The Tax Relief and Health Care Act of 2006 extended a little known tax break through 2007 for California ’s small businesses, their employees and the self-employed that participate in consumer directed healthcare through a Medical Savings Account (MSA).

An Archer MSA is a tax-exempt account that can be set up with a financial institution in which a person can save money to be used for future medical expenses.  Federal law makes MSAs available only to the self-employed and employees of small business who receive qualifying high deductible health plan (HDHP) coverage through their employer.

MSAs are the predecessors to Health Savings Accounts (HSAs), which function in a similar way, but any person, not just small business employees or self-employed individuals, can choose to establish an HSA paired with a HDHP.

Californians eligible to contribute to an MSA get significant breaks on state taxes for those contributions that employees of larger companies can not get.  Employees of large business can only contribute to an HSA and get no deduction for their HSA contributions on their California state taxes, but can deduct the full $5,650 on their federal tax return.

Due to a quirk in state tax law, contributions to Archer MSAs are deductible for both state and federal income tax purposes, whereas contributions to HSAs are not deductible for state tax purposes.  As more businesses begin to offer employees HSA qualifying insurance coverage, an increasing number of employees of small businesses (fifty or fewer employees) will become eligible to open not only Health Savings Accounts but also Archer Medical Savings Accounts.

MSAs have different tax-free contribution limits than HSAs.  For example, if an employee of a small business were to have a $5,650 deductible HSA qualifying insurance policy for his family through his or her employer, (s)he could contribute as much as seventy-five percent of the insurance deductible to a MSA on a state and federal tax-free basis.  In this example the employee would be able to take a $ 4,237.50 tax deduction on both his California state tax return and his federal tax return and could also contribute an additional $1,412.50 to an HSA.  Unfortunately the additional $1,412.50 HSA contribution would only be deductible for federal tax purposes, but not for state taxes.

Speculation is that due to the change in control of Congress from the Republicans that typically favor tax-saving options, including HSAs, to Democrats that generally favor other types of healthcare options, this tax break likely will not be extended past 2007.   However, those Californians that open a Medical Savings Account in 2007 will be grandfathered in and eligible to make MSA contributions ongoing even after the current cut off year 2007.

Adapted from article by James G. Knight MD, CEO, Consumer Directed Health Care, Inc.