Health Savings Accounts (HSA) provide significant tax advantages. First, to qualify for an HSA, you must be enrolled in a “high-deductible” health insurance plan. This is an important consideration, as some people may not be comfortable with higher annual deductibles, as the out-of-pocket costs may be more than they can afford.
HSAs were established under the Medicare Modernization Act of 2003. According to the IRS, those are plans in 2019 “with an annual deductible that is not less than $1,350 for self-only coverage or $2,700 for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments and other amounts, but not premiums) do not exceed $6,750 for self-only coverage or $13,500 for family coverage.” If you can handle the higher deductibles, HSAs provide triple tax advantages by allowing you to save for current health expenses and/or future health expenses.
Triple Tax Advantages
The first tax advantage is that contributions to an HSA are pre-tax, as they are either withheld from your paycheck or deductible in calculating your adjusted gross income. This allows you to lower your taxable income in the year of contributions.
The second tax benefit is the ability to withdraw funds tax-free if used for qualified medical expenses. Qualified expenses include most services provided by licensed health providers, as well as diagnostic devices and prescriptions. If you’re familiar with Flexible Savings Accounts (FSA), this is similar in that you can use pre-tax dollars for current year health expenses (co-pays, deductibles, etc.). The HSA is slightly better than the FSA in that you do not need to know before the year starts how much to save, as you can carry-over all unused HSA dollars. Unlike FSAs, which have a maximum year-to-year carry-over of $500, HSAs have no limit on carry-overs or when the funds may be used.
The third tax benefit is tax-free earnings. At a minimum, your HSA should provide a cash account that pays some interest on your balance. Many plans have an investment feature where you can invest for the long-term in a diversified portfolio of stock and bond mutual funds.
There is also a strategy to maximize the account’s benefits. You can invest the money for long-term appreciation, letting it grow tax-free, rather than spending it on current health care needs. By doing this, the HSA resembles a Roth IRA in that it grows tax-free, but you also get the benefit of a current tax deduction. By growing the HSA as long as possible, you can hedge against the risk of rising health care costs.
HSAs do have contribution limits. For 2019, an individual may contribute up to $3,500; $7,000 for a family. People over 55 may add another $1,000 per year as a catch-up contribution, so the over 55 limits are $4,500 for self-only and $8,000 for a family.
Health care costs continue to rise. According to the Fidelity Retiree Health Care Cost Estimate, an average retired couple age 65 in 2018 needed approximately $280,000 saved (after tax) to cover health care expenses in retirement. Of course, the amount you’ll need will depend on when and where you retire, how healthy you are, and how long you live.
You can also make a one-time transfer from an IRA. Individuals may make a tax-free rollover from an IRA to an HSA once in their lifetime. The rollover is limited to the maximum allowable contribution for the year, minus any amount already contributed.
Before age 65, account owners face a 20% penalty for withdrawals for non qualified expenses. Starting at age 65, account owners may take penalty-free distributions for any reason. However, to be tax-free, withdrawals must be for qualified medical expenses.
So, for some people, a strategy to consider would be to fund your projected retirement health care costs in an HSA. This could provide you with the peace of mind of having your health expenses covered by tax-free dollars. If your other retirement dollars are depleted, you can still access these dollars for your retirement by taking taxable distributions.
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Post Written by: Christopher M. Stock, MBA, AIF®