When Should You Open a Health Savings Account?

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If you qualify, an HSA could be a great place to save money.If you're enrolled in a high-deductible health insurance plan, you may have been offered the opportunity to open a health savings account, or HSA. In many cases, your employer may even make a contribution on your behalf.

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.

What is a health savings account?

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:

  • To qualify for an HSA, you need to participate in a qualifying high-deductible health insurance plan (more on that in the next section).
  • With an FSA, you generally have to spend all of the money in the account each year. You can carry over a small amount for a short time, but an FSA isn't a savings accumulation vehicle. Meanwhile, you don't have to use your HSA funds by any particular deadline -- all unused funds can roll over year after year.
  • Not only can HSA money roll over, but funds can be invested until you're ready to use them. This works in a similar manner to most 401(k) plans in the sense that you can choose from a selection of investment funds.

Qualifying for an HSA

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:

  • Individual coverage with a deductible of at least $1,400 and an out-of-pocket maximum of up to $6,900.
  • Family coverage with a deductible of at least $2,800 and an out-of-pocket maximum of up to $13,500.
  • Medicare recipients who also have a high-deductible health plan are ineligible, as are any individuals who have a qualifying high-deductible health plan but are also covered by a non-qualifying health plan (for example, through a spouse's employer).

2020 contribution limits

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.

What expenses can you use HSA funds to pay?

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:

  • Ambulance services
  • Medications (prescribed drugs or insulin only)
  • Routine physical examinations
  • Costs of medical care in a nursing home
  • In-home nursing care
  • Dental work
  • Hospital care
  • Long-term care expenses
  • Health insurance premiums (that you pay and don't receive any other tax benefit for)
  • Lab tests
  • Chiropractic care
  • Psychiatric care
  • Glasses, contact lenses, eye exams
  • Fertility treatments
  • Costs associated with a service animal
  • Hearing aids
  • Medical supplies (bandages, wraps, etc.)
  • Expenses to modify your home in a medically-necessary way, such as installing an entrance ramp for a wheelchair.

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

A triple-tax benefit

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:

  • Contributions to your HSA up to the annual limit are made on a pre-tax basis. That is, you get to exclude (deduct) them from your income in the year they're made.
  • While the money is in your HSA and invested, your investments can grow and compound on a tax-deferred basis. You won't have to pay any capital gains or dividend taxes each year on your investment profits.
  • Finally, if the money in your HSA is used for qualified healthcare expenses, your withdrawals are 100% tax-free as well.

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.

What if you don't need all of the money for healthcare costs?

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.

A great way to manage your healthcare costs in retirement

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.

If you're eligible for an HSA, take advantage

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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