Breaking Down the Basics of HSAs
Health Savings Accounts (HSAs) might be the single most powerful tax-advantaged savings vehicle in the IRS tax code. You can deduct contributions, experience tax-deferred gains and withdraw money tax-free for qualified tax expenditures. It’s essentially a no-tax savings vehicle when used correctly. However, many Americans are missing out on this valuable tax planning, savings and investment option.
A recent report by HealthSavings Administrators shows many consumers and financial advisors don’t understand HSAs. In their survey, they found nearly 60% of advisors aren’t offering HSAs to their clients, roughly 26% don’t discuss HSAs with clients at all and 36% reported that they don’t understand HSAs. Furthermore, 40% of advisors claim their clients don’t understand HSAs either.
The lack of knowledge about HSAs leads to people underutilizing or improperly using them. The HealthSavings Administrators survey found 47% of advisors position HSAs as a short-term savings account. This supports research findings by the Employee Benefit Research Institute (EBRI), which found few Americans, roughly 5%, invest their HSA in anything other than cash.
Account balances tend to be low, with perhaps only a bit more than $1,000 carrying over from year to year. EBRI found 66% of HSA users spend money from the account each year. In essence, people are using their HSA as a checking account and not for the long-term investment tax benefits.
With so many misunderstandings and suboptimal use around HSAs, we need to learn when and how they can be optimized.
Eligibility and Basic Features
The tax code (IRC Sec. 223) allows individuals and families covered by a High-Deductible Health Plan (HDHP) to set aside money in an HSA. But not all HDHP plans are HSA eligible. The best way to know if your HDHP plan is qualified for an HSA is to ask your employer. Plans through an employer or a broad marketplace often state if they’re HSA eligible. Some employers and health care plans even offer HSAs for their HDHP participants. If not, you can set up an HSA through an outside bank or other financial institution.
Once you find out if your plan is HSA eligible, you’ll have to meet a few other requirements before contributing to the HSA:
- You must meet the HDHP requirements,
- You can’t be covered under any other type of plan,
- You can’t be enrolled in Medicare,
- You can’t be claimed as a dependent, and
- You have to be enrolled on the first day of the month.
Eligible individuals have to also meet minimum deductible amounts and withdraw less than the out-of-pocket expenses limit (deductibles included). The IRS sets these numbers every year.
Tax Treatment and Investments
One of the biggest benefits of using an HSA are the tax benefits. Contributions you make, up to a certain amount, are tax deductible. In 2019, you could contribute $3,500 to an HSA for an individual plan and $7,000 for a family plan. For 2020, the IRS announced an increase in both limits – $3,550 for individuals and $7,100 for families.
The money your employer contributes to your HSA counts against the contribution limit, but it’s not considered taxable income to the employee. Additionally, if you’re age 55 or over, you can put away an additional $1,000 per year. However, if both spouses want to do this, they would need two separate HSAs. (You can’t jointly own an HSA.)
Once money is in an HSA, you can hold it in cash or invest it. Some HSAs offer a variety of investment choices, like indexed mutual funds at a low cost. When you contribute to an HSA, it has to be in cash – stock and property contributions aren’t allowed.
HSAs can be used as a long-term investment vehicle. The benefits of doing so is that annual gains aren’t taxed and withdrawals come out tax free – as long as they’re used to cover qualified healthcare expenditures.
If you invest for the long run, you can let your money compound and grow over many years to support your retirement health care expenses. HSAs can even be used for things like Medicare premiums and long-term care insurance premiums in retirement.
However, if you decide to use the HSA as more of an annual checking account for medical expenses and put your money in cash, there are still benefits. Essentially, you still get the deduction for contributing. This is beneficial as many people are unable to deduct their out-of-pocket medical expenses. As such, the higher your tax bracket, the more tax savings you get by using an HSA.
And money in an HSA rolls over, so you don’t have to spend it by the end of each year. As such, you can let your money grow over a long period of time.
When you hit age 65, you likely won’t be able to use an HSA as you’ll start Medicare. Once you enroll in Medicare Part A or Part B, you can’t contribute to an HSA anymore. In some situations, you can delay Medicare enrollment if you’re still working. Even then, you’ll likely need to continue to defer Social Security if you want to take advantage of an HDHP and an HSA. If you start Medicare during a year when you’re using an HDHP, you can still make pro-rata or proportional contributions for the year to an HSA.
If you don’t spend your HSA withdrawals on qualified health care expenditures, the distributions will be taxed at your ordinary income tax rate and will also be subject to a 20% penalty tax. If you’re paying 35% federal tax rate, your tax rate on the HSA distribution would jump to 55%. The good news is the penalty goes away at age 65. After 65, you can use the money for other expenses without penalty, but you will pay ordinary income tax on it.
If you’re enrolled in an HSA, you’re usually unable to take advantage of a Flexible Spending Account (FSA) the same year – unless it’s a Limited Purpose FSA. These special purpose FSAs can be set up for things like child care, vision or dental expenses. FSAs don’t carry over for year to year like an HSA, though.
All the detailed rules surrounding HSAs might feel daunting – but the basics are quite simple. If you have an HDHP and the money to fund an HSA, you should consider contributing to it because the tax benefits are extremely favorable. HSAs are a great long-term investment vehicle and more than just a way to make medical expenses tax deductible each year. Consider your options when selecting health care insurance – an HSA-eligible HDHP could be the right move for yourself now and in the future.