A health savings account, or HSA, is a tax-advantaged account that can be used to pay for qualified medical expenses including copays, coinsurance, and deductibles. By using pre-tax money to save for these expenses, an HSA may be used to help lower overall medical costs.
What Is an HSA?
An HSA is a tool designed to help someone with a high deductible health plan (HDHP) reduce their health care costs. In fact, having an HDHP is required to open an HSA.
Individuals enrolled in an HDHP tend to pay a lower monthly premium but have a high deductible. As a result, they typically end up paying for more of their own health care before their insurance plan kicks in to pick up the bill. Combining an HDHP with an HSA may help reduce the higher costs of health care that can come with this type of plan.
For 2020, the IRS defines high deductible plans as any plan with a deductible of $1,400 or more for individuals and $2,800 or more for families. What’s more, an individual’s yearly out-of-pocket expenses can’t exceed $6,900 ($13,8000 for families). For 2021 the deductible amounts will remain the same, but the yearly out-of-pocket expense maximums will be $7,000 for individuals and $14,000 for families.
HSA Contribution Rules
Yearly HSA contributions can be up to $3,550 for individuals, or up to $7,100 for families, in 2020. Persons 55 or older by the end of the tax year have the option to make an additional contribution of $1,000 per year. HSA contributions can be made by the qualified individual, their employer, or anyone else who wants to contribute, including friends and relatives.
Contributions are made with pre-tax money and can grow tax-free inside the HSA account. Some accounts allow money to be invested in mutual funds or even stocks. Withdrawals made to cover qualified medical expenses may not be taxed. And because money in the account is pre-tax—Uncle Sam never took a bite out of it—qualified medical expenses can essentially be paid for at a slight discount.
Qualified HSA Medical Expenses
The IRS provides a long list of qualified medical expenses. Some of them include:
• Copays, deductibles, and coinsurance
• Dental care
• Eye exams, contacts, and eyeglasses.
• Lab fees
• Psychiatric care
• Prescription drugs
But there are also a number of unqualified expenses as well. These costs include:
• Cosmetic surgery
• Teeth whitening
• Health club dues
• Nonprescription drugs
• Nutritional supplements
What Are the Benefits of an HSA?
Saving in an HSA lowers taxable income. The money contributed by a qualified individual to the account is pre-tax money, so it will be excluded from gross income, the money on which income taxes are paid. This is the case even if an employer contributes to an employee’s account on their behalf. So an individual who earns $50,000 a year and maxes out their HSA contribution will only be taxed on $46,450. Contributions made with after-tax funds are tax deductible on the current year’s tax return.
There are other considerable tax advantages that come with funding an HSA. Contributions to an HSA can earn interest or returns on investments, growing tax-free. This tax-free growth is comparable to a traditional or Roth IRA. However, HSAs have a significant tax advantage over these accounts.
Not only are contributions made with pre-tax money, but withdrawals that are made to pay for qualified medical expenses aren’t subject to tax at all. Compare that to Roth accounts where contributions are taxed on their way into the account, or traditional IRAs where withdrawals are taxed.
Another advantage of HSAs is that contributions roll over from year to year. In comparison, flexible spending account (FSA) funds, which also allow pre-tax contributions to save for qualified health care expenses, must be spent in the same calendar year they were contributed, or risk losing the funds.
Employers can opt to provide either a grace period of up to two and a half months after the FSA plan year ends or a carryover to the following plan year of up to $500 of unused plan funds. HSAs don’t follow this same use-it-or-lose-it bind. Funds contributed from year to year are available the next year, and there is no time limit determining when the account holder has to spend the money.
What Are the Disadvantages of an HSA?
There are some disadvantages to saving in an HSA combined with high-deductible plans. Despite smaller premiums each month, HDHPs put individuals at risk for considerable out-of-pocket expenses, which may result in a greater financial burden than with other health care plans. Even accounting for contributions to an HSA, it may be difficult to come up with enough money to cover a plan deductible associated with a costly medical procedure and other medical expenses.
Another potential disadvantage is that HSAs effectively preclude account owners from using their savings for anything but medical expenses until they turn 65. Withdrawals for anything other than qualified medical costs before this age will be subject to income taxes and a 20% penalty.
Some HSAs providers charge a monthly fee for account maintenance. These fees are typically no more than a few dollars a month. But even a $5 monthly fee adds up to $60 over the course of a year, which could be more than the cost of a co-pay for an annual check-up with a physician. So be aware that fees might take a significant bite out of potential savings.
HSA contributions and distributions, whether for qualified medical expenses or not, must be reported on the account owner’s tax return. As such, there is a level of record keeping involved that may not be required for other types of health insurance plans.
Finally, much like tax-advantaged retirement accounts, money inside an HSA can be invested, which may potentially increase the amount saved. By the same token it can also mean that money may be lost. So it’s important to understand that if the investments don’t do well, the HSA account balance may drop.
Using an HSA to Save for Retirement
Pre-tax contributions and tax-free growth might make HSAs a powerful savings tool for some people, even if they end up saving a lot of money not needed for qualified medical expenses. When an account holder turns 65 years of age, they are allowed to make penalty-free withdrawals to cover any expenses. Withdrawals will be subject to regular income tax, as they are with other traditional retirement accounts.
If other retirement accounts, including 401(k) and IRA accounts, have been maxed out, contributing to an HSA can be another way to save even more for retirement.
Using an HSA for retirement might also be a good way to prepare for the health care expenses that might be encountered as a person ages. In fact, health care may be the biggest expense in retirement. According to some estimates, a 65-year-old couple will need more than $387,000 to cover health care costs over the rest of their lives.
Most people become eligible for Medicare, which covers many health care costs, at age 65. Unfortunately, Medicare is not an HDHP, so contributions to an HSA are not allowed after enrollment in a Medicare plan. However, Medicare premiums are treated as qualified expenses and can be paid for with money saved previously in an HSA.
If a person becomes chronically ill or needs help with the tasks of daily living as they age, they may need long-term care at home or in a nursing facility. Medicare does not cover long-term care, but long-term care insurance premiums are qualified expenses and can be paid with HSA funds. Saving in an HSA before these potential costs arise may offset the amount spent overall on retirement health care expenses.
Deciding Whether to Use or Save HSA Funds
If a person has medical bills that need to be paid right now and there is no other way to cover them, it is probably wise to use available HSA funds.
However, there is no time limit on using the money in an HSA. If there’s no rush to reimburse a personal bank account for medical bills, an HSA account can be used like an emergency fund or savings account.
For example, if a person has enough in their regular bank account to cover a $30 copay for a doctor’s office visit and $250 spent on contact lenses over the course of a year, they could leave that money in an HSA to continue growing tax-free. If that $280 is needed at a later date, the receipts for these expenses can be used for reimbursement at that time.
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For people who are generally healthy and want to save for future medical expenses or retirement, having a high-deductible health plan and an HSA might be an attractive choice. HSAs may help control medical costs now and save for retirement expenses later.
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