This Open Enrollment Season, Ask About a Health Savings Account
By Zeke Anders on September 15, 2023
We’ve discussed Roth IRAs before, and how the tax-free earnings can be a tool for managing taxes in retirement. But is there an account out there that is better than a Roth? There might be, and arguably it is the Health Savings Account. To clear up a common source of confusion, a Health Savings Account is different from a Flexible Spending Account. A Flexible Spending Account (FSA) is also a pre-tax account for health expenses, but it is a use-it-or-lose-it account. Any funds left over at the end of the plan year may be lost, so it is crucial to be conservative with your contributions and estimate your health expenses accurately. A Health Savings Account (HSA), on the other hand, is not use-it-or-lose-it. An HSA balance rolls from year to year if you don’t use it, and can even be invested, usually above a minimum balance requirement. Not everyone has access to an HSA and there are some rules to be eligible to contribute to one.
The most important rule is that your health insurance must be exclusively a high deductible health plan. In healthcare insurance, the “deductible” is the amount of costs you pay out of pocket before your insurer Medicare does not qualify, so once you file for Medicare you will not be eligible to contribute to an HSA any longer, but you can keep an existing HSA. If you are still working, your Human Resources department can help you determine if your healthcare plan is eligible for an HSA, but the IRS definition of a high-deductible health care plan has a minimum deductible of $1,500 for individual care or $3,050 for a family, and a maximum deductible and other out-of-pocket expenses of $7,500 for individual care or $15,000 for a family in 2023[1]. Some employers offer you a choice between a high-deductible, HSA eligible healthcare plan, and a lower deductible, non-HSA-eligible healthcare plan. The right option for you will depend on your physical and financial situation. If you anticipate having high medical expenses, a lower deductible plan might be better for you. If you have lower expected medical expenses, then considering a high-deductible plan to contribute to an HSA might make sense. Again, you must be exclusively covered by the high-deductible healthcare plan. If you use a secondary insurance plan, such as through a spouse’s employer, which is not a high-deductible plan, then you will not be eligible to contribute to an HSA. If you are married, you’ll also need to consider your spouse’s healthcare options and needs, as there are different contribution limits for an individual versus a family, which we’ll cover later.
Once you know that you are eligible for an HSA, you’ll want to consider the benefits of contributing to one. Contributions are pre-income tax and, unlike 401(k) contributions, are excluded from U.S. payroll (FICA) taxes as well. Above a certain amount, you can invest the funds in your HSA, like a 401(k). That allows your HSA to grow tax-deferred. Finally, if you use your HSA funds for qualified medical expenses, your withdrawals will be tax-free. That’s a triple tax advantage, pre-tax contributions, tax-deferred growth, which becomes tax-free if used for qualified medical expenses. No other account has all three benefits. Even if you contribute to an HSA and immediately withdraw the funds, you’ll get the benefit of pre-tax contributions and tax-free withdrawals. Investing your HSA has the potential to dramatically increase the tax benefits, however. An invested HSA balance of $10,000 earning 7% per year could grow to $19,671 in 10 years, $38,696 in 20 years, and $76,122 in 30 years[2]. Investment returns are not guaranteed, but with compound interest an invested HSA can provide a significant source of tax-free funds in retirement. There is a long list of qualified expenses, include prescription drugs, certain long-term care costs, even everyday items such a hand sanitizer and sunscreen[1]. A limited amount, based on your age, can even be used for qualified long-term care insurance premiums[2]. There are many opportunities to use your HSA funds. Like all good things, though, there is a catch.
If you take non-qualified withdrawals from an HSA before age 65, you’ll owe taxes and a 20% penalty. That is a longer period than a 401(k) or IRA, where the penalty ends at 59 ½, and it is a higher penalty (20% versus 10%). At age 65, however, an HSA can be treated like a Traditional IRA, and withdrawals for non-qualified expenses will be taxable, but have no penalty. From another perspective, an HSA is more liquid than an IRA or 401(k), since you can access the funds tax-free and penalty-free for qualified medical expenses at any time. This can be valuable in a medical emergency, which is exactly when you might need an unplanned distribution. Additionally, there is currently no time limit on reimbursement for medical expenses you pay out of pocket, then withdraw from an HSA later. For example, let’s say you opened an HSA account this year, and then incur medical expenses in 2024, but pay out of pocket. If in 2026 you find you need some cash, you could reimburse yourself for the 2024 expenses if you kept the receipts. The distribution would still be considered “qualified” and you wouldn’t owe taxes or a penalty. This can let your investments grow for years before you reimburse yourself. While the penalty on non-qualified distributions should be a significant factor in deciding whether to contribute to an HSA and how much to contribute, the funds are accessible without penalty for certain expenses and after age 65.
Like other tax-advantaged accounts, contributions to an HSA are limited each year. For 2023, the contribution limits are $3,850 for self-only coverage, and $7,750 for a family[3]. Individuals age 55 or older can contribute an additional $1,000. The limits for 2024 are $4,150 for an individual, and $8,300 for a family, plus $1,000 for individuals over age 55. The deadline to make 2023 contributions to an HSA is April 15, 2024. As mentioned above, for families it is important to consider everyone’s healthcare needs and options. If one spouse uses coverage from a high-deductible plan, they’ll be limited to the “self-only” contribution amounts. If both spouses are covered by a high-deductible plan, they can use the “family” contribution limits. But if one spouse has higher healthcare expenses than the other, it might make sense to use two different health plans to balance access to an HSA for one spouse and a low deductible plan for the spouse with higher healthcare expenses. You also want to consider whether your employer will contribute to an HSA, either through matching contributions or a flat amount.
One last note regarding HSA beneficiaries. If your spouse is the beneficiary of your HSA, he or she keeps the beneficial tax treatment of the account. For any non-spouse beneficiaries, however, the HSA funds they inherit will be fully taxable, unlike a Traditional IRA which can be spread over 10 years. For that reason, it might be a good idea to try to use up your HSA during your lifetime or leaving it to charity if you have philanthropic wishes.
While not as well known as 401(k)s, Traditional IRAs, Roth IRAs, or 529s, Health Savings Accounts may offer the best tax benefits of any account type. They offer a triple tax advantage of pre-tax contributions, tax-deferred growth, and tax-free distributions for qualified expenses. Not everyone is eligible to contribute to HSAs, such as those enrolled in Medicare, but if you are still working it is worth asking your Human Resources department if there is an HSA-eligible healthcare plan, and considering whether an HSA helps you achieve your goals.
[2]Author’s own calculations
[3] https://www.irs.gov/forms-pubs/about-publication-502
[5]https://www.fidelity.com/learning-center/smart-money/hsa-contribution-limits
Zeke Anders – Planning Specialist | zanders@twickenhamadvisors.com
Disclaimer
Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.
