Healthcare is an integral piece of life. However, accessing proper health services can be costly. For this reason, it is necessary to find an effective way to manage your health expenses as part of your overall financial plan.
While having health insurance is a great first step, there are further steps you can take to ensure that your medical expenses will be adequately covered. This is especially important if your health coverage might not pay for expensive or extensive medical procedures or if you have high deductible health insurance. Health Savings Accounts (HSAs) have been developed to provide an effective and tax-efficient solution in such instances.
What is a Health Savings Account?
HSAs come to your aid in situations where your health insurance falls short. HSAs are saving accounts in which you can save money for future qualified medical expenses. HSAs provide a significant number of benefits. In addition to covering qualified health expenses, HSAs provide an innovative way to enhance retirement savings and take advantage of tax benefits.
Who can open a Health Savings Account?
IRS regulations specify who is eligible to make contributions to a Health Savings Account. To qualify to open and make contributions to an HSA, individuals must be:
- 18 years old or older
- Covered by a High Deductible Health Plan (HDHP)
- Not enrolled under Medicare
Individuals covered by any health plan other than an HDHP are not eligible to open an HSA. An HDHP is a health plan that has a deductible of $1,400 or greater for an individual ($2,800 or greater for a family) and a maximum out of pocket limit of $6,900 for an individual ($13,800 for a family) in 2020. These limits are adjusted by the IRS each year.
While HDHPs generally have lower monthly premiums, the downside of a higher deductible is that you will pay for many of your annual health expenses out of pocket before your insurance kicks in. In general, an HDHP pays for expenses arising from preventive services but does not cover other health costs until you meet your deductible for the year. HSAs offer a tax-effective way to bridge the payment gap for uncovered expenses until you reach your deductible.
How do Health Savings Accounts work?
Once you determine that you qualify to open a Health Savings Account, you have the option of opening the HSA either through your employer (if they offer one) or through a separate financial institution such as a bank, credit union, or insurance company.
There are two ways to make contributions to your account. The first option is to have your employer automatically deduct contributions from your payroll. Another option is to manually make your contributions as you elect throughout the year. Either way, the contributions that you make to your HSA are considered tax-free by the IRS.
For 2020, the HSA contribution limit is $3,550 for individuals and $7,100 for those with families. These limits are set by the IRS and adjusted for inflation each year.
You can access your HSA money at any time to pay for qualified health expenses. In some cases, you may be given a debit card to use specifically to pay for qualified health expenses. Alternately, the HSA plan may reimburse you from the account after you provide a copy of receipts to verify any out-of-pocket medical expenses that you paid.
HSAs may be used to pay for prescription medications, some over the counter medications, dental expenses, psychological counseling, medical equipment, and many other medical services. The IRS produces a publication that lists and explains the qualified medical expenses that are eligible for coverage by your HSA, offering a great deal of flexibility in how you choose to utilize the funds.
A reasonable concern that many people may have is what happens to their HSA following a job transfer if the HSA is provided by their employer. Similar to a 401k or other employer-provided retirement savings account, the HSA funds belong to the individual and not the employer, so you retain your HSA regardless of job changes. The individual has the ability to roll over the HSA to their new employer’s plan or transfer the funds to a non-employer financial institution HSA without penalty, much like a 401k.
Benefits Associated with Health Savings Accounts
There are various tax benefits to having a Health Savings Account. For instance, contributions to an HSA are considered tax-free. This means that the money that you set aside in your HSA will not be subject to federal income tax and are excluded from gross income on your tax return. Many states also consider HSA contributions exempt from state income tax.
Secondly, contributions made into an HSA can be invested and earn income over time. Like contributions, the income earned in an HSA is not taxed or included in your gross income for tax purposes.
Lastly, HSA funds are not subject to any tax when they are withdrawn to pay for qualified medical expenses regardless of age. Should an individual choose to withdraw funds for purposes other than paying for eligible medical expenses, those funds are subject to taxation and a 20% withdrawal penalty. However, this penalty is waived for accounts whose owner is dead, disabled, or 65 years old and above.
No Forfeiture of Funds
Unlike Flexible Spending Accounts (FSAs), you do not have to spend all of your HSA savings in the year it was saved. There is no forfeiture of unused funds for Health Savings Accounts. If an account holder has not exhausted the money in their HSA by the end of the year, this money will be rolled over year after year. This is one reason many people use HSAs as an additional vehicle to fund their retirement, as you have the option of saving money and withdrawing it at age 65 or older without a 20% penalty.
One of the major benefits of HSAs is the ability to direct how you would like to have your savings invested. In general, the investment options for an HSA have very few limitations. Funds can be invested in stocks, bonds, mutual funds, and even real estate or other alternative investments. To take advantage of this benefit, be sure to open your HSA with a custodian that allows you to specify the kind of investments you would like to make.
At Dean, we strongly believe in the importance of preparing for the unexpected. HSAs are a valuable tool for safeguarding against unplanned medical expenses that can easily derail even the most solid financial plan, while offering a unique opportunity to increase savings and take advantage of tax benefits. To learn more about your HSA investment options or to discuss whether an HSA might be of benefit to you, please don’t hesitate to reach out to a Dean advisor. We are always looking for opportunities to help our clients better live the life they envision.