will be amended to conform with the new federal rule. A few non-conforming states, including Wisconsin, Minnesota, and Kentucky, have issued guidance instructing employers how to deal with this issue in the interim period (until the state legislature decides whether or not to amend the state law to conform with the new federal rule).
Employers should determine whether they have employees in any non-conforming states and, if so, monitor developments in those states closely. In non-conforming states, you may need to identify any enrolled children who are not an employee’s qualifying child or qualifying relative and include the value of that coverage in the employee’s income for state tax purposes.