Health Savings Accounts (HSAs) were signed into law in 2003 by George W. Bush. HSAs are bank or brokerage accounts that allow you to save for qualified medical expenses. Many people do not fully understand how these accounts function or how they may be beneficial, even though they have been available for nearly 15 years. I’ll describe how these plans currently operate and why we think you may want to consider using them, if you’re eligible.
Who’s eligible?
You must satisfy a few rules to be eligible to open and fund an HSA[1]:
- You must be enrolled in a high-deductible health insurance plan (HDHP).
- In 2017, the HDHP must have an annual deductible that is not less than $1,300 for self-only coverage, or $2,600 for family coverage, and the annual out-of-pocket maximum expenses (deductibles, co-payment, and other amounts, but not premiums) cannot exceed $6,550 for self-only coverage, or $13,100 for family coverage.
- Please note that we do not recommend that you select a HDHP just to become eligible to contribute to an HSA.
- You cannot have other health coverage (with a few exceptions[2]).
- You aren’t enrolled in Medicare.
- You can’t be claimed as a dependent on someone else’s tax return.
If you aren’t eligible to fund an HSA, stay tuned for a future article on Flexible Spending Accounts (FSAs) that may apply to your situation.
How do HSAs work?
HSAs allow you to make annual tax-deductible contributions to help pay for current or future qualified medical expenses. Qualified medical expenses are those expenses that qualify for the medical and dental expenses Federal income tax deduction.[3] This includes most medical, dental, vision, and chiropractic expenses.
Even insurance premiums count as qualified medical expenses in a few scenarios:
- If you are paying for long-term care insurance,
- If you are receiving health care continuation coverage (COBRA),
- If you have health care coverage while receiving unemployment compensation under federal or state law, or
- If you are 65 years or older and pay for Medicare and other health care coverage.
Contributions
In 2017, you’re allowed to contribute $3,400 for a self-only HDHP or $6,750 for family HDHP coverage. Individuals age 55 or older are eligible to make a $1,000 catch-up contribution on top of the self-only or family limits. Employer contributions count towards the self-only and family maximums. Contributions can be made up until the tax filing deadline for the prior tax year.
Contributions to an HSA made by you or your employer can be used immediately but do not have to be used in the year they are made. Funds stay in the account until you spend them. If you leave your employer you may keep your HSA. However, you will no longer be eligible to make contributions unless your new employer also offers an HDHP.
Distributions
HSA trustees (the companies that administer these accounts) offer interest on your deposits and some even allow you to invest a portion of your account balance through a brokerage account. Funds grow tax-free and are not taxed upon withdrawal as long as they are used for qualified medical expenses. Distributions from HSAs for non-qualified expenses are taxed as ordinary income and are subject to a 20% penalty, unless you are at least 65 years old or disabled.
Expenses
Importantly, money used to pay a qualified medical expense does not have to be in the HSA at the time an expense is incurred. For example, if your HSA balance is only $2,000 but you incur $5,000 in qualified medical expenses this year, you could pay the first $2,000 from the HSA account and the remainder from your savings. If you contribute to the HSA in a future year, you can immediately reimburse yourself for a prior year’s expense. In this example, the $3,000 can still be reimbursed, even if you already paid the balance from another account.
Why we like HSAs
HSAs offer attractive advantages for those who are eligible and have the cash flow to support contributions. Unlike any other account type offered today, HSAs offer triple tax savings – 1) contributions are tax deductible at the Federal level, 2) income is tax-free, and 3) withdrawals are tax-free as long as they’re used for qualified medical expenses. You can think of an HSA as a Roth IRA that also allows for a deduction for eligible contributions. Deductions for HSA contributions occur “above the line,” meaning you can deduct contributions without itemizing your deductions on Schedule A, and high income earners are not subject to a phase-out of deductions. Your employer’s contributions on your behalf are not treated as income for Federal income tax purposes.
The IRS also allows for a Qualified HSA funding distribution.[4] This once in a lifetime option allows you to take funds out of an IRA (not an ongoing SEP or SIMPLE IRA) tax-free in order to fund your HSA. For example, suppose John and his wife are 60 years old and are eligible and interested in making the maximum family contribution to their HSA this year but cash flow is tight and they can’t come up with $7,750 (family maximum of $6,750 plus $1,000 catch-up based on age). They could take pre-tax dollars from their IRA and do a trustee to trustee transfer in order to fund their HSA this year. In this scenario, the contribution is not tax deductible, but the distribution from the IRA is not taxable. John has taken dollars that would normally be taxed as ordinary income upon withdrawal and moved them into an account that will grow tax-free, and will not be taxed when he spends the money on qualified medical expenses. If John and his wife are in the 33% marginal tax bracket, they have just saved themselves $2,550 in taxes!
If you reach age 65 and still have funds in your HSA, a few additional possibilities open up as well. You can use HSA funds tax-free and penalty free to pay premiums for employer-sponsored health coverage if you are still working, or for Medicare Part B (but not premiums for Medigap insurance).
HSA caveats
Funding an HSA offers significant benefits. However, there are a few factors to keep in mind when using your HSA:
- Coordination between you and your employer is key as contribution limits apply to combined employer and employee contributions.
- Consider paying expenses using a debit card to track your spending.
- Beware of high HSA fees. Some HSA providers waive monthly charges if you keep a minimum balance, but others may charge account opening fees, ongoing monthly fees, fees to invest, and fees to close an account. These fees can eat into your HSA’s financial benefits.
- There are restrictions on contributing to an HSA and a Flexible Spending Account (FSA) in the same year. Only certain FSA accounts are eligible for use in conjunction with an HSA. Check with your accountant and or FSA provider to ensure that you are allowed to fund both accounts.[5]
- If you’re thinking of taking a qualified HSA funding distribution, work with your accountant to ensure that the transaction is completed correctly and you receive the intended benefit.
What to look for in an HSA
As with any bank or brokerage account, there are features to look for when deciding where to open your account. Your employer may suggest an HSA provider, however, you are free to open your HSA account wherever you wish. We recommend looking for the following:
- An account that provides a debit card for each user and possibly ATM or check writing privileges, depending on how you anticipate paying for health care services.
- The ability to track your expenses easily to confirm that spending is going towards qualified expenses.
- A competitive interest rate on deposits.
- Investment options if you plan to let funds accumulate in the account and want upside potential.
You can compare HSA providers here and here. These sites are not exhaustive but provide some insight into the range of benefits, fees, and interest rates that HSA providers offer.
In conclusion
Funding an HSA may reduce your taxes somewhat each year, but is unlikely to materially affect your financial plan. Despite the tax benefits I’ve described, HSA contribution limits will likely keep your balance modest compared to what you can save in a retirement account.
Nevertheless, if you like the idea of paying some of your healthcare costs with pre-tax dollars, give HSAs a shot!
[1] https://www.irs.gov/pub/irs-drop/rp-16-28.pdf
[2] https://www.irs.gov/publications/p969/ar02.html#en_US_2016_publink1000204039
[4] https://www.irs.gov/publications/p969/ar02.html#en_US_2016_publink1000204081
[5] https://www.irs.gov/pub/irs-drop/rr-04-45.pdf