Funding mechanisms for medical expenses.

A previously published item (see Goldsberry, et al., Tax Clinic, "Deductibility of Tuition and Related Fees as Medical Expenses," TTA, November 2002, p. 701) emphasized that tax-deductible medical expenses may include items (e.g., special-school tuition and fees) not commonly thought of as medical expenses. Taxpayers needing to fund large and ongoing expenses of this sort will also be interested in exploring tax-advantaged ways to pay these expenses beyond deducting them under the 7.5% of adjusted-gross-income threshold. Examples of potential alternatives include funding via Sec. 125 "cafeteria plans," health reimbursement arrangements (HRAs), IRA and/or Sec. 401(k) withdrawals and medical savings accounts (Archer MSAs).

Cafeteria Plans

Sec. 125 cafeteria plans are by far the most common tax-advantaged medical expense reimbursement arrangements (after actual medical insurance). Flexible spending accounts (FSAs) are funded by employee contributions on a pre-tax salary-reduction basis to provide coverage for specified expenses (e.g., qualified medical expenses or dependent care assistance costs) incurred during the coverage period. Reimbursement is subject to reasonable conditions, including a maximum salary-reduction amount that may be set by the plan's terms. Participants must use the FSA amounts for the specified expenses or forfeit any amounts remaining as of the plan year-end; see, generally, Prop Regs. Sec. 1.125-1.

Actually obtaining reimbursement may be problematic; as a practical matter, participants regularly report problems in convincing plan administrators that expenses (such as special school tuition and fees) are legitimate medical expenses properly reimbursable by the plan. Also, reimbursements actually available are frequently less than the total actual medical expense, due to employ ee-mandated limits on FSA funding.

HRAs

Another alternative may be an HRA, which is an employee benefit plan intended to reimburse employees for medical expenses not covered by other insurance. In general, HRAs are funded by the employer, without employee salary reductions, to reimburse an employee for substantiated medical care expenses incurred by the employee and his or her spouse and dependents. HRAs typically provide reimbursement up to a maximum dollar amount for a coverage period, and may provide for carry forward of any unused amount.

The reimbursed medical expenses are excludable from the employee's gross income and deductible by the...