by Matt Frankel, CFP | Oct. 22, 2018
The HSA is a way to set aside money for healthcare expenses on a tax-advantaged basis, but there's a lot more to it. HSAs have some pretty valuable advantages over other healthcare savings vehicles such as flexible spending accounts (FSAs), so here's what you need to know before you decide whether to open or contribute to an HSA of your own.
In a nutshell, an HSA is a type of savings account that allows eligible Americans to set aside money on a tax-deferred basis for healthcare expenses.
HSAs are often confused with flexible spending accounts, or FSAs. While both are designed to help American families save for healthcare expenses on a tax-advantaged basis, there are a few key differences. Specifically:
The main downside to health savings accounts is that not everyone can get one. As I briefly mentioned in the last section, you need to have a qualifying high-deductible health plan as defined by the IRS.
The IRS's definition is updated annually, but for 2020, here's what the IRS considers a 'qualifying" plan for HSA purposes:
For 2020, qualified individuals can contribute as much as $3,550 to their HSA if they have individual health coverage, or as much as $7,100 if they have a family health plan. Like many other tax-advantaged savings vehicles, HSA participants over 50 have a catch-up contribution allowance -- they can contribute an additional $1,000 per year on top of their applicable limit.
It's worth mentioning that these limits are set annually and will likely be adjusted upward over time to keep up with inflation. So the 2021 limits (and qualifications) are likely to be much different.
In addition, if your employer makes contributions on your behalf, they'll count toward your annual limit. In other words, the limits I just discussed are the total contribution limits from all sources.
The IRS publishes a list of common items that it considers to be "medical expenses" in Publication 502. To be clear, this isn't an exhaustive list, so just because a certain expense isn't on it doesn't necessarily mean that it's ineligible for HSA spending.
Just to name a few of the most common expenses you can use your HSA funds to pay:
While this doesn't cover everything, there are some expenses that are never eligible for HSA spending. These include, but are not necessarily limited to childcare services, illegal substances, cosmetic surgery, health club dues, nonprescription drugs (except insulin), nutritional supplements, and weight-loss programs that aren't specifically to treat a disease or diagnosed medical condition
Here's one of the most unique and compelling benefits of an HSA. They are the only type of tax-deferred investment vehicle to offer participants a triple tax benefit. Here's what this means:
In other words, as long as you use the money to eventually pay for healthcare costs, an HSA combines the tax-deduction that you'd get with a traditional IRA or 401(k) with the tax-free withdrawals you'd get with a Roth IRA.
As I mentioned earlier, any money you contribute to your HSA and don't use for that year's healthcare expenses can be rolled over. There's no limit to how many years you can roll the money over for, or how big your account can get.
You can also use your HSA funds at any time, and for any reason, after you turn 65. If your withdrawals after 65 aren't for qualified healthcare expenses, the funds you take out will be considered taxable income, just like with a traditional IRA or 401(k), so it essentially becomes a retirement account with an added tax-free healthcare cost benefit.
If you're fortunate enough to never need the money in your HSA to cover healthcare costs, it can be a fantastic way to plan for the inevitable high costs of healthcare after you retire.
Many Americans are surprised that even with Medicare, there are a great deal of healthcare costs that they'll need to pay out of pocket. In fact, Fidelity estimates that a couple retiring in 2019 at age 65 will need $285,000 to cover healthcare costs throughout their retirement. And, keep in mind that this refers to a couple in average health with an average-length retirement. If you encounter any serious health issues or you live significantly longer than the average American, your out-of-pocket healthcare costs could be significantly higher.
Here's the point: If you were to withdraw this amount as needed from a tax-deferred account such as a traditional IRA or 401(k), you'd need to take out significantly more money in order to cover your tax bill. Just for perspective, if you're in the 22% marginal tax bracket in retirement, you'd need to withdraw more than $365,000 to cover that $285,000 in healthcare costs. Meanwhile, with an HSA, you could get the same annual tax deduction benefit but you wouldn't have to withdraw an extra penny to cover taxes.
The bottom line is that if you have an HSA at your disposal, it's a smart idea to use it to your advantage. Your HSA can not only be a smart way to set aside money on a tax-free basis to cover your near-term healthcare expenses, but can be an important component of your retirement planning strategy as well.
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