Health Savings Accounts: A Tax Trifecta
When I was studying for the CFP® exam, one of the instructors introduced the course by saying that the breadth of knowledge needed for financial planning is like a lake that’s a mile wide and an inch deep (he was very fond of metaphors). He meant that while the rules aren't always hard to understand, there are a lot of them. As it turns out, he had a great point and one example of this is the Health Savings Account. At first glance, there’s a lot going on here which can make Health Savings Accounts, or HSAs, intimidating, but if you take the time to understand them, you’ll discover an excellent option for saving for both medical expenses and retirement. With that in mind, let’s dig in!
An HSA is a tax-friendly account that can be used by individuals or families covered by a high-deductible health insurance plan to pay for medical expenses not covered by the plan. To be eligible for an HSA you must have a health insurance plan with a deductible of at least $1,400 for individuals and $2,800 for families (as of 2020) and a maximum out-of-pocket expense of $6,900 for individuals and $13,800 for families. Additionally, if you are covered by a non-high-deductible-plan (such as Medicare Part A) for the entire year or can be claimed as a dependent on another person’s tax return, you cease to be eligible. If you’re not sure of your eligibility, consider consulting HR at your place of employment or speak with a CPA. Often HSA eligible employer-sponsored health insurance plans will let you know that they’re eligible and have an option for opening an account through their preferred provider. If that’s not the case, many financial institutions also offer HSA accounts, many of which will set you up with a debit card linked to the account that you can use to pay for qualified medical expenses directly from the account.
Assuming you’re eligible, the next step is contributing. As of 2020, individuals can contribute up to $3,550 and families can contribute $7,100 per year. This includes any contributions made by your employer or another family member so be sure to keep an eye on that so as not to over-contribute. If you’re 55 or older you can also make a catch-up contribution of an additional $1,000 each year. Any contributions that you make to the account are 100% tax-deductible (similar to pre-tax contributions made to a retirement account) and interest earned on the account is tax-free (similar to after-tax contributions made to a retirement account) so long as you use the account for qualified medical expenses. Qualified expenses include deductibles, vision care, dental care, prescription drugs, and co-pays, but do not include premiums (there are exceptions for individuals over the age of 65 who may need to pay Medicare premiums). Distributions made for non-medical expenses will incur a 20% penalty in addition to regular income taxes unless the individual is 65 years or older. Once you enroll for Medicare (typically at age 65), you are no longer eligible to contribute to an HSA, however, the HSA gains a bit of flexibility at this point (this is where it gets interesting!). After the age of 65, the account takes on the traits of a hybrid retirement account. Any distributions taken from the account for qualified medical expenses remain tax-free (much like a Roth IRA). But you can also take distributions from the account for non-medical expenses. These distributions are taxed similar to those taken from a traditional IRA meaning they are taxed like income, but you are no longer penalized by that 20% penalty tax applied to non-qualified, pre-65 distributions. Hence the tax trifecta! Contributions are tax-deductible, the account grows tax-free with regards to distributions for qualified expenses, and once you turn 65, non-qualified distributions can be made while preserving a tax-deferred status for the account.
What does this all mean? It means HSAs are a great way to save both for current medical expenses and future retirement needs. No other account has quite the same characteristics. If you’re thinking about choosing an HSA option, there are a few more things to keep in mind. The first is that your HSA balance rolls forward each year. This is different from Flexible Spending Accounts (FSAs) which are often confused with HSAs but are different, largely because of their use-it-or-lose-it feature. Any balance you have in your HSA at the end of the year simply rolls forward to the next year whereas FSAs only let you roll forward up to $500 each year. Secondly, to be eligible, you have to have a high deductible plan which means you will have just that: a high deductible. With that in mind, you’ll want to make sure that a deductible makes sense for your situation. It helps to be healthy and have limited medical expenses as well as the ability to pay for the higher deductible if need be. Furthermore, if having a high deductible prevents you from seeking needed medical care, the financial benefits probably aren’t worth it (make sure you’re taking care of yourself!). Finally, HSAs are portable meaning they follow you if you leave your employer and take another job (though your ability to contribute may change if you enroll in an ineligible plan).
 These tax features are at the federal level meaning contributions are deductible on your federal taxes and earned interest is not taxed at the federal level. When it comes to state taxes, however, both of those features vary from state to state.
Folger, Jean. “Health Savings Accounts: Advantages and Disadvantages.” Investopedia. Investopedia, November 20, 2019. https://www.investopedia.com/articles/personal-finance/090814/pros-and-cons-health-savings-account-hsa.asp.
Kagan, Julia. “Health Savings Account – HSA.” Investopedia. Investopedia, November 18, 2019. https://www.investopedia.com/terms/h/hsa.asp.
Lankford, Kimberly. “Retirees, Avoid These 11 Costly Medicare Mistakes.” www.kiplinger.com. Kiplingers Personal Finance, October 12, 2018. https://www.kiplinger.com/slideshow/insurance/T039-S003-costly-medicare-mistakes-2018/index.html.