In 2003 the United States Congress passed into law something truly great. With the passing of the Budget Reform Act, a little known, little understood, but very powerful tool was created for taxpayers called a Health Savings Account. And with this tool Congress gave us something that I believe is the best deal we have gotten from Washington in a long, long time.
What is a Health Savings Account (HSA)?
An HSA is an opportunity given to individuals and families who have high deductible health insurance plans to save for their medical expenses, with tax benefits attached. It allows individuals save up to $2,900 ($5,800 for families) per year ($3,800/$7,600 if over 55), and when they do so they get a tax deduction (above the line) on that year’s tax return. Then, for as long as the money remains in the HSA it grows tax free. Finally, when the funds are taken out of the investment for medical reasons they come out tax free as well. Did you catch that? If you put money into an HSA and use it for medical reasons it is never taxed! There is nothing else like it.
Don’t I Get a Deduction for Medical Expenses Anyway?
Yes, subject to three big “ifs.” You can deduct out of pocket medical expenses on you tax return if you have enough other deductions to itemize (not just take the standard deduction), if your income is not so high that your itemized deductions begin to be reduced by formula at the end of Schedule A, and Big If your medical expenses exceed 7.5% of your Adjusted Gross Income (AGI). Only expenses over 7.5% of AGI can be deducted. That means that if you make $80,000 this year the first $6,000 (80,000 x .075) of medical expenses cannot be deducted.
Double Up the Tax Benefits!
So, if you open up an HSA and fund it during the year you automatically get the benefits of a tax deduction. This is the case even if you spend the same money on medical costs a week later. You could literally know that you have a $1,000 medical bill coming, put the $1,000 into your HSA and then go pay the bill the next day. Just for doing so you get the deduction. However, in doing it this way you only take advantage of one of the tax benefits.
If you have the money, an even better way would be to fully fund an HSA each year and then pay for medical expenses out of pocket. Then you would get the deduction for the HSA. On top of that you could also get the itemized deduction for medical expenses (subject to the things mentioned above). The money in the HSA would grow tax free. Then when you need it for medical expenses that you can’t afford in the future it would come out of the account free of tax as well. Double the deductions while you are in need of them and then get the money tax free in the future when your income is lower (such as in retirement).
Is it Worth Having a High Deductible in Order to Have an HSA?
In almost all cases I would give an emphatic yes! I have spent many, many hours analyzing health insurance options for myself and my clients. I look through 100+ options for a person or family, taking into account the premium, deductible, co-insurance payments, etc. When all costs are considered together, higher deductible plans work out to be the better deal almost every time. This is actually a good topic for a future blog entry. Anyway, HSA plans on there own are often the best deal in health insurance, and then when you add in the tax benefits they are even harder to beat.
Some Other Great Tax Perks
For those in the higher tax brackets, as well as those who are eligible for employer retirement plans, there is an additional bonus to an HSA. As you probably already know, your ability to contribute to an IRA or Roth IRA is phased out and then eliminated at certain income levels. There is no income limitation on eligibility to contribute to an HSA. This is a way that you could contribute to something much better than an IRA even when you can’t contribute to a Traditional or Roth IRA because of your income. Also, with many retirement accounts you are required to begin withdrawing funds (and being taxed on them) once you reach 70 1/2. With an HSA you can leave the money growing in the account until you need it.
What if I Need the Money for Something Else?
The answer to this depends on your age. If you are not 59 ½ or older during the year there is a 10% penalty plus taxes for pulling the money out for non-medical reasons. Once you arrive at 59 ½ the penalty goes away. At that point you will pay taxes on the money you use for non-medical purposes, just as you would if you used money from an IRA or other retirement account.
Some Nuts & Bolts
In order to take advantage of this incredible opportunity you must first have a “High Deductible Health Plan” (as defined by congress). Also, you (and your spouse) must not be eligible for employer sponsored health insurance (unless the employer offers an HSA plan). The easiest way to know if a health plan meets the definition of “high deductible” is to ask the insurance company or agent. Every company that I am aware of offers at least one (and usually several) HSA eligible plans, and usually it is indicated in the name of the plan. (By the way, “high deductible” is only $1,100 for an individual or $2,200 for a family). Also, you cannot contribute to an HSA after you turn 65.
Once you have an HSA eligible plan the next step is to actually set up an HSA account. Most health insurance companies do not offer the actual savings account, but require you to do it through a third party instead. This is most commonly done at a bank. As HSAs are a relatively recent creation there are not a ton of options out there yet. And unfortunately many of the options do not pay a lot of interest. However, with a little research you can find some good deals. One national bank that I know of actually offers six types of investments for the funds – anything from a money market account to 100% stock mutual funds. So if you are pretty confident that the money you are putting into your HSA will be there for a long time before you need it you would be able to invest it a little more aggressively and make it grow.
Once you have established the account the bank usually issues a debit card for you to use to pay for your medical bills. This makes getting money out of the account very easy. Just don’t accidentally use it to buy gas or groceries!