Are Health Savings Accounts Right for You?
A Health Savings Account (HSA) is a tax-advantaged personal medical savings account that can be used for qualified healthcare expenses. They have been in existence since George W. Bush signed them into law in 2003 and have become a more significant part of medical expense planning for individuals, given the dramatic rise in health insurance costs.
Triple Tax Benefits
To be eligible to contribute to an HSA, you must be enrolled in a High Deductible Health Plan. HSAs provide triple tax benefits; the first being that contributions to the plans are made with pre-tax dollars through payroll deductions. Contributions are excluded from gross income and are not subject to federal (and most state) income tax. If you itemize deductions, after-tax contributions are allowed and would be deductible on your income tax return. In 2019, the contribution limit is $3,500 per year for an individual and $7,000 for a family. There is also a $1,000 “catch-up” contribution available to people over the age of 55. Individuals can contribute to an HSA past age 65, as long as they have not registered for Medicare.
The HSA was historically seen as a transactional account, funding current year medical expenses with tax-free contributions taken directly from one’s paycheck. They were similar to Flexible Spending Accounts and Healthcare Reimbursement Accounts. However, they have developed into more of an investment vehicle—similar to a 401(k)—since the account balances can be rolled over year-to-year. Flexible Spending Accounts and Healthcare Reimbursement Accounts are use-it-or-lose-it accounts. This roll-over ability provides flexibility on how to fund future medical costs after retirement when you may not have income.
This leads us to the second tax benefit: contributions are invested, and the growth on the investment is tax-free. Withdrawals are not subject to tax if used for eligible medical expenses. Eligible expenses include a wide range of medical, dental, and mental health services and can include premiums for Medicare Parts A, B, and D.
The third benefit of the HSA is that there are no required minimum distributions from the account. Therefore, by using HSA monies to pay for future medical expenses, you may be able to reduce taxable withdrawals that would otherwise be made from your retirement accounts.
An additional (non-tax) benefit is portability. This means that even if you change employers or health insurance plans, or retire, the money in your HSA remains available to you for future qualified medical expenses.
A Few Disadvantages Worth Noting
HSAs are not for everyone. There are several disadvantages to these plans to be aware of.
Some HSAs charge fees. Find out if your plan charges per transaction, per month, or if you can get it waived by maintaining a minimum balance.
As the account owner, you are responsible for keeping receipts for every withdrawal to prove that all the money was used toward qualified medical expenses.
High Deductible Health Plans can place a greater financial burden on the patient if costly medical procedures are required since the plans have higher deductibles and therefore, greater out-of-pocket expenses. Thus, HSAs may not be the best option for those who expect to have significant healthcare expenses, as you will use the money in the year contributed and not benefit from the long-term tax-free growth.
Important to remember is that if you use the funds for non-qualified expenses, the distributions are taxable. Also, if you use the funds before age 65, the penalty is 20% of the distribution, in addition to the tax.
The Bottom Line on Health Savings Accounts
Generally, we consider HSAs to be an excellent planning vehicle to combat the rising cost of health care. The most effective way to leverage these accounts is to pay for current medical expenses from present cash flow while funding the HSA with the future in mind. If you can afford to do this, it will allow your HSA assets to grow tax-free for a longer period, providing you with a greater pool of funds to pay for future medical costs.
The more you understand how to use the accounts wisely, the greater the benefits are.