Health Savings Accounts: Are They Just What the Doctor Ordered?
Many individuals are concerned about the high cost of medical insurance premiums and how to pay for escalating medical expenses. It is estimated that a couple retiring in 2018, both age 65, should expect to spend out-of-pocket an estimated $280,0001 on healthcare over their estimated lifetimes. One possible solution to the high cost of health insurance in retirement is to take advantage of a health savings account (HSA).
What is an HSA?
An HSA is a savings vehicle with special tax advantages that is used in conjunction with a high deductible health plan (HDHP). Both were created by the Medicare Modernization Act of 2003.
What is an HDHP?
An HDHP is a medical plan which has a minimum annual deductible in 2018 of $1,350 for individuals or $2700 for families, and a maximum out-of-pocket of $6,550 for individuals or $13,300 for families. The HDHP is permitted to include preventative care such as annual physicals which are not subject to the deductible. Also, the individual cannot be covered by any other health plan and cannot be claimed as a dependent on another person’s tax return.
HDHPs are attractive because they have lower premiums than traditional health insurance. The premiums are lower because you are paying for first dollar coverage out of your pocket. For example, the annual premium for an individual may be $1,881.66 for an HDHP, versus a low deductible plan with a premium of $3,597. Also, with an HDHP you will take on more responsibility because you may need to research costs when paying out-of-pocket expenses.
How Does an HSA WORK?
HSAs are portable, meaning your account stays with you if you change employers or leave the work force. There is no “use it or lose it” attached. You can use your account to pay for current qualified medical expenses, or let your account grow for future medical expenses. Your contributions are tax deductible and can be made by yourself, your employer, or your family members. The HSA is the “trifecta” of the investing world:
- Contributions are tax deductible;
- Earnings are tax–deferred; and
- Distributions for qualified medical expenses are tax-free.
What are Qualified Medical Expenses?
IRS Publication 502 contains a list of allowable expenses including dental care, chiropractic care , managed care deductibles and co-pays, and capital expenses to increase medical access to a home, to name a few. Although you cannot use the funds to pay regular health insurance premiums, you can use it to pay for COBRA, Medicare Part B and Part D, and qualified long-term care (limits do apply).
How Can an HSA Help You Save on Taxes?
Contribution limits for 2018 are $3,450 for individuals and $6,900 for families. There is a special catch up provision permitting an additional $1000 contributions for insured individuals over the age 55. So, a family with two individuals both over the age of 55 can contribute a maximum of $8,900. Any amount that your employer or family member adds to your HSA is deducted from your total eligible contribution limit. You can claim a tax deduction even if you do not itemize your deductions on Schedule A, and your contributions can be made until April 15 of the following tax year.
There is a 20% penalty plus income tax due on any distribution that is not made to pay for a qualifying medical expense prior to the age of 65. Over the age of 65 there is no penalty, but you would pay income tax on distributions for non-qualified medical expenses.
Should I Save in my 401k or HSA?
When considering how to save for retirement, there are more options available than traditional retirement plans. While HSAs and 401(k) plans have some things in common, there are also differences that many people aren’t aware of. Both plan types allow you to contribute pre-tax dollars by deferring salary, to save towards your retirement. As stated earlier, in the case of an HSA, the funds must be used for qualified medical expenses. 401(k) plans allow you to defer up to $18,500 of your salary in 2018 ($24,500 at age 50 or over, including a catch-up component). 401(k) plans allow for penalty-free withdrawals at age 59 1/2, subject to ordinary income tax. Withdrawals from HSAs are penalty-free starting at age 65 and are not subject to taxation if used for qualified medical expenses.
HSA rules allow funds to be carried over indefinitely, with the triple benefit of funds going in tax-free, growing tax-free, and coming out tax-free, as long as they are used for qualified medical expenses. This contrasts with 401K distributions where, depending on your age and the plan provisions, you may have an IRS penalty when withdrawing the funds, and any withdrawal will be taxed at your ordinary income rate.
HSA contributions made from payroll deductions are truly pre-tax in that Medicare and Social Security taxes are not withheld on those deductions, in contrast to pre-tax 401(k) contributions, which are subject to both Medicare and Social Security tax. Both pre-tax 401(k) contributions and HSA payroll contributions are not subject to state or federal income tax.
There are no requirements to take minimum distributions at age 70 ½ from HSA accounts as there are for IRAs and 401(k) plans (although those distributions may differ according to your company’s plan and if you are a 5% owner of a company). Any unused balance in an HSA can be passed on to a spouse, and the spouse can continue to enjoy the same tax-free use of the account for qualified medical expenses.
If you take advantage of the benefits of an HSA, you should still make sure that you continue to contribute the percentage that will allow you to receive the maximum company match to your 401(k) plan, if offered. There is no substitute for receiving an instant return on your investment tax-deferred.
There is a tax rule that allows for a one-time tax-free transfer of funds from your retirement plan to an HSA. This is not the same as a rollover to a qualified retirement plan, as the rollover to the HSA counts toward your annual HSA contribution limit. It does allow you to move a small amount of money from a retirement plan where you would have to pay taxes on withdrawals for medical expenses, to the HSA where withdrawals for such purposes would be tax-free.
So if we lived in a perfect world, you would strive to fund your 401k and HSA to the maximum allowable annual contribution limit each year. If you are faced with limited dollars to defer, it pays to analyze your options regarding your own personal situation to maximize your tax saving and retirement dollars. After you do your analysis, maybe the HSA is just what the doctor ordered.
*Fidelity Healthcare Study 8/16/2016
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Any opinions are those of Tim Neuville and Jill Hoenings and not necessarily those of RJFS or Raymond James.
The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional.