By: Michael Lipsey, CFP®, AIF®
Imagine that you can deposit money into an account that:
- Gives you a tax deduction
- May reduce your FICA (Social Security) taxes
- Grows tax free and may generate tax free distributions
- Might be set up with money from your employer
- Can add to your retirement savings
I know what you are thinking, “Impossible. An account like would be from ‘The Twilight Zone’.” In my deepest Rod Serling (or Jordan Peele) voice…”Submitted for your approval, meet the Health Savings Account (HSA).”
HSAs were established in 2003 as part of the Medicare Prescription Drug Improvement and Modernization Act. They combine a high deductible health insurance plan (HDHP) with a tax favored savings/investment account, the HSA.
How does this work?
To qualify for an HSA, you must choose an HDHP for your health insurance coverage. An HDHP is usually one of the options for health insurance through your employer or individual health insurance plan. Using an HDHP saves health insurance premiums because you are choosing to pay more out of pocket when you have non-catastrophic healthcare expenses. You can then contribute your premium savings to an HSA account and use the money for medical expenses. But you don’t want to use the money you put into your HSA. More on this later.
Let’s talk about the tax advantages:
- Immediate tax deduction – Similar to a 401k contribution, the HSA reduces your taxes when you contribute.
- FICA tax savings – if made through payroll deduction, contributions are considered a “salary reduction”. FICA taxes are not saved if a contribution is not made through payroll deduction.
- Tax free growth – withdrawals are tax-free when used to pay for qualified medical expenses, including dental and vision – expenditures many traditional health insurance plans may not cover.
- Employer contributions – because many employers pay for some or all of employees’ health insurance premiums, they may offer contributions to an HSA as an incentive to use an HDHP. Usually, this plan is better than a 401k match because the deposit is made with no required contribution from you, and you are immediately 100% vested. Employer contributions are not taxed as compensation.
Why HSAs are a great deal
Most taxpayers concentrate the most on up-front deductions. Being able to deduct HSA contributions gives taxpayers a big advantage over having to pay medical expenses from regular savings. Most healthcare expenses are deductible only if you itemize and only to the extent that they’re greater than 7.5% of your adjusted gross income. That eliminates most taxpayers, and even those who qualify often see a substantial disparity between what they can deduct and what they spend.
The hidden, and potentially larger, benefit to HSAs comes from the tax-free growth that they offer. If you use money on qualifying medical expenses, then all the income and gains that your HSA investments produce is free of federal income tax. Only if you take money out for something other than qualified expenses will you face tax and penalties.
HSAs versus FSAs
HSAs are commonly confused with Flexible Spending Accounts (FSAs). Flexible Spending Accounts also let you set aside pre-tax money toward annual healthcare expenses. However, FSAs generally require you to use all the money you set aside during the calendar year or shortly thereafter, with any unused money forfeited. By contrast, HSAs can hold money for years into the future. The great news is you can have both an HSA and an FSA. Here is a comparison of HSAs versus FSAs.
|Eligibility||Must have a qualified high deductible health plan (HDHP).
Self-employed can contribute.
|All employees are eligible regardless of whether they have insurance or not.
Self-employed cannot contribute.
|2019 Contribution Limit||$3,500 Individual Coverage
$7,000 Family Coverage
$1,000 additional “catch up contribution for individuals over age 55.
|Contribution Source||Employer and/or employee||Employer and/or employee|
|Rollover||Unused contribution can be rolled over to the next year.||Unused contribution is lost at end of year.|
|Withdrawals||Allowed, but incurs taxes plus a 20% penalty.||Not allowed.|
|Interest Earned||Interest earned in the account is tax-free.||Account does not earn interest.|
|Portability||Employee keeps account even if s/he changes jobs.||Account is forfeited after a job change.|
|Accessibility||Can only access what has been contributed into the account.||Complete access to the annual election, regardless of whether the account has been funded or not.|
|Contribution Amendment||Employee can change contribution amount during the year.||Employee is stuck with the contribution amount chosen at the beginning of the year.|
How to best use an HSA
Remember when I said that you don’t want to use the money you put into your HSA? Here is what I meant. Imagine if you had a tax-deductible Roth IRA. How much money would you put in it? Probably all you could. When would you spend the money? Only when absolutely necessary because you would want to preserve the tax-free growth as long as possible.
Ok, you are putting all you can into your HSA and, unless there is an emergency, you are not spending the money for many years. If this is true, a long-term investment strategy will make the most sense. Let’s assume you are 40 years old: you contribute $3500; your employer contributes $1000; the investments earn 6% per year (remember no guarantees, this is an investment account). At age 65, you will find that you have accumulated over $250,000 in your HSA.
Why you may not want to set one up
The High-Deductible Requirement. A High-Deductible Health Plan is required in order to qualify for an HSA. If you or a family member has high medical expenses, or if you are not comfortable with the out-of-pocket maximum, an HSA may not be right for you. For 2019, these are the policy requirements to be eligible to set up an HSA:
|Minimum annual deductible
Minimum annual out of pocket expense limit
|Minimum annual deductible
Minimum annual out of pocket expense limit
Taxes and penalties. If you withdraw funds for non-qualified expenses before you turn 65, you’ll owe taxes on the money plus a 20% penalty. After age 65, you’ll owe taxes but not the penalty.
Recordkeeping. You must keep receipts to prove that your withdrawals were used for qualified health expenses. If you are a good recordkeeper, here is a tip – There is no requirement under current law that the withdrawals be taken in the same year the health expenses are incurred. You can save receipts from many years to allow for a single larger tax-free withdrawal from the account in the future.
Fees. Some HSAs charge a monthly maintenance fee or a per-transaction fee, which varies by institution. While typically not very high, the fees do cut into your bottom line. Sometimes these fees are waived if you maintain a certain minimum balance.
Now you can see why we love HSAs. Many factors will impact your decision of whether an HSA account is right for you, so please contact us if you have questions and want to learn more.