In the midst of the confusion and concern brought on by implementation of the Affordable Care Act, one health-related financial tool stands out as a bright spot: the health savings account (HSA). Those eligible for such an account receive three levels of valuable tax benefits: contributions are tax deductible, the money grows on at least a tax-deferred basis, and any money withdrawn to pay for qualified medical expenses comes out tax-free.
Since account balances can be carried forward from year to year (unlike flexible spending accounts, which have an annual "use-it-or-lose-it" provision), HSAs can be helpful in saving not just for today's healthcare costs but for later life healthcare expenses as well. For some, an HSA can even be used as a powerful additional retirement savings account with unusually generous tax benefits.
The ABCs of HSAs
Health savings accounts are for people with a high-deductible health plan (HDHP). To qualify, an individual's plan must have an annual deductible of at least $1,250 (All figures are for 2014.); a family's plan must have an annual deductible of $2,500 or more. (HSAs have no restrictions or phaseouts related to a taxpayer's income level.)
If your plan meets those requirements, you are eligible to make tax-deductible annual contributions of up to $3,300 for individuals or $6,550 for families. Those over 55 can add an additional $1,000 per year. This money may be used to pay for deductibles, co-pays, prescription drugs, eye care, dental care, and even health-insurance premiums if you are unemployed or paying for "COBRA" continuation coverage through a former employerSM.
HSA funds also may be used to pay a portion of premium costs for most long-term care policies. The amount you're allowed to use each year for this purpose depends of your age — it ranges from $370 if you're 40 or younger to $4,660 if you're 71 or older. (See IRS Publication 502 for more details.)
Where to open an HSACertain banks, credit unions, health-insurance providers, and even some mutual funds (including the SMI funds) offer HSAs.
Such HSA "custodians" vary widely in the benefits they offer and the fees they charge. Some offer only the ability to save; others allow you to invest. Some pay very little interest on savings; others pay more. Some charge monthly or annual fees; others charge nothing. Some make it easy to access the money to pay for healthcare expenses via a debit card; others are designed strictly as long-term savings vehicles. Several web sites, such as HSAsearch.com, monitor much of the HSA landscape, listing providers along with fees and account features.
Maximizing HSA contribution benefits
If you have a high-deductible health plan and your employer offers the option of funding an HSA through payroll withholding, that money will not be subject to federal or state income tax (exception: Alabama, California, and New Jersey do treat HSA contributions as taxable income). Importantly, funding an HSA directly through your employer also means the money won't be subject to Social Security (6.2% of up to $117,000 in earned income) or Medicare (1.45% of all earned income) taxes.
If you have an HDHP but not the option to fund an HSA through payroll withholding, you can fund an HSA on your own. You'll get both federal and state income-tax benefits by listing the contributed amount on Form 1040 (you do not have to itemize deductions). Unfortunately, you won't receive the Social Security and Medicare tax breaks.
If you'd like to use an HSA custodian other than one tied to your employer, consider using two accounts — your employer's and one of your own choosing. You could use payroll withholding to contribute to your workplace HSA (which will enable you to avoid paying all taxes on the money), then move the money into your preferred HSA through periodic "trustee-to-trustee" transfers (be sure to check on any restrictions and fees).
Maximizing HSA withdrawal benefits
If later you switch to a health plan that does not have a high deductible, or you join Medicare, you no longer qualify to make contributions to an HSA. Nevertheless, you can still use any already accumulated HSA savings for qualified healthcare costs. You can even use HSA funds to reimburse yourself for the money Social Security withholds from your benefits to pay Medicare premiums. (HSA funds, however, may not be used to pay for supplemental policies such as "Medigap").
What if you don't need all the money you accumulate in an HSA for healthcare expenses in your later years? If you take money out of the account prior to age 65 and use it for anything other than qualified healthcare costs, you'll owe taxes and a 20% penalty. But at age 65 or older, you can use the money for whatever you'd like and owe only taxes — no penalty. Just as with a traditional IRA, you received a tax deduction on the money you contributed, enjoyed tax-deferral on the gains, and now have to treat withdrawals as ordinary income for tax purposes.
For high-income earners, there's one more option worth highlighting — a way to turn an HSA into something of a super IRA, with the benefits of both a traditional and a Roth IRA. Here's how it works. Prior to age 65, you fund an HSA but pay for health care expenses out of pocket (rather than taking money out of the HSA). Along the way, you make sure to keep all the receipts for qualified medical expenses that you pay for with other funds.
In retirement, assuming you don't need all the money in your HSA for current healthcare costs, you can begin reimbursing yourself based on the receipts you've accumulated over the years for expenses paid with non-HSA funds. This is the best of all worlds: you received a tax deduction on the money you contributed to your HSA originally (like a traditional IRA), and now are able to take out those contributions and earnings completely tax-free (like a Roth IRA).
This strategy works best for high-income earners, as most people need to tap their HSA account as they go through life to cover current healthcare costs. But if you can afford to contribute to an HSA and cover healthcare costs with other funds, it's a unique and highly tax-advantaged way to create another stream of retirement income.
Is an HSA right for you?
You may have many health insurance choices available to you, especially if you work for a large company. Aiming for the lowest-deductible plan you can afford, perhaps paired with a flexible spending account, may seem attractive. But it's well worth crunching the numbers using your household's recent healthcare costs to estimate which is truly your best option.
An increasing number of people are finding that using a high-deductible health plan and a health savings account is the best choice. Being able to carry balances forward, and with some custodians, invest the funds, an HSA may turn out to be the most cost-effective way to cover your healthcare costs now, as well as in the future.