Americans are generally aware of tax-advantaged investment vehicles such as 401(k) plans, individual retirement accounts and 529 college savings plans. But one instrument, the health savings account, isn’t as well known, although it offers three separate tax benefits.
HSAs were established under the Medicare Modernization Act of 2003 and are available to people covered by “high-deductible health plans”. For 2017, these are plans “with an annual deductible that is not less than $1,300 for individual coverage or $2,600 for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments and other amounts, but not premiums) do not exceed $6,550 for individual coverage or $13,100 for family coverage.” Given the introduction of the marketplace (Healthcare.gov) over the past few years, plans meeting (or exceeding*) these deductible criteria are becoming much more common.
An HSA allows account owners to pay for current health care expenses if they need to and, importantly, to save for health care expenses in the future.
An HSAs first advantage is that contributions are deductible for income tax purposes, or if made through a payroll deduction, they are pretax. Second, any earnings on the HSA proceeds are tax-free. Third, account owners may make tax-free withdrawals for qualified medical expenses. There’s no other vehicle under the tax code that has this kind of preferential treatment.
Qualified expenses include most services provided by licensed health providers, as well as diagnostic devices and prescriptions. These are the same requirements applied to medical expenses itemized on Schedule A and found in IRS Publication 502. HSA funds can also be used to pay for long-term care insurance premiums, COBRA coverage, health care coverage while unemployed, and once you are age 65 or older, Medicare or other health care insurance.
Qualified medical expenses are those incurred by you and your spouse or tax dependent (claimed on your tax return). If your spouse is the designated beneficiary of your HSA, then it will be treated as your spouse’s HSA after your death. If you spouse is not the designated beneficiary, then HSA becomes taxable just like an IRA.
Unlike health care flexible spending accounts (“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. Even if the account is opened through an employer-sponsored program, all money in an HSA belongs to the account owner. Accounts are held with a trustee or custodian, which may be a bank, credit union, insurance company or a brokerage and can be invested in bank accounts, annuities, stocks, mutual funds or bonds..
We typically advise clients to take advantage of enrolling in HSA-eligible, high-deductible health plans if their employer offers them and they don’t typically, or currently, have high out-of-pocket health care expenses. When it makes sense, we recommend contributing the maximum amount to the HSA annually, as this allows you to save tax-free for future health care costs.
For some folks closer to retirement, funding your HSA even at the expense of lowering retirement plan contributions may make sense. We all know that medical expenses will come into play at some point later in life and planning for this makes sense. And statistics are easily obtainable indicating that the average lifetime, out-of-pocket expenses for health care in retirement approach $250,000. So why not take advantage of the deduction from current contributions and the tax-free nature of the distributions. In a way, contributing to your HSA is still saving for retirement, but the funds are just earmarked toward qualified medical expenses.
Investing your HSA account for long-term appreciation and letting it grow tax-free, rather than spending it on current health care needs, can also help maximize the benefit to help cover health care costs later on in life. In this sense, the HSA resembles a Roth IRA in that it grows tax-free, but you also get the benefit of a current income tax deduction. From a retirement and financial planning perspective, we advise clients to keep growing the HSA as long as possible as a hedge against the risk of rising health care costs.
OK that all sounds great, so what else do I need to know?
HSAs have contribution limits. For 2017, an individual may contribute up to $3,400; for a family, that amount is $6,750. People over 55 may add another $1,000 per year as a catch-up contribution.
To quickly fund an HSA, you can make a direct transfer from an IRA. An individual may make a tax-free rollover from an IRA to an HSA once in his or her lifetime. The rollover is limited to the maximum allowable contribution for the year, minus any amount already contributed.
Penalties for Nonqualified Expenses
Before age 65, account owners face a 20 percent penalty for withdrawals for nonqualified medical expenses. These include elective cosmetic surgery, hair transplants, teeth whitening and health club memberships, among other things.
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.
Important inconsistencies between the IRS and the Affordable Care Act (ACA)
While the ACA allows parents to add their children (up to age 26) to their health plans, the IRS’s definition of a “qualified dependent” is different, which may mean that you cannot use your HSA funds for your child’s out of pocket medical expenses, even if they are covered under your health plan. Children need to be age 19 or younger, or age 24 or younger and a full-time student, or any age if they are permanently disabled.
Out of Pocket Limits
*The ACA (Affordable Care Act) out of pocket limits for ACA-compliant plans are not consistent with the IRS out of pocket limits for HAS-qualified HDHPS. The ACA’s limits ($7,150 individual/$14,300 family for ACA-compliant plans) are slightly higher than the IRS out of pocket limits for HSA-qualified HDHPs ($6,550/$13,100). This is important to note. Individuals and plans sponsors need to be aware of these differences and choose a health care plan with the appropriate deductibles in order to take advantage of the benefits of an HSA. In order to qualify as an HDHP, the hurdle is that the plan meets the lower out-of-pocket limits for HDHPs.
An HSA is really an important financial planning tool and you may benefit from taking some time to understand how they work. Like saving for retirement, the sooner you can start HSA contributions and allow them the time to grow, the more likely they are to have a material impact on your planning.
Please reach out to your Wealth Advisor for additional information.